The market for lemons
Berkeley’s new Nobel Prize economist wins for explaining asymmetric markets

By Diane Ainsworth, Public Affairs

17 October 2001 | He didn’t coin the term “lemons,” but whenever consumers get stuck with one — whether it’s a used car, a faulty appliance or a less-than-adequate health care insurance policy — Berkeley economist George Akerlof’s Nobel Prize-winning theory comes alive.

One of three economists to be awarded the Nobel Prize in economics this year, Akerlof first introduced the notion of “asymmetric information” as a factor in the performance of some markets more than 30 years ago. Recognized last week by the Royal Swedish Academy of Sciences, his work was characterized as “foundational” and “immense “ in the field of economics, and paved the way for the development of current theories of behavioral economics.

“More than any other person in economics, George has worked to show how the insights from sociology and psychology could broaden, enrich and increase the power of economics,” said Henry Aaron, a senior fellow at the Brookings Institution. “He is, in my opinion, perhaps the most imaginative and creative applier of insights from other disciplines.”

His 1970 study, “The Market for Lemons” “brought him to fame in the economics communit,” Aaron said. Added Thomas Schelling, distinguished university professor of economics at the University of Maryland. “He is an exceedingly imaginative guy.”

Akerlof’s theory of information economics is based on asymmetric markets, in which one side of the economic equation — either the buyer or the seller — has more information than the other party. In a situation in which the seller has more information than the buyer, for instance, the seller will have the upper hand and the ability to skew the outcome of the sale.

Buying a used car
To illustrate the idea, Akerlof analyzed a familiar economic transaction, the buying and selling of a used car. In this market, he noted, the seller has more information than the buyer about the condition of the vehicle. The buyer, consequently, is suspicious of the product and makes inferences about its quality based on limited information. He or she may not be willing to pay as much for the car as it is worth, assuming it’s not a lemon.

The presence of asymmetric information in various markets can bring about adverse effects, such as a lowering of the quality of products (like used cars) for all consumers, said Alan Auerbach, chair of the economics department in the College of Letters and Science.

“Normal markets are good because they allow people to trade fairly,” Auerbach said. “When you have asymmetric information at work …that (fair-trade situation) breaks down. The buyer of a used car, for instance, is immediately suspicious of the car because he/she has limited information about it. That causes other people to have difficulty selling their cars too.”

Akerlof’s pioneering work in information economics has been applied to a wide range of industries, including health care insurance, unemployment and financial markets.

“George’s ‘Market for Lemons’ paper led to a revolution in economic theory, on information and how that affects markets,” said fellow Berkeley economist Matthew Rabin, winner of a 2000 MacArthur “Genius” Award. “His prize was for a fundamental contribution.”

In the health insurance industry, an analysis of asymmetic information can explain how eligible and desirable consumers may be priced out of coverage.

Buyers have more information — in this case because they know how healthy they are and the insurance companies don’t,” Auerbach said. Insurers “may raise their prices because they infer that some, perhaps many, of the buyers who they attract and whose health is not fully known to them, may be sick.” But in raising the costs of coverage, “they will price some of the healthy and desirable potential customers out of the market.”

Collaborators’ contributions
Two economists sharing the 2001 Nobel Prize with Akerlof — Michael Spence of Stanford University and Joseph Stiglitz of Columbia University — expanded on his premise to identify variations of the basic principle.

Spence identified “market signaling,” which refers to actions that individual market participants may take to increase their chances of an advantageous outcome. In education, for example, a student may want to attend to a four-year college for the obvious reasons: to learn more and become more skilled. But a secondary factor may be at play: the degree may be desirable because it will show employers how intelligent and hard-working the individual is. In business, firms may use dividends to signal their profits to others in the stock market, another example of market signaling.

Stiglitz explored the opposite type of market adjustment, in which less-informed parties elicit information from better-informed parties by offering them a menu of options; the choices made are revealing. A common example is insurance company screening, in which the insurance company obtains information and categorizes customers by risk classifications. Lower-quality insurance premiums, offering less coverage for much higher deductibles, can be one of the tradeoffs.

“This work is fundamental to our understanding of market failures,” Auerbach said. It’s important that economists understand how markets work, he added, “because as the markets work better, people become wealthier.”