We need to understand how it is
that a free market works
to enable millions of people
to cooperate peacefully together.
I know no better way to bring this out
than by a very simple example
that I owe to an old friend of mine Leonard Reed,
who once wrote a little article
called I, the Pencil.
You know, it's a funny thing, he said,
there's nobody in the world who knows
how to make a pencil.
Now that seems like a silly thing to say, isn't it?
This is just the most obvious thing.
It's only a piece of wood with
with something black in the middle
and a little red tip at the end.
What do you mean, nobody knows how to make a pencil?
Well suppose you were to start to set out to make a pencil.
First of all, you'd have to get some wood, don't you?
Where do you get the wood?
You have to go to the Pacific Northwest,
probably, and cut down some trees.
How do you cut down some trees?
You have to have some saws to cut it with.
Where do you get the saws?
You have to have some steel. Where do you get the steel?
You have to have a steel mill.
In order to have the steel mill, you have to get the iron ore.
And you can add all the rest.
So, in order to know how to make a pencil
you would have to know
everything there is to know about how to start from
iron ore and coal, and get iron and
convert it into saws and cut down trees.
But that's only the beginning.
This black stuff in the middle that we call lead, isn't lead.
It's graphite I think,
I'm not absolutely sure
and I'm told it comes from some mines in South America.
So, in order to get that black stuff in between
you would have to take a trip down to South America
and know all about how to extract
graphite from the mines in South America.
Now this little red tip at the top, that's rubber.
Where's it come from?
Well, the major source of natural rubber is Malaya.
But what happens when I go down to the store
and I put down a quarter and get two of these pencils?
I am trading with thousands of people all over the world,
people in Washington state who are cutting down trees,
people in South America, people over in Malaya.
How is it that they are led to cooperate with one another?
That's the miracle of the price system.
Because note, these thousands of people
who have been led to engage
in this simple transaction with me,
not one of them has been forced to do it.
Nobody has had a gun to his head
They've all done it, why?
Because each one of them thinks
he's better off in this transaction.
And somehow or other I've done it
because I think I'm better off.
Everybody has benefited,
there's been no central direction,
these people who have cooperated with one another,
don't speak the same language,
they're people of all different religions,
they may hate one another in every respect.
But this hasn't prevented them, somehow or another,
from being led to cooperate together.
It hasn't prevented some kind of wonderful machinery
from bringing together,
these various components all together,
into this little pencil.
What is that machinery?
What is it that has induced people to do this?
How has it been brought about?
That machinery is the price system.
That machinery is what the story is all about.
And, as a result, the price system enables you
to have cooperation among millions of people peacefully,
cooperating on one little phase of their life,
while each one goes about his own business
in respect to everything else.
It works so well, it works so efficiently,
that ordinarily we're not aware of it.
The price system operates in this way
because it doesn't require orders.
It operates in this way because it can transmit information
in a very efficient way
without any person having to send an order.
What happens if you, or the rest of us,
want to get some more pencils?
Well, the people who are manufacturing pencils
suddenly discover that they're making some money.
And they say, we'd better make some more pencils.
Nobody has told them about that.
They've just discovered it down at the corner drugstore.
And they, in turn say, send out some orders
to people who are making, producing the wood,
to the people producing the rubber.
The effect of this is to raise the prices a little
all the way down the line
for the particular items in demand,
and that higher price becomes a signal
to people all over the world
that there's a greater demand,
a greater desire for this particular object.
And the only people who have to know about it
are the people who are in a position to provide
the additional wood, or the additional graphite,
or the additional rubber.
So the information is transmitted economically
and efficiently.
And it's transmitted to those who need it
from those who need it.
In the second place, the information combines with it
an incentive to act on the basis of that information.
It's no good, sending out a message to people
"we need more wood"
but we're only going to pay you the same amount we did before.
You're not going to get anything out of it.
Well, so you need more wood? Fine.
That's the end of it.
The beauty of the price system
is that, along with this information,
and this is the second stage,
goes an incentive to act on the basis of it.
Because the man who is selling wood,
if the price has gone up a little,
well he figures he can make a little more money in that way.
So he has an incentive to act on it.
And that incentive is there
because his income is ultimately going to be determined
by the prices of the things he sells.
The price system can operate
to coordinate the activities of millions of people
around the world because it combines three functions.
The function of transmitting information,
of providing an incentive for people to act
on the basis of that information,
and last, but not least,
a mode for distributing the product of that activity.