Knowledge And Decisions

More complex operations obviously involve more complex knowledge — often far more complex than any given individual can master. The person who can successfully man a gas pump or even manage a filling station probably knows little or nothing about the molecular chemistry of petroleum, and a molecular chemist is probably equally uninformed or misinformed as to the problems of finance, product mix, location, and other factors which determine the success or failure of a filling station, and both the manager and the chemist probably know virtually nothing about the geological principles which determine the best way and best places to explore for oil — or about the financial complexities of the speculative investments which pay for this costly and uncertain process. It has been said that no one knows how to make even a simple lead pencil. That is, there is no single person who knows how to mine the graphite, grow the wood, produce the rubber, process the metal, and handle all the financial complications of running a successful business. In short, we are all in the business of selling and buying knowledge from one another, because we are each so profoundly ignorant of what it takes to complete the whole process of which we are a part.

COSTS AND INCREMENTAL SUBSTITUTION

Given the inherent factor of scarcity, any kind of economy tries to maximize the output from its given inputs — or, in other words, to get the most value for its costs. Because resources have alternative uses, and because alternative products produce consumer satisfaction, substitution is a crucial factor of economic life, both in production and in consumption. We have already noted how the same ingredient can go into many different products. It should also be recognized that many different products can be ingredients in a consumer’s sense of well-being. We normally think of physically similar things as substitutes: Plymouths and Chevrolets, rye bread and whole wheat, vodka and gin, etc. But in fact people may choose between spending their disposable cash on adding another room to the house or on taking a vacation abroad, between stocking their wine cellar and buying a season’s pass to the baseball games, or between retiring early and sending a child to college. The particular nature of the satisfactions need not be the same.

Substitution does not imply perfect substitutions. There are all degrees of substitutability: most people would consider two pints of milk as a perfect substitute for a quart of milk, but would consider a cold shower a very poor substitute for sex. How well one thing substitutes for another cannot be determined by how similar they are in physical characteristics, or indeed, by any purely objective criteria. Economists define substitutability in terms of people’s subjective preferences as revealed by their overt behavior. If a rise in the price of coffee causes people to buy more tea, then economically speaking, we can say that they are substitutes without having to investigate the chemical or physical characteristics of either. Similarly, if an increase in the price of stereo equipment causes people to buy more clothes instead, then economically these two goods are substitutes, without regard to their material disparities or even the implausibility of the connection.

Substitution takes place in production as well as consumption. Electric wires can be made of copper, steel, or aluminum, and the proportions of the three vary according to the relationship of their respective costs. Again, substitutes need not be perfect substitutes; the weight advantage of aluminum is more important for some purposes, while for other purposes any price differential will cause the immediate substitution of steel or copper. Through substitution, an economy can — in effect — transform one product into another by shifting some of their common inputs. For example, the economy can easily accomplish the old alchemists’ dream of transforming lead into gold by simply shifting the labor, machinery, and managerial skills used to make lead into the production of gold instead. From an economic point of view, it does not matter that this is not “really” transforming one metal physically into another. What matters is that a reduction in the output of one leads to an increase in the output of the other. In World War II, we transformed our automobiles and refrigerators into tanks and airplanes by this very process of redirecting resource inputs into other product outputs.