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In this lecture we examine the importance of property rights to the price system, and the role of the price system in producing the information needed to operate a modern industrial economy and to promote effective trade among individuals, firms and nations.

The fall of the Soviet Union was one of the most dramatic events of the twentieth century. Although many factors contributed to the demise of that economic system, the most basic and important was the absence of property rights to both the resources and to the outputs of the system. Here we are speaking of��3-D� property rights�those that are defined, defendable, and divestible. Because the government denied its people property rights (except in the most narrow instances), the system did not prosper and grow, but rather it atrophied and eventually collapsed.

In 1990, in a perceptive article in The New Yorker , Robert Heilbroner�an economist who had always leaned toward socialism�expressed profound surprise at the demise of the Soviet economy. 1 He revealed that he had seen the pending �political disaster,� but �it was the economic side of the Russian collapse that came as a shock,� he wrote. For awhile, he was stunned. �All we know for certain is that the system deteriorated to a point far beyond the worst economic crisis ever experienced by capitalism, and that the villain in this deterioration was the central planning system itself.� Indeed, he wrote that �the wonder is not that the Soviet economy has given out but that it went on as long as it did.� He credited that longevity to �inspired, or simply bizarre, improvisations that compensated for the underlying disorganization.�

But why such disorganization? The answer is that without property rights, and the market system and prices that property rights enable, the critical element of economic coordination is missing. The missing critical element was the constantly changing array of market prices which, in a market system, provide both the information and also the incentive to seek out and use the appropriate information. The information itself is critical, but without the incentive that automatically comes with it in a market system, the production of information is less likely to occur and, even when information is produced, the progress to be gained by using the information productively is unlikely to occur.

One of the people who understood this was F. A. Hayek. In 1945, in a now-famous essay in the leading U.S. economic journal, �The Use of Knowledge in Society,� he explained why central planning could not work. 2 This essay followed several years of what is now known as the �socialist calculation debate,� a discussion among economists during the 1930s and 1940s over whether a socialist�or central economic planning�system could function. Ludwig von Mises and F.A. Hayek argued that it could not, because there would be no prices to inform the planners. Oscar Lange argued the opposite�he claimed that the planners could simply follow inventories in warehouses. If they went up, the centrally-planned price should be lowered; if they went down, the price should rise.

But Hayek argued in �The Use of Knowledge in Society � that far more is needed than the levels of currently produced products in a warehouse. He paints a picture of an economic world that depends on fragmented, remote, and unspoken knowledge that cannot be gathered together and used by a single planner, no matter how brilliant the mind or how thorough an investigation that planner makes.

Instead, economic coordination occurs through the existence of prices. Hayek describes the �marvel� of a world integrated through market prices, which together convey almost instantly the crucial information that leads to a balancing of supply and demand. He refers to an unknown event (it could be a mine collapse; it could be a strike) that causes a shortage in the supply of tin. As soon as that shortage is felt by any seller, the price offered for tin rises; or if sensed first by a purchaser, the bid price of tin rises. The event may occur in Asia or South America, but either way, an American who is buying tin will quickly learn that the price went up.

The buyer in America doesn't have to know why the price went up. All he or she has to know is that the price is higher; in response, the buyer will immediately begin to save by economizing on the use of tin, looking for a cheaper substitutes in order to save money.

The owners of businesses using tin will gain by finding good substitutes quickly. Those who fail to do so face rising costs, which reduce their gains from owning the business. Similarly, users of products requiring tin seek substitutes as they see (or correctly predict) rising prices for products utilizing the now-more-scarce tin. This instantaneous reaction helps to funnel the tin to those who want it the most (those who have fewer good alternatives and are thus willing to pay the higher prices}. It also dampens the effects of what otherwise would be a greater price shock � or even a shortage� if prices did not react quickly to the change in scarcity. Thus is the economic system driven to efficiency, through the mechanism of prices. Prices are the vehicle of information. Private ownership of property rights mean that there are gains captured by sellers who find higher valued users, and by buyers who find the best ways to economize. Thus property rights are the enabler and the driver of the market process.

Hayek's contention was that central planners, who would not have this natural or automatic mechanism of information (and incentives) driven by price changess, would not be able to manage supply and demand to meet the demand of consumers � even assuming that the planners gave consumer demand high priority. Central governments were supposed to set prices, but they did not have the information to do so quickly or to reflect fully the constantly emerging patterns of scarcity.

A leading economics text summarizes three main functions of prices in a market system: 3

Markets register information derived from the choices of millions of consumers, producers, and resource suppliers and tabulate it into a summary statistic called the market price. This statistic reflects information about preferences, costs, relative scarcity, taking into account timing, location, and circumstances. Most importantly, prices provide consumers, producers, and resource suppliers with everything they need to know in order to make wise decisions that add to the net wealth of people in the economy.

Market prices also coordinate the choices of buyers and sellers, bringing their decisions into line with each other. Excess supply will lead to falling prices, discouraging production and encouraging consumption until the excess supply is eliminated. Alternatively, excess demand will lead to price increases, encouraging consumers to economize on their uses of the good and encouraging suppliers to produce more of it, eliminating the excess demand and bringing the choices of market participants into harmony.

As the Soviet Union failure demonstrated, people must be motivated to act before production plans can be realized. Market prices rewards those who work, cooperate with others, use efficient production methods, supply goods that are intensely desired by others, and invest productively for the future.

No government agency needs to tell business decision makers to use resources wisely (that is, minimize the per-unit cost) or to produce those goods intensely desired by consumers. Self-interest and the pursuit of profit will do these jobs. Self-interested entrepreneurs will seek to produce those goods, and only those goods, that consumers value enough to pay a price that is sufficient to cover their costs. Self-interest will also encourage producers to use efficient production methods and adopt cost-saving technologies because lower costs will mean greater profits. Firms that fail to do so, as even giant firms have learned, will be unable to compete successfully in the marketplace. Similarly, no one has to tell individuals that they should develop skills that are highly valued by others. Higher earnings will do the job.

Prices convey good information only in a system based on property rights. Property owners have a strong incentive to respond to information in the market place. Central planners do not. That is because the owner of a resource who sells to a buyer who utilizes only part of the value of the resource receives (and thus gains) much less than the owner who finds (and sells to) the potential user with the highest valued use of the resource. The potential personal gain to the owner of each resource and each product is a powerful motivator. So too is the personal gain to each consumer. That potential gain spurs each consumer to economize on resources for which prices rise, and to substitute the use of resources for which prices are falling or at least not rising as much.

Information is a valuable resource, but it is costly. Not all information can or should be gathered. The incentives that stem from private ownership guide an owner in collecting information. These incentives may be different from those of governments.

To illustrate, let's say that a private owner decides to build a landfill for garbage, perhaps to conduct a business of accepting waste from other companies and burying it underground. This owner is liable for damages if the waste deposited in the landfill leaks out and harms others. So the owner must decide how to prevent leaks and how to clean them up if they occur. The owner has to figure out how much resources � such as a clay cap or a protective plastic liner inside a clay cap � should be allocated to keeping the landfill from causing harm. Spending too little to keep pollutants from escaping could bring costly lawsuits. But spending more than is necessary imposes needless costs and wastes resources. How much should be spent? That is the question facing the owner.

To make the decision, good information is crucial. Yet gathering more information (such as finding out where the groundwater is located underneath this land or exploring which kind of plastic liner is the best) is costly.

The owner, operating in the private sector, has an incentive to gather just enough information�not too much and not too little. Why? Both the costs and the benefits of seeking more information fall on the owner. The cost of poor information leading to a poor decision is the greater liability from lawsuits brought by neighbors whose property is damaged from leaks from the landfill. The benefit of good information is avoiding increased liability and the possibility of using surface of the landfill constructively in the future. Weighing the costs and benefits of more information, the owner will not end up with perfect or complete information but seeks to make a reasoned choice based on the costs and benefits of seeking more knowledge.

In contrast, suppose that a government regulator, not the owner, has the authority to decide whether the landfill can be built.(This regulator might be a local zoning officer or a an environmental protection administrator.) In most cases, this individual will not pay for the time and resources consumed in the search for information�in fact, the regulator may simply demand that the owner supply a lot of information in order to receive a permit.

The regulator does, however, have some important incentives. If the landfill in the future causes damage, the regulator could be blamed for not being sufficiently demanding. Thus, his or her incentive will be to require as much information possible before allowing the landfill to be built. The regulator may ask for study after study to make sure that the proposed landfill will really be safe. Unlike the owner, the regulator receives no benefit�such as income from customers�by letting the landfill move into operation quickly. Not surprisingly, people running small businesses often complain that regulators are simply asking for too much paperwork.

In other words, the information-gathering process is affected by where the costs fall. It is an important duty of a good government to see that 3-D rights are in place. An alternative is to rely on government regulation, controlled politically and administered by bureaucracy. The logical extreme of such a system is socialism, in which government owns the means of production. But more common now is a mixture of private ownership in which regulators limit what property owners can do, or order them to follow certain procedures.

As we will see in more detail in Lecture 5, when regulation weakens the rights either of one who undertakes an action, or one whose property is harmed by that action, then owners no longer get the proper signals to act for the net benefit of society. For example, a regulator might demand too much or too little information.

An owner who does not have the full rights and duties of �3-D rights� might seek too little information. For example, the property rights of neighbors � including the right to be free from damage from another's property � may not be effectively protected under law. In this case, the owner may not be willing to pay the cost of preventing pollutants from leaving the site, because the costs of any harm are likely to fall on others. The incentive to seek further information is weak because the owner doesn't expect to pay the costs of making a poor decision.

Information is generated when property rights are 3-D and trade produces a working price system. But some information is also necessary to produce well-defended property rights in the first place. For example, lack of good information can make it difficult to defend a property right to clean groundwater. To protect such a right, an owner going to a court of law asking for compensation for a violation of the owner's ground water right, asking for an order to stop an ongoing violation, must provide good information to the judge in support of that case. And good information is seldom free.

Suppose, for instance, that Bill's hazardous waste contaminates groundwater when Mary owns a right to the water. In order to sue Bill successfully in a common law court of the sort found in English-speaking nations, Mary must show three things: a) she suffered the damage for which she demands compensation, b) the cause of the damage was groundwater contamination, and c) Bill was the source of the contamination. If Bill's pollution flowed underground to her groundwater, and the concern is long-term health, it may be difficult for Mary to get adequate and convincing information to prove her case.

For hazardous wastes, the effects are usually local enough that tracing the contaminants (elements b) and c) above) may not be a severe problem. But the health effects (element a) above) typically are uncertain. In the case of air pollution from my car or factory, the source (b) and (c) may be harder to trace and the health effects (a) also uncertain. This lack of good information about source and cause makes it more difficult to defend the rights of those downwind or downstream to breathe clean air and drink uncontaminated water.

Without reliable information on which to base a damage suit, courts are unable to defend property rights effectively against invasion or takings. The polluter is allowed to take something�air or water quality�which rightfully belongs to another, without consent of the rightful owner. The person who suffers pollution has not been able to defend his or her property right.

The problem of proving the source of harm and the actual harmful effects of pollution has been used to justify a great deal of government intervention in the pollution area. In the United States, for example, the failure of courts to stop harmful air pollution as quickly as many people wanted led to the passage of the Clean Air Act of 1970. This law established limits on the emissions of certain pollutants from factories and ushered in an era in which government-set regulations, not court decisions, determined whether companies were causing illegal pollution. Other laws, such as those controlling hazardous waste disposal, also set up requirements for companies to follow, regardless of whether their actions caused any harm or not.

Yet it is critical to realize that government regulators, too, face the same problem as the courts did in trying to decide how to deal with pollution. Government agencies often have no better access than the courts to reliable information about the source and effect of pollutants, which is inherently elusive. Without this information, it is impossible rationally to decide how much control is justified. Relying on regulatory controls to take the place of property rights protections against pollution may make the situation worse rather than better.

A century before Karl Marx wrote in praise of socialism, Adam Smith, the father of economics, stressed that personal self-interest, directed by the market prices that result from trading in a regime of strong property rights, is a powerful force promoting economic progress. In a famous passage in his Wealth of Nations, Smith put it this way:

Every individual is continually exerting himself to find out the most advantageous employment for whatever capital [income] he can command. It is his own advantage, indeed, and not that of the society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society. . . . He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. 4

Smith recognized the invisible hand principle: When property is privately owned, and goods and services are freely traded, the invisible hand of market prices brings the interests of individuals into harmony with economic progress.

A system of strong, privately owned property rights provides a great deal of freedom to individuals. It also restrains them from violating the rights of others, thus holding them accountable for the results of their decisions. Thus individuals, seeking to gain for themselves in the context of a price system, can economically find the information they need to produce more value for others�value they are able to trade for their own benefit. That is how free nations prosper.

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1Robert Heilbroner, "Reflections After Communism,� The New Yorker, September 10, 1990, pp. 98-100. A shorter and more easily found discussion of this topic is Robert Heilbroner, �Socialism,� in The Concise Encyclopedia of Economics , online at: http://www.econlib.org/library/Enc/Socialism.html.

2F. A. Hayek, �The Use of Knowledge in Society, American Economic Review , Sept. 1945, pp. 519-530.

3The three points are adapted from James D. Gwartney, Richard L. Stroup, Russel Sobel, and David McPherson, Economics: Private and Public Choice, 10e , (Cincinnati, OH, Thompson Learning: South-Western, 2003), chapter 3.

4Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Modern Library, 1937), p. 423.