That is how the Nobel Prize described the achievement of Akerlof, along with Stiglitz and Spence, when they were awarded the 2001 Nobel Prize for Economics. Akerlof has been with the University of California-Berkeley’s Economics department in the College of Letters & Science since 1966 and has been recognized for his research that borrows from sociology, psychology, anthropology and other fields to determine economic influences and outcomes. His areas of expertise include macroeconomics, poverty, family problems, crime, discrimination, monetary policy and German unification.
According to colleague Daniel McFadden, George Akerlof and his co-laureates led a revolution in the understanding of how markets behave when different participants have different information about the qualities of commodities being traded. Akerlof showed that in the absence of adequate mechanisms to assure quality and verify and enforce contract provisions regarding quality, markets may fail to form or may do a poor job of allocating resources. Akerlof’s work has had profound implications for the organization and regulation of important real markets such as the labor market, the market for health insurance, and markets for financial commodities.
According to another colleague, Alan Auerbach, George Akerlof’s contributions to economics have been fundamental. His celebrated paper, describing the role of asymmetric information between buyers and sellers in the market for ‘lemons’, broke with established economic theory in illustrating how markets malfunction when buyers and sellers, as seen in used car markets, operate under different information. The work has had far-reaching applications in such diverse areas as health insurance, financial markets and employment contracts. Moreover, Akerlof’s work also helped launch the burgeoning field of behavioral economics. He has made crucial contributions to macroeconomic theory, thereby demonstrating the extraordinary breadth of the Nobel Prize winner’s interests.
Akerlof, Spence and Stiglitz began working on the theory of markets with ‘assymetric information’ in the 1970s. This term applies when players on one side of the market have much better information than those on the other. Research into ‘asymmetric information’ gave economists a way to measure such things as risks faced by a lender who lacked information about a borrower’s credit worthiness. Many markets are characterized by asymmetric information: actors on one side of the market have much better information than those on the other. Managers and boards know more than shareholders about the firm’s profitability, and prospective clients know more than insurance companies about their accident risk. Akerlof demonstrated how a market where sellers have more information than buyers about product quality can contract into an adverse selection of low-quality products. He also pointed out that informational problems are commonplace and important. His pioneering contribution thus showed how asymmetric information of borrowers and lenders may explain skyrocketing borrowing rates on local Third World markets, how it is difficult for the elderly to find individual medical insurance and how it relates to labor-market discrimination of minorities. The theory also explored how people with inside knowledge of a technology company’s financial prospects gain an edge over other investors, while people who don’t fully understand a company’s finances may invest unwisely. This has helped economists explain why the recent bubble in high-technology stocks burst.
Many transactions, such as purchasing a car, are performed on a daily basis by one of the parties vs. a few times in a lifetime by the other party. Clearly this is not a level playing field in terms of information.
This is how Akerlof’s idea about how asymmetric information plays out in the buyer and seller in the market for “lemons” goes. For example, you’re offering a car and I want a car, but I suspect that you are unloading a lemon. I can’t tell whether or not the car is a lemon, but know that that information is available to you. So I will include in my offer to buy my suspicion that the car you’re selling is a lemon. In this model, a seller is selling a good whose quality the seller knows but the buyer cannot observe. As described, it is difficult for a buyer to know if the car in question has problems frequently or not. The seller of the used car, having owned it for some time, knows the quality of the car perfectly. In the used car business, although the buyer doesn’t know the quality of any particular car, they know that some percentage of the cars is good cars and the rest are “lemons”. This is the reason why used cars have lower prices and that a seller won’t get full value from his car once the buyer has driven it off the lot. Fleet sellers, like Hertz, get around this by following a mileage rule when they sell their old cars. They sell when the odometer clicks, regardless of condition or quality of the car. If this rule is credible to buyers, then they won’t suspect that Hertz is unloading a lemon, and Hertz’s cars will, on average, fetch full value in the used-car market.
At the root of the “lemons” problem is the concept of adverse selection, a concept especially important in situations with assymetric information. Adverse selection occurs when only one type of product or economic agent is attracted to some offer intended for the entire population. For example, if a company offers health insurance, people choosing to purchase it will tend to be more sickly than those choosing not to purchase. Adverse selection is a problem in the above example because only the bad cars will be attracted into the market for used cars.
An interesting example of explaining how to overcome the “lemons” problem is college education. Companies would like to hire intelligent and hard-working people but can’t tell in an interview if a person has these qualities. In order to convince potential employers that they are intelligent and hard working, people attend college. A stupid and lazy person can complete a college degree, but it will probably be extremely costly, in terms of time, effort and money, whereas an intelligent and hard working person can complete a college degree relatively easy. The difference between the cost of a college degree for a smart, hardworking person and a stupid, lazy person can assure that anyone with a college degree is smart and hardworking and would probably make a good employee. Interestingly, nowhere in this explanation is it assumed that colleges teach anything of any value at all.
Credit:ivythesis.typepad.com
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