Monday, May 08, 2006

The Economics of Information (Or the Lack Thereof)

The supply and demand model is great for describing markets where lots of buyers and sellers have good information about the standardized product they're haggling over. Of course, people don't always have good information. Take the market for health insurance. There are lots of buyers and plenty of health insurance providers, but buyers have quite a bit of inside information about how healthy they are--much more than the insurance companies trying to assess the health risks of prospective clients. In highfalutin econspeak, information in insurance markets is located asymmetrically. Translation: buyers know more than sellers. Does the supply and demand model do a good job of describing markets where some participants lack good information?

In 2001, George Akerlof, Michael Spence, and Joseph Stiglitz won the Nobel Prize in economics* for their work examining that very question. Their answer: not so much--markets fail to work as well as supply and demand would predict if buyers or sellers lack good information. To paraphrase Joseph Stiglitz: Adam Smith's invisible hand isn't just invisible in markets with poor information--it's not there at all.

In a recent column, Tim Harford writes about the lessons from Akerlof's seminal 1970 paper, The Market for Lemons. The paper explores a market rife with information problems about quality and reliability--the market for used cars. Read Harford's column to see how a bit of bad information can cause a big market failure.

1. How can low prices in the market for used cars reinforce the worst fears of prospective buyers?

2. If potential sellers of high-quality used cars can't successfully convey information about their cars to buyers, what types of cars are most likely to show up in the used market?

3. How have economists attempted to test Akerlof's idea in the market for used pick-up trucks?

4. Some web services allow you to buy title histories for used cars--that is, good information is available but costly to acquire. How does information technology change information problems in the used car market?

5. As part of their contribution to the economics of information, both Michael Spence and Joseph Stiglitz explored the way firms and individuals deal with information problems in labor markets. How might an information-poor job market come to resemble the market for lemons Akerlof describes? Think about the job application process. How would you signal to employers that you won't be a lemon of a worker? How can employers screen potential employees to reduce their chances of hiring a lemon? For example, could a firm attract a richer pool of job candidates by advertising above average wages? How might above average wages change the work habits of a firms employees?

*The Nobel Prize in economics is the highest honor in the field, but it's actually called the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. Alfred Nobel didn't establish the economics prize in his will--Sweden's central bank created the award in his honor.

Topics: Market for lemons, Asymmetric information, Signaling, Screening


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