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VIEWPOINT: ECONOMIC GRAFITTI
Nobel
For Failures
This year's
Nobel prize is for works that point to market imperfections
By Kaushik Basu
As
soon as this year's Nobel Prize in Economics for George Akerlof (University
of California, Berkeley), Michael Spence (Stanford University) and Joseph
Stiglitz (Columbia University) was announced I got a flurry of e-mails
from students and friends. They were congratulating me because these were
among the five or six names that I have been predicting and hoping would
get the prize for the past several years. And I must admit feeling mighty
chuffed by the announcement. The work of Akerlof, Spence and Stiglitz
is among the most creative research that our profession has seen. Their
papers involve a rare blend of logic and social observation.
 The
paper that gets the first mention in the Nobel citation is, rightly, Akerlof's
classic, "The Market for Lemons: Quality Uncertainty and the Market
Mechanism". Much of this paper was written during 1967-68, the period
Akerlof spent at the Indian Statistical Institute in Delhi; and it suffered
the fate common to a lot of truly original research-it was initially rejected
by leading journals as being sub-par. It was eventually published in the
Quarterly Journal of Economics in 1970.
The "lemons" in the title refer to
second-hand cars or duds that used-car sellers often try to pass off as
being of superior quality. This paper, written mainly in the form of examples,
illustrates a point of immense importance. Much of conventional economics
used to be done under the assumption that buyers and sellers were fully
informed and rational. Of course, sensible economists knew that these
assumptions were seldom true in reality. But even then the results and
theorems that emanated from these assumptions were believed to be valid.
What Akerlof showed was that if these assumptions were invalid in a particular
way (if among the buyers and the sellers one side happened to be worse
informed than the other-a phenomenon now referred to as "asymmetric
information"), a lot of conventional economics gets turned on its
head. In particular, the belief that a free market always leads to an
efficient outcome turns out to be false.
When one looks around, it becomes evident that
asymmetric information is a very common characteristic of markets. In
the used-car market, clearly, the seller knows more about the vehicle
than the buyer; in the labour market the worker knows better about her
skills than does the potential employer. Hence, all these markets, left
to themselves, are likely to exhibit inefficiencies.
In the presence of this phenomenon in the labour
market what would workers do? The more skilled among them would somehow
try to "signal" their higher skills. Hence, even if education
did not increase human productivity, if higher education were achievable
only to those who happened to be innately high-skilled, it would be worthwhile
for them to get such degrees in order to signal their higher skill to
potential employers. It was this insight that Spence got as a PhD student
at Harvard and wrote up in a classic paper in 1973 and then in a book
in 1974. This helped produce the huge literature on "signalling"
which gave us deep insights into a variety of phenomena, including why
there can be sustained discrimination against some groups (like a caste,
gender or race) even when these groups may be as skilled or even more
skilled than others. This was contrary to the "Chicago School"
view that a free market wipes out discrimination.
Spence is an unusual economist, who after producing
a relatively small body of research, surprised the profession by abandoning
full-time academics for administration. In 1984, at the age of 41, he
became the dean at Harvard, and later the dean at the Stanford Business
School.
Of the three laureates, Stiglitz's work is the
hardest to describe because his productivity is legendary. He has contributed
papers to virtually every field of economics. I worked closely with him
during 1998-99 when I went to the World Bank on his invitation. He was
then senior vice-president of the bank but was eased out for being too
critical of the "Washington consensus" and the IMF.
Those days, because of his heavy bureaucratic
responsibility, he had a team of research assistants who compiled the
bibliographies for his papers. (Unlike many other intellectuals, Stiglitz
was not fussy about these finishing touches anyway.) One of his assistants
would drop by my office asking for "two non-Stiglitz references on
share tenancy" one day or "one non-Stiglitz reference on peer
monitoring" on another. When I got curious, he said Stiglitz had
told him that no paper of his should have more than 50 per cent of the
references to Stiglitz's own work. Every time Stiglitz revised the paper,
he remembered works he had done many years ago and inserted the references.
That brought his assistant scurrying to me to keep the balance.
(The author is visiting professor at MIT,
on leave from Cornell University where he is professor of economics.)
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