Presentation Speech by Professor Jörgen W. Weibull of the Royal Swedish Academy of Sciences, December 10, 2001.
Translation of the Swedish text.
Copyright © Nobel Media AB 2001
Photo: Hans Mehlin>
Your Majesties, Your Royal Highnesses, Honoured Nobel Laureates, Ladies and Gentlemen,
A well-functioning economy is of utmost importance for society, not only for the material well being of its citizens, but also for the social and cultural development of society as a whole. Economists strive to improve our understanding of how economies work in the hope of helping society find ways to improve the human condition.
A key ingredient for the effective functioning of an economy is information. Economic agents, such as firms and households, need a great deal of information about available goods, services and trading possibilities. This year’s Laureates analyzed problems that may arise in markets where information is asymmetric, that is, where sellers know something buyers don’t, or vice versa.
Asymmetric information is a common feature of market interactions. The seller of a good often knows more about its quality than the prospective buyer does. The job applicant will typically know more about his own ability than the potential employer does. The buyer of an insurance policy usually knows more about her individual risk than the insurance company does. What happens to prices and traded quantities 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 to improve their individual market outcome? What can less informed agents do?
This year’s Laureates addressed precisely these questions. The methods of analysis they suggested have become indispensable instruments in the economist’s toolbox, being nowadays taught in universities all over the world. Applications abound, and range from traditional agricultural markets to modern financial markets. Questions as diverse as the following can, and have been, analyzed: Why is private health insurance so expensive? Why are interest rates so high in many local credit markets in developing countries? Why do some firms pay dividends even when these are taxed more heavily than capital gains? Why do rich landowners not bear the entire harvest risk in contracts with poor tenants? These questions exemplify familiar – but seemingly very different – phenomena. However, they share a common feature: one side of the market is better informed that the other is.
George Akerlof initiated the research on such markets. He pointed out the importance and implications of the fact that sellers in many markets are better informed about product quality than buyers. At any given price, a seller of high-quality units is less willing to sell than is the seller of low-quality units. Rational buyers anticipate this, suspecting that the item they face is of low quality. This rational suspicion depresses prices, which further discourages sellers of high-quality units, who continue to leave the market until only low-quality items remain for sale. Such a downward quality bias is called adverse selection. Adverse selection may thus hinder mutually beneficial transactions. In other words: Adam Smith’s “invisible hand” does not always work as effectively as traditional economics had us believe. Akerlof suggested that many observed market institutions may have arisen precisely to cope with the problem of adverse selection, an insight that has spawned a rich body of subsequent research.
Michael Spence asked under what conditions the better informed agents in the market can truthfully and credibly transmit, or “signal”, their information to the less informed. For such “signaling” to function, sellers of high quality items must take observable measures that are too costly for low quality sellers to undertake. In Spence’s own example, the “sellers” are job applicants in a market where employers cannot observe the job candidates’ ability directly, only indirectly via their educational record. If the less able need to spend more effort and time than the more able to obtain any given level of education, then the latter can signal their ability by undertaking an education which the less able do not find worthwhile, given the prevailing wage difference. Under such circumstances, signaling removes the curse of adverse selection, albeit at a cost – the more able have to educate themselves beyond the less able, even if education has no effect on their productivity. Spence pointed out the existence of a variety of equilibria and how these may entail different returns to education for men and women or blacks and whites, even if the absence of innate productivity differences between these groups. Other examples of market signals are costly advertisements, guarantees, highly taxed dividends paid to shareholdes, and a range of other observed phenomena.
Together with Michael Rothschild, Joseph Stiglitz provided a natural complement to Akerlof’s and Spence’s analyses. Rothschild and Stiglitz asked what less informed agents can do to improve their lot. They showed how and when less informed economic agents extract information from better informed agents on the other side of the market by offering a whole menu of contracts. Like market signaling, such “screening by self-selection” promotes mutually beneficial transactions otherwise rendered unfeasible by adverse selection. A prime example can be found in insurance, where companies usually offer alternative contracts, where higher deductibles may be traded off against lower premiums. In this way, their clients are, by their own choice of contract, effectively divided into distinct risk classes. Low-risk clients typically pay a lower premium, but have to accept a relatively high deductible, which is needed for high-risk clients not to choose this option. Stiglitz has also studied the consequences and economic policy implications of asymmetric information in a host of other markets. In particular, he has analyzed credit markets, financial markets, and labor markets, and, along with Akerlof, pioneered much of modern development economics.
Dear Professors Akerlof, Spence and Stiglitz,
your combined work forms the core of modern information economics. Professor Akerlof, you have shown how and when informational asymmetries in markets can give rise to adverse selection, and you have demonstrated the importance and prevalence of this phenomenon. Professor Spence, you have shown how and when economic agents in such a market can improve their outcome by way of signaling their private information to the less informed agents. Professor Stiglitz, among your many contributions you have shown how and when less informed economic agents can improve their outcome by way of screening the informed agents in the market. The work by the three of you has changed the way economists think about their markets.
On behalf of The Royal Swedish Academy of Sciences, I wish to convey our warmest congratulations for your achievements, and ask you to step forward to receive the Prize from the hands of His Majesty the King.