It is commonly stated in economics textbooks that the fundamental problem in economics is scarcity. We beg to differ. The fact that resources are finite, or scarce, isn't a problem--it's just a fact of life. When allocating resources, choices must be made among competing options. Economics can no more solve the problem of scarcity than it can invent a perpetual motion machine. Rather, THE FUNDAMENTAL PROBLEM IN ECONOMICS IS A LACK OF KNOWLEDGE. Not just any kind of knowledge, but the knowledge of where resources have their highest valued use. This is the primary obstacle that keeps an economy from achieving its purpose of maximizing social wealth. This is the fundamental problem that economics, and economies, must attempt to solve.

Another way of looking at this knowledge problem is to note that people are heterogeneous, that is, they have different preferences. To see the connection between this and the knowledge problem, suppose all people were alike. They liked the same foods, fashions, music, cars, etc. Then the economic planner wouldn't have to look any further than himself to know what people wanted. All he would have to do is ask himself what would give him the most happiness. In answering the question for himself, he would be answering it for all of society, since his preferences were representative of everybody else's.

Of course, people are not all alike. For example, it is incomprehensible to us why some people don't like economics. We love economics, and we're reasonable people. So how it can be that there are people out there who don't like this stuff? Go figure! People have different likes and dislikes--a fact that becomes painfully obvious to most of us at Christmas time. Indeed, anybody who has had to shop for a Christmas present for a distant relative is fully aware of how difficult it is to buy what others want. Imagine going Christmas shopping for the entire economy! Millions of people whom you've never met. Should you give Rodney Smith of Peoria, Illinois Def Leppard's new CD? Gee, what if he already has it? What if he doesn't like Deff Leppard? (Is that possible?) Maybe he only likes classical music. Maybe he doesn't have a CD player!

Different preferences are merely a nuisance at Christmas. They are a fundamental problem when allocating society's resources across millions of consumers. A person who doesn't think that lack of knowledge about people's preferences is a serious problem is a person who thinks that people have essentially the same preferences. On the other hand, if people do have significantly different preferences, then the information produced by the price system is incredibly important. Thus, the appreciation one has for the information produced in prices is directly proportional to how different one thinks people are.

Let's return to the Soviet planner of Chapter 3 who was trying to decide where and what kind of apartment complex to build. He could do a fine job of allocating resources if everyone was like him. The contractor would just have to decide what he wanted, and then order the same thing for everyone else. Of course, if the economic planners' preferences are different from his consumers' preferences, and the consumers have differing preferences amongst themselves, then the planner faces an impossible task. Should he order an extra apartment complex to be built in Moscow or St. Petersburg? Should he build family units or singles? Luxury apartments or efficiencies? He can only make these decisions correctly (i.e. in a way that maximizes happiness) if he knows how much each consumer in his market values housing. Some of his consumers might prefer more automobiles or trips abroad instead of luxury apartments. If they get luxury apartments instead of their heart's desire of a trip to Disneyland, society is made worse off.

In contrast, let's consider how a private building contractor answers these questions in a free market or capitalistic society. It seems safe to assume that the private contractor doesn't spend much time thinking about directing resources to their highest valued use. He does, however, care about the prices of the goods and services which he sells. When examining where to build a new apartment complex, his first consideration is the price of housing. If the market price for apartments is $300 per month in Tulsa, Oklahoma, but $500 per month in Kansas City, Missouri, the contractor will decide to build new apartments in Kansas City (assuming that costs are the same in each city). And this is precisely what we would want the contractor to do if we wanted him to maximize happiness! Consumers in Kansas City would get around $500 a month in extra happiness from having a new apartment in their city, while consumers in Tulsa would derive only about $300 per month in happiness.¹

How can we say this without first doing a study on where an apartment complex is most "needed?" And how can we compare the happiness of consumers in Tulsa and consumers in Kansas City? We can, if we adopt the willingness to pay approach to measuring happiness--and recognize the incredible information contained in prices. Thus, an apartment complex in Kansas City, Missouri would generate a greater increase in society's happiness than one in Tulsa, Oklahoma. The planner's dilemma is solved--almost.

For example, consider a standard demand and supply graph. Generally, the demand curve is interpreted "horizontally." That is, holding price constant, the demand curve reports the maximum quantity of the good that consumers in the market would purchase at that price. However, one can also interpret the demand curve "vertically." Specifically, holding quantity constant, the demand curve reports the maximum amount of money that the marginal consumer would be willing to pay for a unit of the good if exactly that quantity were supplied to the market. In other words, the willingness to pay value of the marginal consumer for every given level of quantity is indicated by the height of the demand curve.²

 The graph above represents the T-shirt example we have been discussing for the past three chapters. At a price of $10.00, the equilibrium quantity of T-shirts sold in the market is Q₀ = 1,000,000. All of the consumers who have willingness to pay values greater than $10.00 are represented on the horizontal axis as lying to the left of quantity Q₀. In contrast, those consumers with willingness to pay values less than $10.00 are represented as lying to the right of quantity Q₀. If one more T-shirt is supplied to the market, the price drops negligibly--from $10.00 to $9.99--and the consumer who ends up with this T-shirt is one who has a willingness to pay value between $10.00 and $9.99, or "right around $10."

How about our statement that willingness to pay measures happiness? Economists do not generally use the term "happiness." Instead, they use a word called "utility." However, if you ask your economics instructor what she means by "utility," most often the response you'll hear is "happiness," or "pleasure."