For more than two decades, research on incentives and market
equilibrium in sit-
uations with
asymmetric information
has been a proliÞc part of economic
theory. In
1996, the Bank of Sweden Prize in Economic Sciences in Memory of Alfred
Nobel
was awarded to James Mirrlees and William Vickrey for their fundamental
contri-
butions to the theory of incentives under
asymmetric information, in
particular its
applications to the design of optimal income taxation and resource
allocation through
different types of auctions. The theory of markets with asymmetric
information rests
firmly on the work of three researchers: George Akerlof (University of
California,
Berkeley), Michael Spence (Stanford University) and Joseph Stiglitz
(Columbia Uni-
versity). Their pioneering contributions have given economists tools
for analyzing a
broad spectrum of issues. Applications extend from traditional
agricultural markets
to modern financial markets. This year’s laureates showed that these —
and many other — phenomena can be understood by augmenting the theory
with the same realistic assumption: one side of the market has better
information than the other. The borrower knows more than the lender
about his creditworthiness; the seller knows more than the buyer about
the quality of his car; the CEO and board of a firm know more than the
shareholders about the profitability of the firm;
insurance clients
know more than the insurance company about their accident risk; and
tenants know more than the landowner about harvesting conditions and
their own work effort. More speciÞcally, the contributions of the
prizewinners may be summarized as follows. Akerlof showed how
informational asymmetries can give rise to adverse selection in
markets. When lenders or car buyers have imperfect information,
borrowers with weak repayment prospects or sellers of low-quality cars
may thus crowd out everyone else from their side of the market, stißing
mutually advantageous transactions. Spence demonstrated that informed
economic agents in such markets may have incentives to take observable
and costly actions to credibly signal their private information to
uninformed agents, so as to improve their market outcome. The
management of a firm may thus incur the additional tax cost of
dividends, so as to signal high profitability. Stiglitz showed that
poorly informed agents can indirectly extract information from
those who are better informed, by offering a menu of alternative
contracts for a specific transaction, so-called screening through
self-selection. Insurance companies are thus able to divide their
clients into risk classes by offering different policies where, say,
lower premiums can be exchanged for higher deductibles. Stiglitz also
analyzed a range of similar mechanisms in other markets. Akerlof,
Spence and Stiglitz’s analyses form the core of modern information eco-
nomics. Their work transformed the way economists think about the
functioning of markets. The analytical methods they suggested have been
applied to explain many social and economic institutions, especially
different types of contracts. Other researchers have used and extended
their original models to analyze organizations and institutions, as
well as macroeconomic issues, such as monetary and employment policy.
Sections 1 though 3 give a brief account of the most fundamental
contributions by the laureates. Section 4 describes some applications
and empirical tests of their models. Below link to download pdf.