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Markets and Information

By Daniel B. Jonas

Often, one of the basic assumptions that economists will make is that markets are characterized by perfect information; that is, the buyers know just as much as the sellers about the quality of goods. However, this is not always the case, as the assumption falls flat when information is either too difficult or too costly to obtain. When there is asymmetric information in a market, one party has a more complete set of information than the other.

This year’s Nobel Memorial Prize in Economic Science was awarded to George Akerlof, A. Michael Spence and Joseph Stiglitz “for their analyses of markets with asymmetric information.” During the 1970s, these three economists established the groundwork for studying markets characterized by asymmetric information.

Used car market leads to insight

Akerlof was the first to explore the field of information economics. In his paper, “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” Akerlof used the market for used cars as an illustrative example of a market where the sellers possess more information about the quality of the goods than the buyers. As a result, the bad products drive the good ones out of the market, and the market becomes biased toward “lemons.” Applying this wisdom to the market for insurance, the Lemons Phenomenon suggests that at any price, only people for whom insurance is a good deal will purchase it, which means that insurers can’t make any money.

Building upon the foundation laid by Akerlof, the research of Spence and Stiglitz examined ways to remedy the problems associated with asymmetric information.

Spence concluded that agents could counteract the asymmetry of information though signaling. Under this mechanism, the more informed party would act in a way that convincingly conveys their positive, unobservable information to the less-informed party. For instance, a corporation might decide to give large dividends to its shareholders in order to signal profitability. Alternatively, a student may aspire to attend a top-notch university and achieve honors to signal intelligence.

In many instances, however, a better-informed party has no desire to bridge the information gap. An individual who is susceptible to contracting the HIV virus would not want to convey this information to his insurance company. To this end, Stiglitz looked at an incentive-based system as a means to extract information from the better-informed party. For example, insurance companies screen applicants to sort their policyholders into various risk pools. They offer a number of packages with different combinations of premiums and deductibles. A healthy individual, thus, will accept a policy with a low premium and large deductible.

Laureates have Cambridge roots

George Akerlof obtained his Ph.D. from MIT in 1966, and is the Goldman Professor of Economics at the University of California at Berkeley. Michael Spence obtained a Ph.D. from Harvard in 1972, and is currently Professor Emeritus of Management in the Stanford University’s Graduate School of Business. He has also taught at Harvard and has been the Dean at both institutions. Joseph Stiglitz obtained his Ph.D. from MIT in 1967 and is currently jointly appointed at Columbia University. He has also held professorships at Yale, Princeton, Oxford and Stanford, and has served as the Chief Economist of the World Bank.