Markets with Asymmetric Information: Akerlof, Spence, Stiglitz Contributions

Markets with Asymmetric Information:
The Contributions of George Akerlof,
Michael Spence and Joseph Stiglitz
Karl-Gustaf Lo
¨fgren
University of Umea
˚, SE-901 87 Umea ˚, Sweden
[email protected]
Torsten Persson
Stockholm University, SE-106 91 Stockholm, Sweden
[email protected]
Jo
¨rgen W. Weibull
Stockholm School of Economics, SE-113 83 Stockholm, Sweden
jorgen.w[email protected]
Keywords: Asymmetric information; adverse selection; signaling; screening
JEL classification:D8
I. Introduction
For more than two decades, research on incentives and market equilibrium in
situations with asymmetric information has been a prolific part of economic
theory. In 1996, the Bank of Sweden Prize in Economic Sciences in Memory
of Alfred Nobel recognized James Mirrlees and William Vickrey’s funda-
mental contributions to the theory of incentives under asymmetric informa-
tion, in particular their applications to the design of optimal income taxation
and resource allocation through different types of auctions. The modern
theory of markets with asymmetric information rests firmly on the work of
this year’s prizewinners: George Akerlof (University of California, Berke-
ley), Michael Spence (Stanford University) and Joseph Stiglitz (Columbia
University). This work has indeed transformed the way economists think
about the functioning of markets. Analytical methods suggested by Akerlof,
Scand. J. of Economics 104(2), 195–211, 2002
#Royal Swedish Academy of Sciences. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK
and 350 Main Street, Malden, MA 02148, USA.
We would like to thank Tore Ellingsen, Bertil Holmlund, Bertil Na¨slund, Bernard Salanie´ and
Lars E. O. Svensson for helpful comments.

Spence and Stiglitz have been applied in explaining many social and
economic institutions, especially different types of contracts.1
Asymmetric information is a common feature of market interactions. The
seller of a good often knows more about its quality than the prospective
buyer. The job applicant typically knows more about his ability than his
potential employer. The buyer of an insurance policy usually knows more
about her individual risk than the insurance company. Such asymmetries
immediately give rise to a number of questions. What happens to prices,
traded quantities and the quality of traded goods, if agents on one side of the
market are better informed than those on the other? What can better-
informed agents do to improve their individual market outcome? What can
less-informed agents do? In their work, this year’s laureates addressed
precisely these questions.
Their pioneering contributions have given economists tools for analyzing
a broad spectrum of issues. Abundant applications range from traditional
agricultural markets to modern financial markets. Why are interest rates so
high in many local credit markets in developing countries? Why do people
looking for a good used car typically turn to a dealer rather than a private
seller? Why do some firms pay dividends even when these are taxed more
heavily than capital gains? Why is it in the interest of insurance companies
to offer a menu of policies, which combine premiums, coverage and
deductibles in different ways? Why do wealthy landowners not bear the
entire harvest risk in contracts with poor tenants? These questions deal with
familiar—but seemingly very different—phenomena. In all cases, however,
a key to the answer relies on one and the same observation: one side of the
market is better informed than the other. The borrower knows more than the
lender about his creditworthiness; the seller knows more than the buyer
about the quality of his car; the CEO and board of a firm know more than the
shareholders about the profitability of the firm; insurance clients know more
than the insurance company about their accident risk; and tenants know more
than the landowner about harvesting conditions and their own work effort.
More specifically, the contributions of the laureates may be summarized
as follows. Akerlof showed how informational asymmetries can produce
adverse selection in markets. When lenders or car buyers have imperfect
information, borrowers with weak repayment prospects or sellers of low-
quality cars may thus crowd out everyone else from their side of the market,
stifling mutually advantageous transactions. Spence demonstrated that in-
formed economic agents in such markets may have incentives to take
1Riley (2001) surveys the developments in the economics of information over the last 25
years, emphasizing many of the issues we raise here.
Dates in brackets refer to publications by Akerlof, Spence and Stiglitz (see Bibliographies);
dates in parentheses refer to works by other authors listed at the end of this article.
196 K.-G. Lo
¨fgren, T. Persson and J. W. Weibull
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observable and costly actions to credibly signal their private information to
uninformed agents, so as to improve their market outcome. Car dealers may
thus offer guarantees on used cars to signal high quality, and the manage-
ment of a firm may incur the additional tax cost of dividends so as to signal
high profitability. Stiglitz showed how poorly informed agents can extract
information from those who are better informed by offering a menu of
alternative contracts for a specific transaction, so-called screening through
self-selection. Insurance companies may thus divide their clients into risk
classes by offering different policies where, say, lower premiums can be
exchanged for higher deductibles. Stiglitz also analyzed a range of similar
mechanisms in other markets, including the common sharecropping contract
between landlords and their better-informed tenants.
Sections II through IV of this paper give a brief account of the most
fundamental contributions by each of the laureates. Section V describes
some applications and empirical tests of their models. Suggestions for
further reading conclude the paper.
II. George Akerlof
Akerlof’s article, ‘‘The Market for ‘Lemons’: Quality Uncertainty and the
Market Mechanism’’ [1970a], is probably the single most important con-
tribution to the literature on economics of information. This paper has all the
typical features of a truly seminal piece. It introduces a simple but profound
and universal idea, offers numerous interesting implications and points to
broad applications. Nowadays, Akerlof’s insights regarding adverse selection
are routinely taught in microeconomics courses at the undergraduate level.2
His essay analyzes a market for a product where sellers are better informed
than buyers about the quality of the good; one example is the market for
used cars. Since then, ‘‘lemons’’ (a colloquialism for defective cars) has
become a well-known metaphor in every economist’s vocabulary.
Akerlof’s idea may be illustrated by a simple example. Assume that a
good is sold in indivisible units and is available in two qualities, low and
high, in fixed shares ºand 1 º. Each buyer is potentially interested in
purchasing one unit, but cannot observe the difference between the two
qualities at the time of the purchase. All buyers have the same valuation of
the two qualities: one unit of low quality is worth wLdollars to the buyer,
while one high-quality unit is worth wH.wLdollars. Each seller knows
the quality of the units he sells, and values low-quality units at vL,wL
dollars and high-quality units at vH,wHdollars.
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
phenomenon whereas ‘‘adverse selection’’ emphasizes its consequences.
Markets with asymmetric information 197
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If there were separate markets for low and high quality, every price
between vLand wLwould support beneficial transactions for both parties in
the market for low quality, as would every price between vHand wHin 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 wis given by w¼ºwLþ(1 º)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.3In 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
3A very early prototype of Akerlof’s result is usually referred to as Gresham’s law: ‘‘bad money
drives out good’’. (Thomas Gresham, 1519–1579, was an adviser to Queen Elizabeth I on
currency matters.) But as Akerlof [1970a, p. 490] himself points out, the analogy is somewhat
lame; in Gresham’s law both sellers and buyers can presumably distinguish between ‘‘good’’
and ‘‘bad’’ money.
4Classical economic analysis disregarding asymmetric information would misleadingly predict
that goods of both qualities would be sold on the market, at a price close to the consumers’
average valuation.
198 K.-G. Lo
¨fgren, T. Persson and J. W. Weibull
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explain many economic institutions’’. This prophecy has come true; his
approach has generated an entire literature analyzing how economic institu-
tions may mitigate the consequences of asymmetric information.
In a later article, ‘‘The Economics of Caste and of the Rat-Race and Other
Woeful Tales’’ [1976c], Akerlof enters into a more thorough discussion of
the significance of informational asymmetries in widely differing contexts,
such as the caste system, factory working conditions and sharecropping. He
uses illustrative examples to show how certain variables, called ‘‘indicators’’,
not only provide important efficiency-enhancing economic information, but
may also cause the economy to become trapped in an undesirable equili-
brium. In the case of sharecropping, where tenancy is repaid by a fixed share
of the harvest, a tenant’s volume of production acts as an indicator of his
work effort on the farm. On the assembly line in a factory, the speed of the
conveyor belt acts as an indicator of the workers’ ability, and can therefore
be used as an instrument to distinguish between workers of different
abilities.
Apart from his work on asymmetric information, Akerlof has been
innovative in enriching economic theory with insights from sociology and
social anthropology. Several of his papers on the labor market have exam-
ined how emotions such as ‘‘reciprocity’’ towards an employer and ‘‘fair-
ness’’ towards colleagues can contribute to higher wages and thereby
unemployment; see Akerlof [1980b, 1982c] and Akerlof and Yellen [1990a].
This kind of emotionally motivated behavior has recently been confirmed
experimentally, see e.g. Fehr and Schmidt (1999, 2000), and has also
received empirical support from interview surveys; see e.g. Bewley (1999).
III. Michael Spence
Spence’s most important work demonstrates how agents in a market can use
signaling to counteract the effects of adverse selection. In the asymmetric-
information context, signaling refers to observable actions taken by econo-
mic agents to convince the opposite party of the value or quality of their
products. Spence’s main contributions were to develop and formalize this
idea and to demonstrate and analyze its implications.5A fundamental insight
is that signaling can succeed only if the signaling cost differs sufficiently
among the ‘‘senders’’. Subsequent research contains many applications
which extend the theory of signaling and confirm its importance in different
markets.
Spence’s seminal paper ‘‘Job Market Signaling’’ [1973a] and book Market
Signaling [1974a] both deal with education as a signal in the labor market. If
an employer cannot distinguish between high- and low-productivity labor
5Informal versions of this idea can be traced to the sociological literature; see Berg (1970).
Markets with asymmetric information 199
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