Economics Nobel 2001

Researchers rewarded for showing how imperfect information skews markets.

This year’s Nobel prize in Economics is a timely reminder that, even in the information age, economic markets can be hampered by insufficient knowledge.

The award went to George Akerlof of the University of California, Berkeley, A. Michael Spence of Stanford University in California, and Joseph Stiglitz of Columbia University in New York City. These three economists revealed the consequences when one party in a transaction knows more than the other.

It’s an everyday situation. When you buy a used car, you can’t possibly know its foibles as well as the seller does. Such ’asymmetric information’ has become a burning issue for the life-insurance market — companies wonder how to insure clients who may know that they are genetically predisposed to a life-threatening disease.

Conventional economic models assume that everyone knows everything. Prices are therefore assumed to find their fair market value efficiently, guided only by market forces — the push and pull of supply and demand — without any central coordinator.

But if buyers and sellers lack this omniscience, as they inevitably do, market forces don’t necessarily create an ideal market, the Nobelists calculated.

Akerlof showed the unhappy consequences of asymmetric information in 1970: it can either cause a market to collapse or can flood it with bad products, an effect called adverse selection. Akerlof illustrated this with reference to used-car sales. Here, because the seller knows more than the buyer, the market can become awash with bad vehicles, called ’lemons’ in the United States.

Economic lemons can be more invidious than shoddy cars, Akerlof pointed out. These effects could cause exploitative interest rates to prevail in local credit markets in developing countries, for example, and lead to discrimination against minority groups in labour markets.

Fair sellers, who can be squeezed out in such situations, try to counter asymmetry of information by offering guarantees and other contracts to buyers. Spence worked out that sellers can signal the quality and reliability of their products, but that it can be a costly business, involving massive advertising campaigns or ostentatious price cutting. Both strategies act like darwinian sexual display in animals — they say to prospective buyers: „We are so good and so strong that we can survive despite this cost to ourselves.“

Stiglitz demonstrated how schemes that encourage the better-informed party to share information with the more poorly informed can reduce information asymmetry. For example, insurance companies may offer lower premiums to clients that reveal personal information.

Having applied his work to economic markets in developing countries, Stiglitz feels that information asymmetries undermine the argument — propounded since the eighteenth century — that markets work most fairly when they are free and unregulated.