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Asymmetries of Information and Economic Policy

This year's Nobel Prize in Economic Sciences went to George Akerlof of the University of California at Berkeley, Michael Spence of Stanford University, and myself for our work on ``asymmetry of information.'' What is that work about and why did we undertake it?

For two hundred years, economists used simple economic models that assumed that information was perfect - i.e. that all participants have equal and transparent knowledge of the relevant factors. They knew that information wasn't perfect, but hoped that a world with moderate imperfections of information would be akin to a world with perfect information. We showed that this notion was ill-founded: even small imperfections of information could have profound effects on how the economy behaved.

The Nobel committee cited our work on ``asymmetries of information,'' an aspect of imperfections of information caused by the fact that different people in a market know different things. For example: the seller of a car may know more about his car than the buyer; the buyer of insurance may know more about his prospects of having an accident (such as how he drives) than the seller; a worker may know more about his ability than a prospective employer; a borrower may know more about his prospects for repaying a loan than the lender. But asymmetries of information are only one facet of information imperfections, and all of them - even when small - can have large consequences.

George Akerlof and I were classmates at MIT in the early 1960s. We were taught the standard models of the day, but they made little sense to us. These models rather simplistically said that demand equaled supply. The joke was that you could teach a parrot to be an economist simply by repeating ``demand and supply.'' This produced rather curious results. If the demand for labor equaled the supply, for example, there couldn't be any unemployment.