Commentary: Why Markets Misbehave

By Michael J. Mandel

We live in a world where much is unknown or hidden, and where partial knowledge is a fact of life. Not surprisingly, much of the best work in economics in recent years has concentrated in areas such as finance, where uncertainty plays a crucial role.

Now, the latest Nobel prize in economics, announced on Oct. 10, goes a step further in highlighting the role uncertainty and information play in economic thinking. George A. Akerlof of the University of California at Berkeley, A. Michael Spence of Stanford University, and Joseph E. Stiglitz of Columbia University received the award for their separate work on "markets with asymmetric information."

Put simply, the economists won for their study of markets in which some people have information that others do not. That includes a wide range of situations. For example, a worker applying for a job knows more about his or her strengths and weaknesses than the potential employer. And a company applying for a loan knows more about its true financial prospects than the bank.

The economics of asymmetric information sends a simple message: Markets behave in odd and surprising ways when there is unequal access to information. And, under these circumstances, there may be room for government intervention or regulation to make markets work better.

NEW VIEWS. The selection of Akerlof, Spence, and Stiglitz gives a lift to those economists who argue that there's a wide gap between the ideal of free markets and the reality of an imperfect world. Akerlof and Stiglitz, in particular, have in recent years argued against conventional policy prescriptions. In his latest paper, Akerlof shows that a little inflation can actually lower unemployment. And Stiglitz has vehemently argued that requiring developing countries that want loans to cut wages and raise interest rates is bad policy, although it was the main prescription of the International Monetary Fund for many years.

Despite these views, all three are card-carrying members of the economic Establishment. Stiglitz was chief economist of the World Bank and head of President Bill Clinton's Council of Economic Advisors. Spence, now a partner in a venture capital firm, was dean of the Stanford Business School for nine years.

The research for which they received their award dates to the 1970s and 1980s. But in many ways, the question they studied--how markets misbehave in the presence of asymmetric information--is relevant today. Consider health insurance, one of the toughest issues Washington faces. It might seem reasonable for individuals to buy their own health insurance, just as they buy cars or houses. But Akerlof's research implies that health insurance suffers an "adverse selection" problem that causes normal market processes to collapse. That means people with bigger health risks are more likely to want to buy insurance. But that drives up rates, making it less likely that healthy people will sign up for insurance, which pushes up rates even more. This explains the need for universal health insurance, in the form of Medicare, for the elderly, to prevent such adverse selection--and it also suggests one reason why it is so hard to construct a satisfactory health-insurance system today.

The same sort of unraveling can happen in credit markets. In the early 1980s, Stiglitz, along with co-author Andrew Wiess, argued that during downturns banks will tend to ration credit rather than simply raising interest rates enough to cover loan losses. The reason: Businesses that suspect they are going to be in big trouble are more likely to ask for loans, at any rates, in order to survive. That means that during recessions, banks will tend to choke off credit, making the downturn worse. This suggests a need for activist monetary policy to counteract the tendency to ration credit.

Or consider college admissions, one of today's odder markets. In the 1970s, Spence showed that attending a selective college is valuable, in part, because it is a way of showing future employers--"signaling," in Spence's words--that you are smart enough to get into a selective college, and hardworking enough to graduate.

There's plenty more. The latest Nobel prize is a sign that the economics profession is truly moving in the Age of Information.

Mandel has a PhD in economics from Harvard University.

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