What if There Were No Prices? Railroad Thought Experiment

Release Date
November 5, 2015

Topic

Basic Economics Economics
Description

What if there were no prices? How would you use available resources?
To appreciate why market prices are essential to human well-being, consider what a fix we would be in without them. Suppose you were the commissar of railroads in the old Soviet Union. Markets and prices have been banished. You and your comrades. Passionate communists all. Now, directly plan how to use available resources.
You want a railroad from city A to city B, but between the cities is a mountain range. Suppose somehow you know that the railroad once built. Will serve the nation equally well. Whether it goes through the mountains or around. If you build through the mountains, you’ll use much less steel for the tracks.
Because that route is shorter. But you’ll use a great deal of engineering to design the trestles and tunnels needed to cross the rough terrain. That matters because engineering is also needed to design irrigation systems, mines, harbor installations and other structures. And you don’t want to tie up engineering on your railroad if it would be more valuable designing those other structures instead.
You can save engineering for other projects. If you build around the mountains on level ground. But that way you’ll use much more steel rail to go the longer distance and steel is also needed for other purposes. For vehicles, girders, ships, pots and pans and thousands of other things.
Which route should you choose for the good of the nation? To answer, you would need to determine which bundle of resources is less urgently needed for other purposes. The large amount of engineering and small amount of steel for the route through the mountains, where the small amount of engineering and large amount of steel for the roundabout route.
But how could you find out the urgency of need for engineering and steel in other uses? Find out more as Professor Howard Baetjer Jr. from Towson University explains market prices through the railroad thought experiment.
 

The Essential Hayek (website): A project of The Fraser Institute, serving as a resource for the life and works of Freidrich Hayek.
“What Do Prices ‘Know’ That You Don’t?” (video): Professor Mike Munger explains how prices convey knowledge about scarcity and need.

To appreciate why market prices are essential to human well-being, consider what a fix we would be in without them. Suppose you were the commissar of railroads in the old Soviet Union. Markets and prices have been banished. You and your comrades. Passionate communists all. Now, directly plan how to use available resources.
You want a railroad from city A to city B, but between the cities is a mountain range. Suppose somehow you know that the railroad once built. Will serve the nation equally well. Whether it goes through the mountains or around. If you build through the mountains, you’ll use much less steel for the tracks.
Because that route is shorter. But you’ll use a great deal of engineering to design the trestles and tunnels needed to cross the rough terrain. That matters because engineering is also needed to design irrigation systems, mines, harbor installations and other structures. And you don’t want to tie up engineering on your railroad if it would be more valuable designing those other structures instead.
You can save engineering for other projects. If you build around the mountains on level ground. But that way you’ll use much more steel rail to go the longer distance and steel is also needed for other purposes. For vehicles, girders, ships, pots and pans and thousands of other things.
Which route should you choose for the good of the nation? To answer, you would need to determine which bundle of resources is less urgently needed for other purposes. The large amount of engineering and small amount of steel for the route through the mountains, where the small amount of engineering and large amount of steel for the roundabout route.
But how could you find out the urgency of need for engineering and steel in other uses? Just one way engineering is used is to build irrigation systems. To assess the importance of a particular irrigation system, you would need to know what the farmers know about how irrigation would increase the yield of their fields.
And to know the value of that increased yield, you’d need to know what grocers know about their customers eagerness for that produce. That in turn depends on what customers know about the better meals they could fix with that produce. How would you find all this out? Just one way to use steel is to build new trucks.
To assess the importance of a particular new truck, you would need to know what the trucker knows about the capacity of his current truck, and how much more quickly he could make the deliveries his customers want with a new bigger truck. To know the importance of those deliveries, you would need to know what his customers know about the value of getting goods delivered.
That in turn depends on what still others know about the uses of those goods at their destinations. To reason about where to route the railroad, you need this kind of information for all possible uses of engineering and steel. That’s a massive amount of knowledge, held by millions of people throughout society.
How might you get it? You might try surveys, but think how many people you would need to survey. All those who prepare meals with produce, and all those who take delivery by truck for starters. The numbers would be staggering. And often people don’t even know what they prefer until they face an actual choice.
So they might not be able to answer survey questions accurately. Even if they could, by the time the surveys were returned and processed, much of the information would be out of date. And even if you could get complete and timely information about what everyone knows, that’s relevant to every use of steel in engineering, you would still need to deduce from it where to build the railroad.
How would you begin to make sense of that mountain of data? In the words of Ludwig von Mises, you would be groping in the dark. You would face what is known as the knowledge problem of central planning. The reason why comprehensive socialism inevitably fails. Central planners cannot get the knowledge they need in order to plan effectively.
You, commissar, simply cannot know on what projects scarce resources should be used for the good of the nation. But now change the thought experiment. Imagine that somewhere in the market economy part of the world, you are the chief operating officer of a railroad company. You work not for the good of the nation, but to generate profits for your firm.
You want to run a railroad line from city C to city D. Again, there’s a mountain range between them. Now, how do you decide on the route? You choose what’s cheapest. You would calculate the total cost of each route for each one, multiplying the amount of engineering required by the price of engineering, and adding that to the amount of steel required times the price of steel.
Then, you would choose whichever cost your company less. You might give no thought at all to the good of the nation or society as a whole. But, and here’s the marvel, by choosing the route that is cheapest for your company you would thereby choose the route that’s best for society.
You would use the bundle of resources that’s least urgently needed for other purposes. Why? Because those market prices you calculate with reflects the urgency of need for engineering and steel in all their alternative uses. For example, suppose customers wanting to taste your meals, would buy better, more expensive produce, if it were on the shelf of their local grocery.
In effect, they’re offering grocers more for produce. So the grocers will offer farmers more for produce. So the farmers who feels would be sufficiently improved by irrigation will offer more for irrigation systems. And those who build irrigation systems will offer engineers more to design them. Now that designing irrigation systems pays engineers better, people who want to hire engineers for other projects, such as railroads, will have to offer them at least as much to make it worth their while.
The higher price tells everyone who uses engineering that it’s become, for some reason, more valuable so maybe they should use less. In this way, the market prices of resources represent the particular knowledge and preferences of millions of people who directly or indirectly use those resources. And the prices communicate that knowledge and those preferences to everyone interested.
Only with market prices to communicate this vast amount of human knowledge to us. Can we calculate the least costly ways of producing the things we want, coordinator activities with the activities of others, use resources where society values the most, and thereby satisfy as many human wants as possible?