Perfect Losers
Economics, it seems, has very little to tell us about the current economic crisis. Whereas the dominant paradigm in finance – the “efficient market hypothesis” – assumes that everyone has perfect information, and therefore that all prices express the real value of goods for sale, any finance professional will tell you that imperfect information is king.
LONDON – Economics, it seems, has very little to tell us about the current economic crisis. Indeed, no less a figure than former United States Federal Reserve Chairman Alan Greenspan recently confessed that his entire “intellectual edifice” had been “demolished” by recent events.
Scratch around the rubble, however, and one can come up with useful fragments. One of them is called “asymmetric information.” This means that some people know more about some things than other people. Not a very startling insight, perhaps. But apply it to buyers and sellers. Suppose the seller of a product knows more about its quality than the buyer does, or vice versa. Interesting things happen – so interesting that the inventors of this idea received Nobel Prizes in economics.
In 1970, George Akerlof published a famous paper called “The Market for Lemons.” His main example was a used-car market. The buyer doesn’t know whether what is being offered is a good car or a “lemon.” His best guess is that it is a car of average quality, for which he will pay only the average price. Because the owner won’t be able to get a good price for a good car, he won’t place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.
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