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Scand. J of Economics 104(2), 195-211, 2002
Marketswith AsymmetricInformation:
The Contributionsof GeorgeAkerlof,
Michael Spence and Joseph Stiglitz*
Karl-GustafLofgren
Universityof Umea,SE-90187 Umea,Sweden
karl-gustaf.lofgren@econ.umu.se
TorstenPersson
StockholmUniversity,SE-10691 Stockholm,Sweden
torsten.persson@iies.su.se
Jorgen W Weibull
StockholmSchoolof Economics,SE-11383 Stockholm,Sweden
jorgen.weibull@hhs.se
adverseselection;signaling;screening
Keywords:Asymmetricinformation;
JEL classification: D8
I. Introduction
Formorethantwo decades,researchon incentivesandmarketequilibriumin
situationswith asymmetricinformationhas been a prolificpartof economic
theory.In 1996,the Bankof SwedenPrizein EconomicSciencesin Memory
of Alfred Nobel recognizedJamesMirrleesand WilliamVickrey'sfunda-
mentalcontributionsto the theoryof incentivesunderasymmetricinforma-
tion, in particulartheirapplicationsto the designof optimalincometaxation
and resourceallocationthroughdifferenttypes of auctions. The modem
theoryof marketswith asymmetricinformationrests firmlyon the workof
this year'sprizewinners:George Akerlof (Universityof California,Berke-
ley), Michael Spence (StanfordUniversity)and Joseph Stiglitz (Columbia
University).This work has indeed transformedthe way economiststhink
aboutthe functioningof markets.Analyticalmethodssuggestedby Akerlof,
*Wewouldlike to thankToreEllingsen,BertilHolmlund,BertilNaslund,BernardSalani6and
LarsE. 0. Svenssonforhelpfulcomments.
? Royal Swedish Academy of Sciences. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 IJF, UK
and 350 Main Street, Malden, MA 02148, USA.
196 K.-G. Lofgren,T Persson and J W Weibull
Spence and Stiglitz have been applied in explaining many social and
economicinstitutions,especiallydifferenttypesof contracts.1
Asymmetricinformationis a commonfeatureof marketinteractions.The
seller of a good often knows more about its qualitythan the prospective
buyer. The job applicanttypically knows more about his ability than his
potentialemployer.The buyer of an insurancepolicy usually knows more
about her individualrisk than the insurancecompany.Such asymmetries
immediatelygive rise to a numberof questions.What happensto prices,
tradedquantitiesandthe qualityof tradedgoods, if agentson one side of the
market are better informed than those on the other? What can better-
informedagentsdo to improvetheir individualmarketoutcome?Whatcan
less-informedagents do? In their work, this year's laureatesaddressed
preciselythese questions.
Theirpioneeringcontributionshave given economiststools for analyzing
a broad spectrumof issues. Abundantapplicationsrange from traditional
agriculturalmarketsto modem financialmarkets.Why are interestratesso
high in many local creditmarketsin developingcountries?Why do people
looking for a good used car typicallyturnto a dealerratherthan a private
seller? Why do some firmspay dividendseven when these are taxed more
heavilythan capitalgains?Why is it in the interestof insurancecompanies
to offer a menu of policies, which combine premiums, coverage and
deductiblesin differentways? Why do wealthy landownersnot bear the
entireharvestrisk in contractswith poor tenants?These questionsdeal with
familiar-but seeminglyvery different-phenomena.In all cases, however,
a key to the answerrelies on one and the same observation:one side of the
marketis betterinformedthanthe other.The borrowerknowsmorethanthe
lender about his creditworthiness;the seller knows more than the buyer
aboutthe qualityof his car;the CEOandboardof a firmknowmorethanthe
shareholdersaboutthe profitabilityof the firm;insuranceclientsknowmore
thanthe insurancecompanyabouttheiraccidentrisk;andtenantsknowmore
thanthe landowneraboutharvestingconditionsandtheirown workeffort.
More specifically,the contributionsof the laureatesmay be summarized
as follows. Akerlof showed how informationalasymmetriescan produce
adverse selection in markets.When lenders or car buyers have imperfect
information,borrowerswith weak repaymentprospectsor sellers of low-
qualitycarsmay thuscrowdout everyoneelse fromtheirside of the market,
stifling mutuallyadvantageoustransactions.Spence demonstratedthat in-
formed economic agents in such markets may have incentives to take
'Riley (2001) surveys the developmentsin the economicsof informationover the last 25
years,emphasizingmanyof the issueswe raisehere.
Dates in bracketsreferto publicationsby Akerlof,SpenceandStiglitz(see Bibliographies);
datesin parenthesesreferto worksby otherauthorslistedat the end of this article.
2More recently, the term "private information" or "hidden information" has become increas-
ingly common in describing such situations. Those terms say more about the causes of the
phenomenonwhereas"adverseselection"emphasizesits consequences.
If there were separate markets for low and high quality, every price
between vL and wL would support beneficial transactions for both parties in
the market for low quality, as would every price between vH and wH in the
market for high quality. Those transactions would constitute a socially
efficient outcome: all gains from trade would be realized. But if the markets
are not regulated and buyers cannot observe product quality, unscrupulous
sellers of low-quality products would choose to trade on the market for high
quality. In practice, the markets would merge into a single market with one
and the same price for all units. Suppose that this occurs and that the sellers'
valuation of high quality exceeds the consumers' average valuation. Alge-
braically, this case is represented by the inequality vH > w, where the
average valuation w is given by w =- AwL+ (1 - A)wH. If both qualities are
sold, consumers are willing to pay at most w. But this maximum price falls
short of vH, the minimum price at which sellers of high-quality goods are
willing to part from their units. High-quality sellers therefore leave the
market until only low-quality goods, the lemons, remain for sale.3 In other
words, Adam Smith's invisible hand is not always as effective as traditional
economics had us believe.4
In his paper, Akerlof not only explains how private information may lead
to the malfunctioning of markets. He also points to the frequency with which
such informational asymmetries occur and their far-reaching consequences.
Among his examples are social segregation in labor markets and difficulties
for elderly people in buying individual medical insurance. Akerlof empha-
sizes applications to developing countries. One of his examples of adverse
selection is drawn from credit markets in India in the 1960s, where local
moneylenders charged interest rates that were twice as high as the rates in
large cities. However, a middleman trying to arbitrage between these
markets, without knowing the local borrowers' creditworthiness, risks
attracting those with poor repayment prospects and becomes liable to heavy
losses.
Another fundamental insight is that economic agents' attempts to protect
themselves from the adverse consequences of informational asymmetries
may explain existing institutions. Guarantees offered by professional dealers
in the used-car market is but one of many examples. In fact, Akerlof
concludes his essay by suggesting that "this (adverse selection) may indeed
6Obviously, job applicants' incentives to acquire education will be strengthened under the
more realistic assumption that education enhances productivity.
0 sH s
(sH, wH). All points northwest of this curve are regarded as better than this
alternative, while all points to the southeast are regardedas worse. Likewise,
the steeper curve through B indicates education-wage combinations that
low-productivity individuals find equally good as the minimum education
L = 0 and
wage wL.7
With these preferences, high-productivity individuals choose educational
level sH, neither more nor less, and receive the higher wage, as this
alternative A gives them a better outcome than alternative B. Conversely,
low-productivity individuals optimally choose the minimum educational
level at B; they are worse off with alternative A, as the higher wage does not
compensate for their high cost of education. Employers' expectations that
workers with different productivity choose different educational levels are
indeed self-fulfilling in this signaling equilibrium. Instead of a market
failure, where high-productivity individuals remain outside of the market
(e.g., by moving away or setting up their own business), these workers
participate in the labor market and acquire a costly education solely to
distinguish themselves from low-productivityjob applicants.
competition have also been influential in other fields, such as growth theory
and internationaltrade.
positively correlated with worker ability, increases with the time a worker
has been employed. Both predictions are consistent with data regarding
young people on the US labor market.
Acemoglu and Pischke (1998) show that asymmetric information about
worker ability can explain on-the-job training in firms. The mechanism
resembles that in Waldman (1984) and Gibbons and Katz (1991). Informa-
tional asymmetries concerning a trained worker's productivity generate a
monopsony (a buyer monopoly) on the local labor market, implying that the
firm can successively pay for training by a wage which falls short of the
competitive wage. The predictions are empirically supported when con-
fronted with data from the German apprentice system.
Other attempts to test for the predicted effects of asymmetric information
have produced ambiguous results. One difficulty with such tests is to
distinguish, in practice, between adverse selection and moral hazard;another
is that screening and signaling partially eliminate the effects of informational
asymmetries.15
In recent years, many insights from the economics of information have
been incorporated into development economics. It is perhaps not so surpris-
ing that models suggested by Akerlof and Stiglitz have had a large influence
in this field, as their early studies were largely inspired by issues in develop-
ment economics. Prime examples are Akerlof's lemons model and Stiglitz's
sharecropping model. Extensions of the latter have been used to explain
institutional relationships between landowners and tenants, such as why
landowners often grant credit to tenants (it has positive incentive effects on
work effort). Arguments based on asymmetric information have also been
used to clarify the dichotomy between modem and traditional sectors in
developing economies. Basu (1997) is an example of a modem advanced
textbook in development economics that builds heavily on the economics of
information.
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