Peaches, Lemons, and Elephants: the 2001 Nobel Economics Prize

Listener 15 December, 2001.

Keywords History of Ideas, Methodology & Philosophy

Prizes for economic achievement are so idiosyncratically given out, that occasionally they get awarded for excellence. This year’s Nobel Prize went to economics to George Akerloff, Michael Spence and Joe Stiglitz, for their investigations into what happens when there is asymmetry of information in market transactions, and the buyers and sellers know different things about the purchased. Their studies show markets do not always function smoothly. For instance, the seller of a second hand car is likely to know more about its defects than buyers, who are therefore suspicious that anything being offered. (Why sell a good car?) Akerloff’s classic 1970 paper ‘The Market for Lemons’ showed how the outcome could be less than efficient. Noone will trade peaches, because buyers suspect them of being lemons.

Stiglitz extended the notion to insurance markets when it is the purchaser of insurance that has the additional information and the seller has to make sure the insured is not too risky. (It turns out one function of an excess or deductable is to bring the two interests in line.) Spence’s contribution, was to show how to convey credibly information that the product you are selling is valuable. For instance a student can signal to potential employers he or she is smart and motivated by achieving academic success in subjects which have little to do the actual job. (MIT economics professor, Paul Krugman, who can never resist a bon mot no matter how unfair, cites the author of “Liar’s Poker”, offering a ‘meaner but similar analysis [when] he declared that would be-investment bankers studied economics in order to demonstrate their willingness to engage in boring, humiliating activities.’)

The immediate practical implication of these studies is that where there is asymmetric information, there may be a case for intervention, although the caveat of the effectiveness of the action applies. (How would one effectively improve the market for lemons?). Recently Akerloff’s analysis has been applied to the share market. How does one know the insider (that is someone who has information most people do not) is actually offering a lemon, while promising a peach?

The analyses also have implications for how to manage the economy as a whole. Keynes’ ‘macroeconomic’ account of how economies experience persistent unemployment, involved some assumptions about how markets functioned, for which there was no underpinning microeconomic theory. (‘Macro’ refers to the economy as a whole; ‘micro’ refers to individual markets.) Monetarists argued these assumptions could not apply because they assumed irrational economic behaviour. While Keynesianism was never extinguished (it worked in practice if not in theory), the lack of proper foundations was a legitimate criticism. Models of markets with asymmetric information have provided the sort of microeconomics which the Keynesians originally assumed, and today the monetarists are on the backfoot, because their account of market behaviour now appears primitive.

I greatly admire these rigorous mathematical models. (Before I became an economist I was trained an applied mathematician.) But by focussing on them, the Nobel Prize committee ignores the really big issues which were once the heart of economics. Like: how do economies and society evolve? how does the economy interact with society? how can we influence the evolution and interaction? (A spoof applied mathematics question might illustrate the irrelevance. The student is asked to calculate the speed of an elephant sliding down a grass slope. An incredible amount of information is given – the coefficient of friction, the angle and direction of the slope, the day and time, the location of the sun and strength of the wind, the colour of the elephant and the grass, and so on and on. The last instruction is ‘you may neglect the shape of the elephant’.)

This irrelevance is well illustrated by the award to Stiglitz, which does not mention among his achievements the redirection of the development strategy of the World Bank, a policy development which is likely to benefit hundreds of millions of peoples in poor countries. It is easy to praise the specificities of his original paper, and ignore the enormous accomplishment of applying it and other key economic ideas (which he did not personally develop), even though the relevance and elegance is lost in order to derive useful conclusions. We do the same in our teaching of economics. Students may (or may not) be able to jump though the hoops of the rigorous models they are taught, but the really important issues are not taught, and they go out into a world bereft of any ability to tackle them. Some through sheer ability and diligent reading and discussion get up to speed, but one is continually struck by the irrelevance of much of the economists’ contribution to the big economic questions New Zealand and the world faces.

Alas, the Nobel Prize in economics reinforces this narrowness. It encourages us to appoint teachers who are as limited, and to belittle those who try to tackle questions because they are important rather than because they are mathematically tractable. Stiglitz’s real contribution to human welfare is unlikely to be recognised by a Nobel, unless they give him the Peace Prize.