When Price Does Not Clear the Market

And other non-Neoclassical tales
Finance and Development has a profile of one of my teachers, Nobel Laureate George Akerlof, written by Prakash Loungani. Akerlof's views are critical to recall in these times when some individuals think supply and demand are sufficient to answer all policy issues. Akerlof's research highlighted the role of information asymmetries that prevent prices for setting quantity demanded equal to quantity supplied. From the article
While unemployment is the topic that has motivated him the most, it is his 1970 article showing how markets might break down in the presence of asymmetric (or unequal) information that won him the Nobel Prize. Indeed, if you play a game of word association with an economics PhD and say “Akerlof,” chances are the response will be “lemons.” This is because the example Akerlof gave was of used car markets, where sellers have better knowledge of whether their car is a good one or a “lemon.” The buyers’ best guess is that the car is of average quality, so they will only be willing to pay the price of a car of average quality. This means, however, that owners of good cars will not place their cars in the used car market. But that in turn lowers the average quality of cars on the market, causing buyers to revise downward their expectations of quality. Now even owners of moderately good cars are unable to sell, and so the market spirals toward collapse.

Akerlof says that the problem dates back to one that has confronted horse traders over the ages: “If he wants to sell that horse, do I really want to buy it?” But problems of asymmetric information are present in most markets, particularly in financial markets. “This [recent financial] crisis gave us glaring examples,” says Akerlof. “Ordinary people thought they were buying homes, not the complex derivatives that they later realized they had ended up buying.”

Akerlof says he chose the example of used cars to make his paper “more palatable” to U.S. readers. But his interest in the subject had been triggered when, during his stay in India in 1967–68, he noticed people’s difficulty obtaining credit. He kept this example in the paper, along with sections on how the “lemons principle” could also explain why the elderly had trouble obtaining insurance and why minorities had difficulty obtaining employment. All this proved too exotic for much of the academic market of the time; the paper was turned down by three leading journals before it was finally published in the Quarterly Journal of Economics.

Today, the questions Akerlof tackled in the “lemons” paper are a staple of the academic diet. And Akerlof himself continues to push the frontiers on the study of such questions, most recently in Identity Economics, coauthored with Rachel Kranton, then at the University of Maryland. Akerlof’s son, Robby, carries on the tradition. A graduate of Yale—where Shiller was one of his professors—and Harvard, he is studying questions such as why corruption and the tolerance of it vary across corporations; what managers can do to increase the legitimacy of their authority (paying efficiency wages turns out to be one option); what accounts for an oppositional culture where minorities disparage the majority and are disparaged in turn; and what fuels protracted feuds between two parties.

The insight that informational asymmetries abound in today's economy leads me to suspect that merely removing impediments to the activities of firms will lead to Pareto optimal solutions. Free markets are not necessarily competitive markets, even if one rules out externalities, and market imperfections (oligopoly, monopolistic competition). And yet, some people are proposing competition as the solution to health care and financial markets, both arguably pervaded by information asymmetries.

Aklerof and Romer analyzed deregulation's impact (and subsequent "looting") in the runup to the S&L crisis, as I discussed in this post. It is a story that has great relevance for the most recent crisis, as Jeff Frieden and I document in our forthcoming book, Lost Decades (Norton, September).