We all know and teach that price sends signals to consumers. And we all know and teach that price sends signals to producers. To the latter group, we often talk about price signaling "what to produce," "how to produce," and "for whom to produce."
The second signal is the focus of this post. Changing prices tell producers not only what products to produce, but also what resources to use. A low price signals that those resources with low opportunity cost or a high marginal benefit/low marginal cost should be used - the concept of marginal productivity.
I used to tell my students to visualize three parcels of land. The first is very productive and very fertile. The ground seems to have a natural resistance to weeds and pests. And when the seed is sown, it naturally falls into rows and the harvest falls in nice, neat piles of its own accord. This land is productive with minimal effort and provides a decent return even when crop prices are low.
The second plot of land requires some work, some additional labor and capital resource inputs. Because of this, a return is possible, but only if prices are higher. The third plot land is a swamp, complete with alligators. Prices have to be pretty high to "drain the swamp" and still provide a return.
An article (complete with video and slide show) in today's issue of The Wall Street Journal illustrates this concept very well. The article explains how rising grain prices drew farmers in Cambodia to expand production by using less productive resources - land that had to be cleared, land that had little access to transportation or lacked irrigation. Now that prices are falling, farmers are getting the signal about "how to produce".
I think the article can also be used to discuss related issues such as role of government in providing infrastructure as a way promoting economic development; and the importance of institutions (laws and property rights) in protecting individuals and promoting growth. There are other concepts that can be developed, as well.
The idea of marginal productivity can also be extended to energy. At $4.00 a gallon for gasoline, bringing certain oil fields into production makes sense. That changes when the price of gasoline falls below $2.00 a gallon. And when we apply the idea to alternative energy sources, we can tie in the substitution effect.
I look forward to your comments.