 Now, a good way to appreciate the importance of market prices is to think what a fix we would be in if we didn't have market prices. So let's do a thought experiment to get at the problems we would run into in the absence of market prices. And the thought experiment I want you to do is to imagine that you are the commissar of railroads in the old Soviet Union. Because we're back in the early days, the Bolsheviks have just taken over. You are a Bolshevik. You are not one of the cynical administrators in later years. You are a passionate Marxist, eager to show the capitalist world that Marxism works better. A fervent belief in the benefits of central economic planning. The Bolsheviks have gotten rid of prices. They're trying to get rid of market prices entirely. They're planning directly for use rather than for profit and trying to operate the economy without the benefit of market prices. Central economic planning. Get away from this chaotic wastefulness of the capitalist economy where one company is trying to drive another company out of business. What absurd waste that is. Let our production be scientifically planned and put in the best locations to produce the goods we need without this chaotic wastefulness of the capitalist system. Now you're the commissar of railroads. And you know that you want to get a railroad from city A to city B. But you have a decision to make because there's a big mountain range between the two cities. And that means you have, of course, an infinite number of choices of the routes. But to keep the thought experiment simple, let's suppose you're trying to decide between going through the mountains or going around the mountains. You want to do that in the way that's best for the Soviet Union. And you know that if you go through the mountains, you're going to use a lot of engineering time because to build the trestles and the tunnels and the elaborate grading to get the railroad through the mountains, you're going to need to use the time of a lot of skilled engineers. And part of you hesitates to do that because you know your engineers are so urgently needed for lots of other things in the Soviet Union. For example, building mines, building irrigation systems, building harbor installations and all sorts of other things. And so your reasoning is that if engineering is more important on these other things than it is in the railroad, well then maybe rather than tie up all these engineers going through the mountains, I should then go around the mountains and I won't need to use so much engineering time. But if you go around the mountains, you're going to use much more steel because you'll have to lay down a lot more steel rail. Through the mountains would be shorter, you could use relatively little steel. Going around the mountains, you use a lot of steel. But you also hesitate to do that because you know steel is so urgently needed in all sorts of other uses. For example, building things mundane, things like pots and pans, the girders for hospitals and concert halls and so on, the steel for the vehicles that people need. And if steel is more important in those other uses than it is steel rails, you want to use less steel and go through the mountains and use the engineering instead. So basically you've got to decide this trade-off. Do I use more steel and less engineering going around? Because we'll imagine that on the trip around the mountains there are just a few stream crossings, so the engineering needs are minor. You use a lot of steel and less engineering, or go through the mountains and use much more engineering and less steel. You want to do what's best for the Soviet Union. You want it to be efficient for the country. Which way would you go? How would you decide what to do? I'd have to ask a lot of questions to a lot of people. You might have to ask a lot of questions to a lot of people. Like what? Well, I'd have to ask all the manufacturers of steel where they're sending their steel, how much steel they have, how much steel they produce. And then I'd also have to ask every other person in the Soviet Union who'd like steel, how much steel are you going to use, how much are you like, and then I'd have to ask how willing would you be to sacrifice this amount of steel if we used it on the railroad? Very good. Okay, so you're asking those questions to determine the urgency of need for steel. How urgently is it needed in other uses? And how abundant is it for these various uses? Good, what else might you need to know? Well, all of those questions, but with regard to engineering as well. I mean, perhaps you could look at some foreign capitalist system to see what their prices were, but they're still going to have different scarcities and different needs. Yeah, leave prices out of it. You'd need to know the urgency of need for engineers in other uses. For example, if you were considering an irrigation, the importance of engineers to build irrigation, you'd need to know things that the farmer knows, such as how much more output there would be from the fields if their fields were irrigated. So you'd need to know what difference is the irrigation going to make. But of course, you're not just interested in the output of the fields. You're interested in the value people put on those outputs. So you'd need to know what the various grocery customers know about how much they want that additional output. So you would need to know a lot of things. How would you get this information? Well, you'd have to have, assuming that you could do it, which of course you couldn't, you'd have to have a comprehensive plan for the whole country ranking all the different uses of steel and engineering time versus the output in terms of the utility for people they provide. And then you'd have to prioritize, by some kind of central committee, to determine what uses of the steel and engineering had the most priority and assign them accordingly, of course, that would be extremely difficult to do. How would you get that information? You'd have to survey everyone and ask. OK, and when you send out a survey, you send out a survey to the Babushkas of Siberia and say, how much more important to you are steel pots and pans than copper pots and pans? And they answer back, oh, much, much more, much more valuable. I'd have to ask them to assign numbers to it. You'd have to ask them to assign some sort of a ranking to it and all. OK, would this be a hard problem? Yes. This problem is known as the knowledge problem of central planning. And the knowledge problem central planning is simply that central planners cannot possibly know what they need to know in order to plan effectively. They just cannot get that knowledge. It's too complicated. So sometimes I begin this by asking students, which way would you go and why? Would you go through the mountains or around? And often there's a very long silence. And then I say to them, that's the right answer. You simply could not know which was the more efficient use, which was the more efficient route for your railroad. In the absence of all this information about the urgency of need for steel and its different other uses and engineering and its steel and other uses, that's the knowledge problem of central planning. It's one of the fundamental reasons why the Soviet Union failed, why central planning cannot work. Let's change the thought experiment slightly and keep all the physical details the same, except now you're not the commissar of railroads in the old Soviet Union, but you're the chief financial officer of a for-profit railroad somewhere in the commercialized capitalist west. And you have the same problem. And we'll assume that you have no trip difficulty getting the right of ways. Which way would you go? How would you decide whether to go around the mountains or through? Which everyone was cheaper. Which everyone was cheaper. Now I'm going to pick on you a little bit for effect. It's not met personally. Typical greedy capitalist. No concern for the well-being of the Soviet Union overall. Well, if I did. The commissar is motivated fundamentally at thinking about what's going to be the best for the success of this country overall and trying to make the decision on that basis. You, capitalist, by contrast, just think what's better from my own selfish company. By choosing what's cheaper. Hold on. I'll let you do it. Leaving more. You can take my punchline from me, aren't you? Sorry. That's fine. Good for you. Greedy capitalist. The greedy capitalist. No concern for the well-being of the nation as a whole. Just a focus on the well-being of my own company and my profits. But the wonder, the marvel of this is, go ahead. You want to do it? Just sure. By choosing what's cheaper, I'm inadvertently leaving more for everybody else to use. That's well said. By choosing what is cheaper, let's think how it works. You would have to compare. You would take the cost. You'd figure for the route through the mountains how much engineering would I need and multiply that by the price of engineering now. So that would give you what you'd have to spend on engineering. And similarly, what would I have to spend on steel going through the mountains? And what does steel cost? The steel where else costs? So you'd get a total cost for the route through the mountains. And you'd do the same for the trip for the route around the mountains and other things being equal. You would choose whichever route was cheaper. Now, what was your point there when you choose what's cheaper? You make sure that the goods that are more highly valuable by other people are conserved. Exactly right. When you choose what's cheaper, you thereby take into account all the specialized information all around the country that all the users of steel know about the importance of steel to them and the suppliers of steel know about how much they have on hand and what their production capability is. The urgency of need for engineering, the availability of engineers, because the urgency of need for steel and engineering is reflected in the price of steel and engineering. A higher urgency of need is going to translate into a higher price so that if steel is relatively more expensive, it's as if the price of steel is saying to you, hey, steel is urgently needed in a lot of other uses. If you can find a way to accomplish your purposes without using so much steel, take it. So you take the less expensive route using less steel and more engineering. You are thereby taking into account all the urgency of need elsewhere in the country and doing what is best for the rest of the country. You are conserving on things that others need more urgently. And the price system in this, I'm tempted to call it, miraculous way guides people in this manner to accomplish their purposes in ways that dovetail nicely with others' efforts to accomplish their purposes using scarce resources. That's the beauty of the price system.