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.
I grew up in an industrial town on the south shore of Lake Michigan - Gary, Indiana - and saw poverty, unemployment, and discrimination. I entered economics because I wanted to understand and do something about these phenomena. To be taught models that began by assuming that unemployment didn't exist seemed a peculiar place to begin.
Our models helped explain why markets didn't work in the way the standard theory said they should: why markets might not exist, why there might be unemployment, why there might be credit rationing. They also explained why shocks to the economy might be amplified, and their effects persist, well after the original disturbance disappeared.
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One of the most profound results of our work concerned Adam Smith's notion that competitive markets led, ``as if by an invisible hand,'' to efficient outcomes. Our analysis suggested that the invisible hand not only couldn't be seen - it wasn't there, or was at best decrepit. In work with Bruce Greenwald of Columbia University, we demonstrated that within a market economy there exist interventions in the market on the part of government that can make everyone better off - even when government is faced with the same information imperfections as the private sector.
Economists have long recognized that in the face of ``externalities'' to economic activity, such as air and water pollution, market solutions are often inefficient. There can be too much production of some commodities - say, pollution generating steel - and too little production of others - like research that advances knowledge. What we showed is that, as soon as one recognizes that information is imperfect - as it obviously is - then these externalities can be shown to be pervasive, and that market failures are similarly pervasive.
It is an irony of history that just as a host of researchers around the world were developing these ideas and enhancing our understanding of the limitations of markets, international economic institutions were pushing the Washington consensus - based on market fundamentalism - which ignored market failures. Today, although these lessons on the limits of the markets have become commonplace in academia, they have still not been brought on board by many international economic institutions. This contributes to frictions between these institutions and countries they advise: many bright, young economists working for developing country governments base their analyses on a deeper understanding of the market economy than that provided by the old ideology and the simplistic models guiding some of the international bureaucrats.
Some people have suggested that the theoretical work on information imperfections recognized by the Nobel committee is unrelated to the policy positions I took at the World Bank on East Asia, on Russia, or development. Not true. The stances I took on financial market liberalization were based on a theory of regulation that was based on asymmetries of information.
Concerns about bankruptcy - that the high interest rates pushed by the IMF in East Asia would force firms into distress, even adversely effect the exchange rates while destroying economies and making countries less attractive to investors - derived from a theory of corporate finance, itself derived from theories of asymmetric information. At the most simplistic level: in a world with perfect information, bankruptcy would not exist - why, indeed, would anyone lend to someone who they knew would not repay them? In the real world, failures in privatization were related in part to problems of corporate governance, problems related to asymmetries of information between managers and owners.
Ideas can sometimes be as powerful as interests. When old ideologies and interests work together as they have in the past, some interests get served and others get left behind. Asymmetries of information are related to asymmetries of economic (market) power. There is a role for government, not only in correcting market failures, but in redressing these asymmetries of power.
Our work, which the Nobel Prize Committee has helped to bring to the attention of a wider public, provides a part of the intellectual foundation of the Third Way, which is increasingly recognized as the only means by which we can achieve economic progress with social justice.
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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.
I grew up in an industrial town on the south shore of Lake Michigan - Gary, Indiana - and saw poverty, unemployment, and discrimination. I entered economics because I wanted to understand and do something about these phenomena. To be taught models that began by assuming that unemployment didn't exist seemed a peculiar place to begin.
Our models helped explain why markets didn't work in the way the standard theory said they should: why markets might not exist, why there might be unemployment, why there might be credit rationing. They also explained why shocks to the economy might be amplified, and their effects persist, well after the original disturbance disappeared.
Secure your copy of PS Quarterly: Age of Extremes
The newest issue of our magazine, PS Quarterly: Age of Extremes, is here. To gain digital access to all of the magazine’s content, and receive your print copy, subscribe to PS Premium now.
Subscribe Now
One of the most profound results of our work concerned Adam Smith's notion that competitive markets led, ``as if by an invisible hand,'' to efficient outcomes. Our analysis suggested that the invisible hand not only couldn't be seen - it wasn't there, or was at best decrepit. In work with Bruce Greenwald of Columbia University, we demonstrated that within a market economy there exist interventions in the market on the part of government that can make everyone better off - even when government is faced with the same information imperfections as the private sector.
Economists have long recognized that in the face of ``externalities'' to economic activity, such as air and water pollution, market solutions are often inefficient. There can be too much production of some commodities - say, pollution generating steel - and too little production of others - like research that advances knowledge. What we showed is that, as soon as one recognizes that information is imperfect - as it obviously is - then these externalities can be shown to be pervasive, and that market failures are similarly pervasive.
It is an irony of history that just as a host of researchers around the world were developing these ideas and enhancing our understanding of the limitations of markets, international economic institutions were pushing the Washington consensus - based on market fundamentalism - which ignored market failures. Today, although these lessons on the limits of the markets have become commonplace in academia, they have still not been brought on board by many international economic institutions. This contributes to frictions between these institutions and countries they advise: many bright, young economists working for developing country governments base their analyses on a deeper understanding of the market economy than that provided by the old ideology and the simplistic models guiding some of the international bureaucrats.
Some people have suggested that the theoretical work on information imperfections recognized by the Nobel committee is unrelated to the policy positions I took at the World Bank on East Asia, on Russia, or development. Not true. The stances I took on financial market liberalization were based on a theory of regulation that was based on asymmetries of information.
Concerns about bankruptcy - that the high interest rates pushed by the IMF in East Asia would force firms into distress, even adversely effect the exchange rates while destroying economies and making countries less attractive to investors - derived from a theory of corporate finance, itself derived from theories of asymmetric information. At the most simplistic level: in a world with perfect information, bankruptcy would not exist - why, indeed, would anyone lend to someone who they knew would not repay them? In the real world, failures in privatization were related in part to problems of corporate governance, problems related to asymmetries of information between managers and owners.
Ideas can sometimes be as powerful as interests. When old ideologies and interests work together as they have in the past, some interests get served and others get left behind. Asymmetries of information are related to asymmetries of economic (market) power. There is a role for government, not only in correcting market failures, but in redressing these asymmetries of power.
Our work, which the Nobel Prize Committee has helped to bring to the attention of a wider public, provides a part of the intellectual foundation of the Third Way, which is increasingly recognized as the only means by which we can achieve economic progress with social justice.