What’s better: Knowing the price of something or knowing with perfect information how much
something should cost?
It’s a trick question.
Suppose there are two farmers – Al Trewis and Moe Cashferme.
Each has 500 acres of land that could grow either corn or soybeans.
Suppose I ask what their plans are.
Both of them text back, “I don’t know.”
Now suppose we borrowed a crystal ball from some genie and we know everything.
Among the things the crystal ball can tell us are that Brazil has had a terrible summer
with drought then late floods that wiped out 40% of their soybean crop.
It also tells us that new uses for soybean curd have pushed up demand for soy paste all
over Asia.
Meanwhile, corn crop yields have hit record highs all over the world and, at the same
time, several countries ended their corn-based ethanol programs leading to an extraordinary
corn surplus.
Our first farmer, Al, has to decide what to plant.
Al never wanted anything for himself.
All he cares about is doing what’s best for all of humanity.
He does research trying to decide which crop will be better for humanity as a whole, but
it’s hard for Al to determine which information is most relevant because he doesn’t trust
price information and the knowledge that he need is too dispersed, too specific, and too
hard to learn.
Now Al knows a lot – but still not enough.
He’s stuck at, “I don’t know.”
So he makes a guess, plants corn.
Al’s put a tremendous amount of time and resources into his research instead of focusing
on what he’s good at – running a farm.
As a result, he doesn’t get much corn planted, has a hard time selling the corn he does produce.
He has to sell for very little and ends up bankrupt.
Let’s look at Moe’s experience.
Since he cares only about profits, he focuses on prices.
In early February, the price of corn futures falls sharply, but soy futures indicate that
prices for soy delivered in August should be excellent.
Why did this happen?
Moe has no idea and he couldn’t possibly care less.
Moe sells a large soy futures contract to lock in the high price and plants soy on every
square inch of land that he owns.
It’s a selfish bet, one that’ll make Moe a lot of money.
Instead of trying to be an expert in all the disparate subjects he’d need to master to
have perfect information about the marketplace, he just focuses time and resources on running
his farm.
And the only other information he used was prices.
So he produced a lot of soybeans and did well for himself.
Which of the two did the right thing, the better thing for society?
What would the genie with the crystal ball have told us?
The genie would have looked at the glut of corn and the shortage of soy that made it
so valuable and told us what people need is more soy.
But of course, there’s no such thing as genies in the real world.
Information is too dispersed, too complicated, to solve the “IDK” problem through research.
There’s just too much to know.
Fortunately, farmers don’t need a crystal ball because prices do exactly what we were
hoping the genie would do.
Farmers don’t need to know why a price is high or low, and in fact no single person
could possibly explain it fully.
But by growing the crop that produces the greater profit, farmers can produce the crop
that solves the shortage, meets the demand, and satisfies the requirements of innovation.
It’s impossible to attain perfect information about the entire marketplace, which is changing
all the time.
Prices are a way of condensing all that information to one easily understood signal.
Almost like magic.