Prices Communicate Dispersed Knowledge

Howard Baetjer: Thank you all for coming today, for being an audience for me. In this section of the course, I’m going to go over what, out of my economics education, I’ve come to see as the three fundamental principles that underlie why free markets are good for human beings.

And so I’ll go over these [00:00:30] three in the coming lectures but just to let you know what’s coming, the first principle is that human beings need the information that’s conveyed by market prices. With market prices to rely on we stay well coordinated with one another.

That’s the point, that’s the first of three points.

The second is the importance of profit and loss. The feedback of profit and loss provide guidance to entrepreneurs [00:01:00] as to what they should do to serve other people. Its a necessary feedback system, that’s the point - that’s the second major point I’m going to give you.

And the third one has to do with incentives and institutions. And the claim is going to be that the free market, free society institutions of private ownership, freedom of exchange, have with them much stronger, [00:01:30] better incentives for people to pay attention to the well being of others then the corresponding more big government institutions of government ownership. And restriction of exchange. Restriction of people’s freedom to exchange. Even when the intentions of those are good.

So that’s what’s coming up and we’ll get right into it now beginning with the talk on prices, knowledge, and coordination. Okay?

[00:02:00] And I’ll do as I always do, and rely on the brilliance of Leonard Read in his wonderful essay, “I, Pencil” as a jumping off point. Okay. So now, for, with for you guys having read up to the point where Leonard Read’s says, the little header is “No one knows” let me ask you to tell me- what are some of the different materials that go into making a pencil, that you can remember? What are some of the different skills that go into [00:02:30] making a pencil?

All right, let’s start with materials. Can you remember it well enough? You guys who read it a while ago? What are some of the things that go into making a pencil?

Student: Well the most obvious one is wood.

Howard Baetjer: Wood. Cedar of a straight grain that grows in Northern California.

Student: There’s graphite mined in Sri Lanka.

Howard Baetjer: Graphite mined in Sri Lanka. Graphite goes into the lead of the pencil, which contains no lead at all. What else?

Student: Rubber trees.

Howard Baetjer: Rubber. To make the eraser. What else?

Student: [00:03:00] There’s the metal that goes to hold the eraser onto the little … [crosstalk 00:03:04]

Howard Baetjer: The metal, the little ferrule, which is made of brass. And brass is made of … ? Zinc and copper. So we need people to mine zinc and copper. What else can you remember?

Student: Paint.

Howard Baetjer: Paint. The lacquer. Which is made by very complex process itself. All right good, that gives us the idea.

Lest go to some of the skills involved in making a pencil then. What are some of the human skills that are needed to make a high [00:03:30] quality, modern pencil?

Student: Well, you need all sorts of productive skills …

Howard Baetjer: Such as?

Student: Things like, cutting down the wood and shaping it.

Howard Baetjer: Lumbering.

Student: Pouring out and making the little tubular piece of graphite

Howard Baetjer: Right, there’s a needle.

Student: But you also need all sorts of folks to support these people.

Howard Baetjer: That’s right. Well, lets just stay with initially just with the machinery, the processes for making the pencil. Yes we need lumbering to produce the wood. [00:04:00] What else?

Student: Mining. For …

Howard Baetjer: Mining. To produce the zinc and the copper.

Student: And the graphite.

Howard Baetjer: And the graphite, and various other things.

All kinds of metallurgy. To produce the zinc and the copper. Refine these things. They’re all, in one paragraph, there’s all sorts of delightful chemical names of chemicals that I don’t know. Like cadmium-​sulfite, and ammonium-​hydroxide, and hydrogenated natural fats, and there’s castor oil and so on. So all sorts of chemistry involved in it also.

Then there’s the transportation. [00:04:30] The leads are baked at 1,850 degrees Fahrenheit, somebody had to make the kiln. Somebody had to operate the kiln. The slats of wood before they’re cut into pencils are kiln dried. So the general point then is there are all kinds of skills that go into making a pencil. And having presented that, Leonard Read asks this question, want to read it for me? “Does anyone?“

Student: Does anyone wish [00:05:00] to challenge my earlier assertion that no single person on the face of the earth knows how to make me?

Howard Baetjer: And we’ll pause there and see if any of you want to challenge that assertion? On the face of it, quite a remarkable assertion. No single person on the face of the earth knows how to make a pencil. Do you agree with him, has he persuaded you?

There is so much involved in all of the different steps that its almost inconceivable that any one person could do it all. [00:05:30] My students, my undergraduate students, sometimes say- well if somebody made a life study of it, they could learn it all.

Well I think perhaps that’s true. But do you suppose there is any one such person now who knows all of that? Certainly not. Okay.

Student: Even if they did, they’d be incredibly inefficient. It goes the Adam Smith pen example.

Howard Baetjer: That’s true. That’s true they still would be inefficient.

Actually, when you raise that, it seems to me, I come back to the idea that they simply couldn’t do it. Because the inefficiency [00:06:00] would be … they couldn’t make a high quality modern pencil without all the efficiencies that come with the advanced machinery. Which they couldn’t produce. Okay. Lets go on from there then. This raises three questions for us. Let me see that again, let me remind myself of what’s there. Okay. Will you read the next paragraph please?

Student: Of course. Actually, millions of human beings have had a hand my creation. No one of who even [00:06:30] knows more than a very few of the others. Now you may say that I go too far in relating the picker of a coffee berry in far off Brazil and few growers elsewhere to my creation. But this is an extreme position. I shall stand by my claim. There isn’t a single person in all these millions, including the president of the pencil company, who contributes more than a tiny, infinitesimal bit of know-​how.

From the stand point of know-​how, the only difference between the miner of graphite in Ceylon, and the logger in Oregon, [00:07:00] is in the type of know-​how. Neither the miner nor the logger can be dispensed with, anymore than can the chemist at the factory or the worker in the oil field, paraffin being a bi-​product of petroleum.

Howard Baetjer: Okay. This takes us to one, the first of three lessons I am going to draw from this piece. And that’s going to lead to a main question that underlies the whole talk. Where in the world is the knowledge needed to make pencils?

Student: In human minds.

Howard Baetjer: In human minds but where [00:07:30] geographically? In what minds?

Student: It’s distributed, across the entire world.

Howard Baetjer: Distributed all over the place. So that’s the first insight that comes out of this. The knowledge that we need to have even something as simple as a high quality modern pencil, is vastly dispersed over the entire globe. Okay? Will you read the next paragraph for me?

Student: Here is an astounding fact. Neither the worker in the oil field, nor the chemist, nor the digger of graphite, or clay, nor any who mans or makes [00:08:00] the ships or trains or trucks, nor the one who runs the machines that does the nerving on my bit of metal, nor the president of the company performs his singular task because he wants me. Each one wants me less, perhaps, than does a child in the first grade.

Indeed, there are some among this vast multitude who never saw a pencil. Nor would they know how to use one. Their motivation is other than me.

Howard Baetjer: Okay lets pause there, look up, what’s he about to say? What is there motivation? If the people involved aren’t interested in making pencils, what are they doing it for? What’s [00:08:30] their motivation for participating?

Student: Profit.

Howard Baetjer: Profit.

Student: The exchange of goods and services.

Howard Baetjer: The exchange of goods and services.

They want to make a living for their family … the reason I hesitate on profit, is profit is sort of an economic category. They want to their wages. Their income. Their reward for it. Continue please.

Student: Perhaps it is something like this- each of these millions sees that he can thus exchange his tiny know-​how for the goods and services he needs or wants. [00:09:00] I may or may not be among these items.

Howard Baetjer: Okay, so then to the second of three lessons I want to draw from this: people are self-​interested. They’re engaging in their different activities, not because they love other people all the way around the world, but because they want to benefit their own families, to benefit their own churches perhaps, to have a better house, braces for their kids, whatever it might be. They are self-​interested.

So the knowledge is dispersed, people are self-​interested. [00:09:30] The last paragraph?

Student: There is a fact still more astounding, the absence of a mastermind, of anyone dictating or forcibly directing these countless actions which bring me into being. No trace of such a person can be found. Instead we find the invisible hand at work. This is the mystery to which I earlier referred.

Howard Baetjer: Okay, so the third lesson that comes out of this is that nobody is in charge.

Now put those three together. [00:10:00] The knowledge we need in order to make goods and services like pencils is spread out all around the world. Everybody involved is out for him or herself. And nobody is in charge.

It ought to be a recipe for chaos, right? When you look at it that way.
So it raises the question, what holds it together? If there’s nobody in charge directing the operation from the top, how do all the people involved in it know what to do?

[00:10:30] Its a really cool question. And to me, its one of the things that first attracted me to economics. In my opinion, its one of the coolest things in the human experience. How does it work? If the knowledge we need is allover the place, everybody is out for herself, and nobody is in charge, what provides the coordination? That’s the question. What provides the coordination?

Let me expand on this a little bit. For example, the timber growers. How do they know to produce [00:11:00] the right amount of cedar? Why don’t they get confused and produce too much pine or oak or maple instead? What tells them, in effect, when we need more cedar and when we need more pine?

There’s got to be something to direct them otherwise we pile up surplices of one kind of timber, and have shortages of another.

What is telling them how much of each kind of wood to produce?

Cedar, which is used in the pencils, is also used in cedar shingles, and cedar pickets, [00:11:30] the picket fence around my house is made of cedar. Cedar shingles, cedar picnic tables, there are all sorts of different uses of cedar. What makes it so that the right amount of cedar goes to making pencils and shingles and picnic tables and pickets?

What directs the cedar to all these different uses? What tells people what’s needed where and how much and when? What provides the coordination? I’ll take an answer from you, [00:12:00] what provides the coordination?

Student: Prices?

Howard Baetjer: Prices does. The every changing prices of all the different chemicals and metals and indeed the skills because the salaries that skilled personnel make, or the prices of their specialized labor, what provides the coordination is prices.

Now, an important idea in this regard is the idea of spontaneous order. There is a terrific orderliness to this process of making pencils, to the economy [00:12:30] overall. But its a spontaneous order. And that’s a term that we all should remember. Spontaneous order.

In the words of the great Scottish philosopher and political economist Adam Ferguson, it’s the result of human action but not the execution of any human design. There are other kinds of spontaneous order that we can be aware of. In the natural world, snowflakes are spontaneous orders.

They’re wonderfully orderly, [00:13:00] right? Each one is a perfectly six sided crystal with identical sides. Where did that orderliness come from? Was there a designer? Sometimes it may be possible to conceive of the Almighty as being just a really creative God who’s, oh I have an idea for another one and all these gazillions of snowflakes, each one individually designed. Probably not, probably its just a consequence of the spontaneous action of water vapor under certain conditions [00:13:30] of humidity and temperature and air pressure that causes these things to crystallize in different ways.

Another very important spontaneous order is language. Its wonderfully orderly, the grammarians can tell us the rules we follow to change a declarative sentence into an interrogative sentence. But nobody designed language, it just evolved, it grew out of the interaction of people over a long period of time. And [00:14:00] that’s the nature of a market economy also, its wonderfully orderly. But the order wasn’t designed, it just happened.

Think how orderly it is. Is there any of us that has any doubt that at lunchtime when we break, we can walk down to the closest drugstore and buy a pencil? In fact, wouldn’t we be astonished to find, if we got there that they didn’t have any pencils? We’d think what is wrong with … this is nuts, they don’t have any pencils?

But think what that implies about our expectations [00:14:30] of how orderly it will be. The right amount of goods get to the right places at about the right times and nobody is in charge. Its a very cool thing. And its peoples responses to ever changing prices that is behind it.

All right, that is the end of this part of it. What we’re going to do next is go on to the question of- whether market prices should always be used or whether there’s justification [00:15:00] for controlling prices at any time?
But lets leave that for later and see if there are any questions to this point.

Student: Something that … what I think it really is that makes people suspicious of the greedy capitalists who are just out to make money is they have in the back of their minds - okay sure, if the incentives are lined up correctly, [00:15:30] so that by promoting their own self interest they will promote the interest of others, then that’s good and they’ll do it but I think what’s motivating their thought is they have a much more pervasive worry that maybe those incentives won’t always be lined up and they’ll, the first chance they get they’ll take the opportunity so that they can make money by selling healthy nutritious food to people, they will. But if they can make money [00:16:00] by poisoning people, they’ll do that too.

And they’re very worried- I think that’s the worry people have from a left-​wing perspective.

Howard Baetjer: I think that’s right, and I think its a reasonable worry. And I believe there are people out there in the world who would make money by poisoning others if they could get away with it. So we won’t have a perfect system. There will be such people in a system that is more government run [00:16:30] than free market also. There’s the danger that some of those not so nice people might get into positions of power. So … I don’t think that’s an answer. But I want to address how the market process can address this, oh suppose the capitalists try to collude with one another.

They get together and conspire against the public to raise prices. As long as freedom of entry is legal, as long as anyone is permitted to compete, [00:17:00] that collusion and raising prices opens up a space for somebody else to come in and say well I’ll offer you the product at a lower price.

So the operation of the system does depend a lot on the alertness of entrepreneurs who see something going on that’s displeasing the public, and will offer them a better alternative. It will never work perfectly, because human beings are imperfect. But there’s an overall robustness to the system, in other words, heres one way to put [00:17:30] it- to be in favor of a free market is to be pro-​market, rather than pro-​business.

Adam Smith never had anything good to say about business people. Thomas Sole used to promise an A to any student in his classes who could find anywhere in the wealth of nations anything positive that Adam Smith had to say about business people. And no one ever got an A.

So Adam Smith was suspicious of business people. [00:18:00] He thought they would try to collude against the public and get away with chiseling and so on. But he saw that if you have this overall process where consumers are allowed to choose from any of the providers available, the providers who are going to make the most money in the long run are those who get a deserved reputation of giving high quality, dependable service. And because customers will turn away from the crooks.

It won’t be immediate, people will get hurt along the way. But [00:18:30] I don’t think there’s a better way to do it. Does that address what you’re getting at?

Student: I think so. I mean, I think that’s the kind of answer I would myself give to somebody who raised those kinds of worries.

Howard Baetjer: Yeah.

Student: And I share your opinion about it, that it will never be perfect but there’s no better system.

Howard Baetjer: And its important I think for people who advocate free markets to recognize that free markets don’t work perfectly. We’re going to get to profit and loss in the next while, the process of commercial and economic evolution is a real mess. There’s failures [00:19:00] allover the place and mistakes and wasted resources. But, I’m not sure there’s any better way.