Review Journal

Market with Asymmetric Information: The Contribution of George Akerlof,

Michael Spence and Joseph Stiglitz
By Karl-Gustaf Lofgren, Torsten Persson, Jorgen W. Weibull,
Scandinavian Journal of Economics; Vol. 104, NO.2 (Jun., 2002) , pp. 195-211
Reviewed by Iman Sufrian
NPM 1206313974
A. BACKGROUND/INTRODUCTORY
The introductory paragraph summarizes the background information and purpose of the
research (specific questions the study researched).

Research on incentive schemes and market equilibrium in situations with asymmetric

information contributes large part of economic theory. Those research on market
equilibrium and incentives schemes are largely based on theory contributed by three
researchers namely: George Akerlof, Michael Spence and Joseph Stiglitz. Those
three researchers and authors contribute significantly on how economist think about
the functioning of markets. Analytical methods suggested by those three researchers
have been applied in explaining a wide spectrum of social and economic interaction,
especially different types of contracts.
Asymmetric information is widely accepted as a common feature of market
interaction. This feature immediately give rise to a number of questions. For
example: if the buyer of insurance policy usually knows more about his individual risk
than the insurance company, what would happen to the police insurance price,
number of police insurance sold and the quality of police insurance? If certain
individual know better about his own risk profile, what can he do to improve his
individual market outcome? What can the insurance company do to extract more
relevant information from insurance buyers? Such questions can be answered by
using the analytical method suggested by Akerlof, Spence and Stiglitz.
The purpose of this paper try to discuss about the contribution of those three
researcher in economic theory, specifically on asymmetric information market topic.

B. METHODOLOGY
Then, explain the methods that were used to investigate the research questions (use past tense).

Authors of this paper conducted a wide literature review of Akerlofs, Spences and
Stiglitzs works, especially on asymmetric information topic. Based on literature
review, the authors of this paper then summarize and synthesize the contribution of
Akerlof, Spence and Stiglitz on asymmetric information topic.
Authors of this paper also conducted literature review of other researchers that
applied and tested Akerlofs, Spences and Stiglitzs ideas.
C. JOURNAL CONTENT
Mention the major results of the study (use past tense).
State what the author of the study learned.

1. Contribution of George Akerlof

Akerlofs article, The market for Lemons: Quality Uncertainty and the Market
Mechanism [1970], was seen as a seminal paper on economics of information.
Akerlofs essay analysed a market for a product where sellers knew more of the
quality of the products they sold that the buyers. Akerlof gave a used cars market as
an example. He modelled the used cars market as followed:
a. There were two qualities of goods available. They were high quality goods and
low quality goods in fixed shares and (1-)
b. Each buyer was interested only one unit of good but unable to observe the
difference between the two qualities at the time of purchase.
c. All buyers had the same valuation of the two qualities: one unit of low quality was
worth wL and one unit of high quality worth w H. wL < wH
d. Each sellers knew the quality of the units he sold and valued low quality units at
vL and high quality units at vH. vL < vH.
e. If separate markets had existed for low quality goods and high quality goods,
every price between vL and wL would have supported beneficial transactions for
both parties in the market for low quality, as would have for every price between
vH and wH for high quality goods. Those transactions would have been socially
efficient outcome: all gains from trade would have been realized.
f. However, if the market was not regulated and the buyers were unable to
distinguish the quality between low quality and high quality products, dishonest
sellers of low quality goods would chose to trade in high quality market. In reality,
2

the market would merge into one single market with one and the same price for
all units. If this occurred, then the valuation of high quality was higher than the
consumers average valuation. This was shown algebraically as follows v H >
where was given by = w L + (1-) wH. If both quantities were sold, the high
quality good only sold at most .
Implication of Akerlofs model:
a. Since high quality goods are only sold at where v H > , high quality sellers
would leave the market until only low quality goods remained for sale in the
market. This was seen as the market failure since invisible hands of classical
Adam Smiths proofed ineffective to predict that both goods were sold at its fair
value.
b. Another fundamental insight from Akerlofs work is that economic agents
attempts to protect themselves from adverse consequences of informational
asymmetries explained existing institution. For example, guarantees offered by
professional sellers was one of the example.
Akerlofs later article, the Economics of caste and of the Rat-race and Other woeful
Tales [1976], was a more thorough discussion of the significance of asymmetric
information in widely differing contexts. In this article, Akerlof showed how certain
variables, called indicators, may not only provided important efficiency-enhancing
economic information, but may also cause the economy trapped in an undesirable
equilibrium. Akerlof gave an example of sharecropping, where tenancy was repaid by
a fixed share of the harvest, a tenants volume of production acted as an indicator of
his work effort on the farm.
Akerlof also gave significant contribution in enriching economic theory with insights
from sociology and social anthropology. Some of his paper on labour market had
explained how emotions such as reciprocity towards an employer and fairness
towards colleagues could contribute to higher wages and thereby unemployment.
This Akerlofs idea revealed in his article [1980b, 1982c]. His idea was confirmed
both experimentally and empirical support from interview surveys conducted by Fehr
and Schmidt [1999, 2000] and Bewley [1999].
2. Contribution of Michael Spence
3

Spences most important works showed how economic agents in a market could use
signalling to mitigate the effects of adverse selection problem. Economic agents tried
to convince the opposite party of the value or quality of their product. Spences main
contribution were to develop and formalize this idea and to show and to analyse its
implications.
Spence modelled a labour market and used education as a signal in the labour
market in his seminal paper Job Market signalling [1973a] and his book Market
Signalling [1974]. He modelled job market as followed:
a. An employer could not distinguished between high and low productivity labour
when hiring new workers.
b. Job applicants (the sellers) could acquire education before entering the labour
market.
c. The productivity of low-productivity workers, w L, is below that of high productivity
workers wH, and the population shared of the two groups were and 1-.
d. Although, the employer could not directly observed the productivity of workers,
the employers could observe the workers educational level. Education was
measured on a continuous scale s0, and the necessary cost in terms of effort,
expenses or time- to reach each level is lower for high-productivity individuals.
e. To focus on signalling aspect, Spence assumed that education did not affect a
workers productivity, and education had no consumption value for the individual.
Therefore, under perfect information, perfect competition and constant return to
scale, all applicants would chose as little education as possible. However, under
asymmetric information, by contrast, high productivity workers might acquire
education as a signal of their ability.
f. All employers expect all job applicants with at least a certain educational level
with sH > 0 to have high productivity. This implied uneducated workers (s=0) was
seen as low productivity workers. Under perfect competition and constant return
to scale, all applicants with educational level s H or higher were offered a wage
equal to their expected productivity, w H, whereas those with lower educational
level are offered the wage w L. Given this wage schedule, each job applicant
would choose either the lowest possible education s L=0 ant obtain low wage wL,
or the higher educational level s H and the higher wage wH. An education between
these levels did not yield a wage higher than w L but cost more; similarly, an
education above sH did not yield a wage higher than wH, but cost more.
g. Job applicants preferences were represented by two indifference curve, which
were drawn to capture the assumption that education was less costly for high4

productivity individuals. The flatter curve represented those education- wage

combination (s,w) that high productivity individuals found equally good as their
expected education wage pair (sH, wH). All points northwest of this curve were
regarded as better than this alternative, while all points to the southeast were
regarded as worse. Similarly , the steeper curve through B indicated educationwage combination that low productivity worker individuals found equally good as
the minimum education sL=0 and wage wL.
Implication of Spence model:
a. High productivity individuals chose educational level s H, neither more nor less
and receive the higher wage, as this alternative A gave the better outcome than
alternative B. Similarly, low productivity individuals optimally chose s = 0 an
received wL at point B. Low productivity workers were worse off with alternative A
as the higher wage did not compensate the high cost of education. Employers
expectation that workers with different productivity chose different level of
educational level are indeed self-fulfilling in this signalling equilibrium. Labour
market did not experience market failure where high productivity individuals
remain outside of the job market (e.g. by moving away or setting up their own
business), instead these workers participated in labour market and acquire a
costly education solely to distinguish themselves from low productivity individuals.
b. However this equilibrium was fulfilled if the expected level of education were
neither too high that high productivity applicant prefer to refrain from education
or , or so low that low productivity applicants prefer to educate themselves up to
that level.
c. Spence indicated that a certain signalling equilibrium is the socially most efficient.
In this equilibrium, high productivity individuals prefer to acquire minimum
education level to distinguish themselves from low productivity individuals.
d. Spence also showed the existence of other equilibria, with modified model where
no applicants acquired education if the employer did not expect education was a
productivity signal. Employers expected that all applicants would have average
level of productivity on the market regardless their level of education.
e. Spence also stated the existence of possibility of equilibria where different groups
of applicants had different educational incentives. For example, high productivity
men (black) may be expected to acquire another lever of education than equally
productive women (whites). In such equilibria, the return to education differed

between men and women, or black and whites, as do their investment in

education.
Spence also contributed to the field of industrial organization. His model of market
equilibrium under monopolistic competition had also been influential in other fields
such as growth theory and international trade
3. Contribution of Joseph Stiglitz
Stiglitzs most important articles was written together with Rothschild on adverse
selection Equilibrium in Competitiv Insurance Markets: An Essay on the Economic
of Imperfect information [1976d]. This article was seen as a natural complement to
the analysis of Akerlof articles and Spences articles. Stiglitz and Rothschild started
with the question of what uninformed agents could do to improve their outcome in a
market with asymmetric information.

D. SUMMARY
Include a summary as well as your own analysis and evaluation of the article.
Know the article thoroughly.
Do not include personal opinions.
Be sure to distinguish your thoughts from the authors words.
Focus on the positive aspects and what the author(s) of the study learned.
Note limitations of the study at the end of the essay:
o Do the data and conclusions contradict each other?
o Is there sufficient data to support the authors generalizations?
o What questions remain unanswered?
o How could future studies be improved?

Based on above parts, this articles has provided a thorough framework on the theory
of adverse selection which is firmly based on the existence of asymmetric
information of market interaction. This theory of adverse selection, its consequences,
and economic agent can act to extract private information/hidden information from
6

opposite party in order to improve his economic outcome are largely based on works
of three researcher namely George Akerlof, Michael Spence and Joseph Stiglitz. The
contribution of those three authors can be summarized as follows:
1. George Akerlof demonstrated how informational asymmetric can create adverse
selection problem in markets.
2. While Michael Spence showed that better informed economic agents in
asymmetric information market may have incentives to take certain actions to
give signals to uninformed agent, in order to improve their market outcome.
3. Stiglitz mentioned how poorly informed economic agents can extract private
information from those who are better informed by offering a set of alternative
contracts for a specific transaction, usually called screening through selfselection.
This articles also review other authors works that applied and tested the work of
these three researchers works. Most of other authors works that try to apply and
test the models suggested by George Akerlof, Michael Spence and Joseph Stiglitz
confirm the prediction of the models.
Moreover, the models suggested by those three author also successfully applied in
many other economic and social settings for example financial economics, industrial
organization. However, some attempts to test the prediction of the models suggested
by Akerlof did revealed some ambiguous results. For example a direct test carried
out by Bond (1982) on data from a market for second-hand small trucks did not
support the asymmetric information hypothesis. Chiappori and Salanie (2000)
examined whether individuals who buy car insurance car insurance with better
coverage have more accidents. However, they failed to find statistical support for
such correlation as suggested by adverse selection and signalling model. The
difficulty of such tests is to distinguish between adverse selection and moral hazard
problem; another is that screening and signalling partially eliminate the effect of
informational asymmetries.
Recently, many insights from economics of information have been incorporated into
development economics. This phenomena can be seen as
Organization

 The introductory paragraph summarizes the background information and purpose of the
research (specific questions the study researched).
Then, explain the methods that were used to investigate the research questions (use past tense).
Mention the major results of the study (use past tense).
State what the author of the study learned.
Critique: A Critical Review and Assessment of the Article
Include a summary as well as your own analysis and evaluation of the article.
Know the article thoroughly.
Do not include personal opinions.
Be sure to distinguish your thoughts from the authors words.
Focus on the positive aspects and what the author(s) of the study learned.
Note limitations of the study at the end of the essay:
o Do the data and conclusions contradict each other?
o Is there sufficient data to support the authors generalizations?
o What questions remain unanswered?
o How could future studies be improved?

REFERENCES
Holcombe, Randall G; Sobel, Russell S., Consumption externalities and economic
welfare, Eastern Economic Journal; Spring 2000; Vol 26 No. 2; 157.
Pindyck, Robert S.; Rubinfeld, Daniel L., Microeconomics (3rd edition), Prentice Hall,
1996,
Varian, Hal R., Intermediate Microeconomics A Modern Approach (Fifth Edition),
W. W. Norton & Company, New York-London, 1999.