George A. Akerlof
George Akerlof, along with Michael Spence and Joseph Stiglitz, received the 2001 Nobel Prize “for their analyses of markets with asymmetric information.” Although much of economics is built on the assumption of perfect information, various economists in the past had considered the effects of imperfect information. Two giants in this area were ludwig von mises and friedrich hayek, who predicted that socialism would fail because central planners could not possibly have the information they needed to plan an economy. One of the next steps in relaxing the perfect-information assumption was to assume, realistically, that one side of a market has better information than the other. That is what all three of the 2001 Nobel Prize winners did.
In his classic 1970 article, “The Market for Lemons” Akerlof gave a new explanation for a well-known phenomenon: the fact that cars barely a few months old sell for well below their new-car price. Akerlof’s model was simple but powerful. Assume that some cars are “lemons” and some are high quality. If buyers could tell which cars are lemons and which are not, there would be two separate markets: a market for lemons and a market for high-quality cars. But there is often asymmetric information: buyers cannot tell which cars are lemons, but, of course, sellers know. Therefore, a buyer knows that there is some probability that the car he buys will be a lemon and is willing to pay less than he would pay if he were certain that he was buying a high-quality car. This lower price for all used cars discourages sellers of high-quality cars. Although some would be willing to sell their own cars at the price that buyers of high-quality used cars would be willing to pay, they are not willing to sell at the lower price that reflects the risk that the buyer may end up with a lemon. Thus, exchanges that could benefit both buyer and seller fail to take place and efficiency is lost.
Akerlof did not conclude that the lemon problem necessarily implies a role for government. Instead, he pointed out that many free-market institutions can be seen as ways of solving or reducing “lemon problems.” One solution Akerlof noted is warranties, because these give the buyer assurance that the car is not a lemon, and the buyer is therefore willing to pay more for the car with a warranty. Also, the sellers who are willing to offer the warranty are those who are confident that they are not selling a lemon. Another market solution that has come along since Akerlof’s article is Carfax, a very low-cost way of finding out a car’s history of repairs. Akerlof also went beyond cars and showed that the same kind of issues arise in credit markets and health insurance markets, to name two.
Akerlof, along with coauthor Janet Yellen, also did some of the pioneering work in new keynesian economics. They considered the case of firms with market power that follow a rule of thumb on pricing. The rule of thumb they considered was that firms do not increase price when demand increases and do not reduce price when demand falls. They showed that such a rule of thumb is “near rational”; that is, firms do not lose much profit from following this strategy relative to a strategy of immediately adjusting prices. They also showed, however, that if many firms followed this strategy, the effect on the overall economy was substantial. This lack of adjustment of prices, they noted, would mean that increases in money-supply growth (see Money Supply) would increase the growth of real output, and short-run drops in money-supply growth would reduce the growth of real output.
More recently, Akerlof has tried to explain the persistence of high poverty rates and high crime rates among black Americans. He and coauthor Rachel Kranton argue that many black people face a choice between going along with the mainstream culture and succeeding economically or acting in opposition to that culture and sabotaging themselves. The incentives are high, they argue, for doing the latter.
Akerlof earned his B.A. in economics at Yale in 1962 and his Ph.D. in economics at MIT in 1966. For most of his professional life, he has been an economics professor at the University of California at Berkeley. In 1973–1974, he was a senior economist with President Richard M. Nixon’s Council of Economic Advisers; from 1978 to 1980, he was an economics professor at the London School of Economics.
About the Author
David R. Henderson is the editor of The Concise Encyclopedia of Economics. He is also an emeritus professor of economics with the Naval Postgraduate School and a research fellow with the Hoover Institution at Stanford University. He earned his Ph.D. in economics at UCLA.