Markets and firms
George Akerlof (1940–)
1558 English financier Sir Thomas Gresham advises that “bad money drives out good.”
1944 John von Neumann and Oskar Morgenstern publish the first attempt to analyze strategic behavior in economic situations.
1973 US economist Michael Spence explains how people signal their skills to potential employers.
1976 US economists Michael Rothschild and Joseph Stiglitz publish Equilibrium in Competitive Insurance Markets, a study of the problem of “cherry picking” when insurance companies compete for customers.
Until US economist George Akerlof started studying prices and markets in the 1960s, most economists believed that markets would allow everyone willing to sell goods at a certain price to make deals with anyone who wanted to buy goods at that price. Akerlof demonstrated that in many cases this is not true. His key work, The Market for Lemons (1970), explains how uncertainty caused by limited information can cause markets to fail. Akerlof stated that buyers and sellers have different amounts of information, and these differences, or asymmetries, can have disastrous consequences for the workings of markets.
The buyer of a second-hand car has less information about its quality than the seller who already owns the car. The seller will have been able to assess whether the car is worse than an average similar car—whether, it is a “lemon”—an item with defects. Any buyer that ends up with a lemon feels cheated. The existence of undetectable lemons in the market creates uncertainty in the mind of the buyer, which extends to concerns about the quality of all the second-hand cars on sale. This uncertainty causes the buyer to drop the price he is willing to offer for any car, and as a consequence prices drop across the market.
Akerlof’s theory is a modern version of an idea first suggested by English financier Sir Thomas Gresham (1519–79). Gresham observed that when coins of higher and lower silver content were both in circulation, people would try to hold on to those of a higher silver content, meaning that “bad money drives good money out of circulation.” In the same way sellers with better-than-average cars to sell will withdraw them from the market, because it is impossible for them to get a fair price from a buyer who is unable to tell whether that car is a lemon or not. This means that “most cars traded will be lemons.” In theory this could lead to such low prices that the market would collapse, and trade would not occur at any price, even if there are traders willing to buy and sell.
A car dealer can reduce a buyer’s risk when selling a car by offering guarantees. In many cases markets adjust to account for asymmetric information.
Another market in which lemons affect trade is the insurance market. In medical insurance, for instance, the buyers of policies know more about the state of their health than the sellers. So insurers often find themselves doing business with people they would rather avoid: the least healthy people. As insurance premiums rise for older age groups, a greater proportion of “lemons” buy policies, but firms are still unable to identify them accurately. This is known as “adverse selection,” and the potential for adverse selection means that insurance companies end up with, on average, much greater risks than are covered by the premiums. This has resulted in the withdrawal of medical insurance policies for people over a certain age in some areas.
Born in Connecticut in 1940, George Akerlof grew up in an academic family. At school he became interested in the social sciences, including history and economics. His father’s irregular employment patterns fostered his interest in Keynesian economics. Akerlof went on to study for an economics degree at Yale, then gained a PhD from MIT (Massachusetts Institute of Technology) in 1966. Shortly after joining Berkeley as an associate professor, Akerlof spent a year in India, where he explored the problems of unemployment. In 1978, he taught at the London School of Economics before returning to Berkeley as professor. He was awarded the Nobel Prize for Economics in 2001, alongside Michael Spence and Joseph Stiglitz.
1970 The Market for Lemons
1988 Fairness and Unemployment (with Janet Yellen)
2009 Animal Spirits: How Human Psychology Drives the Economy (with Robert J. Shiller)