On George Akerlof’s “The Market for Lemons”
The Economist magazine is running a series on six big economic ideas that have shaped the field in recent decades, and they start with one of the best—George Akerlof’s 1970 “The Market for Lemons.”
The concepts in the paper were groundbreaking insights about the price distortions that come about when one party has more information than the other, and influence economics and regulation to this day. But the history of the paper and its ideas also illustrate how close-minded mainstream economics has been, a problem that continues to plague the field.
Akerlof shared his Nobel with Joe Stiglitz and Michael Spence. All three economists questioned a basic premise of standard microeconomic theory—that parties to market transactions have equal and perfect information, and that information equality helps produce market-clearing prices (covering not only commodities, but labor and finance) resulting in fair competition between equally informed parties.
This presumption about individual transactions was linked to claims that the totality of these fair, competitive private market transactions produces optimal overall social returns. Any flaws were consigned to “market failures” where the government could step in, but in standard theory those are rare events, with fair market transactions dominating.
If asymmetric information only explained a few marginal market failures that deviate from the perfect information scenario, it wouldn’t be so important. After all, Akerlof’s original paper was about the market for used cars. How important is that?
But the ensuing decades have shown the pervasive nature of the problem. In market after market—financial, labor, housing—information asymmetry and the accumulation of rents and unequal power are fundamental features. Thus it is the theoretical perfect market that is the rare exception, if it exists at all, and the asymmetric, unequal relationship that characterizes all markets.
Ideas have consequences, of course. Belief in fair and equal market transactions was part of the reign of “market fundamentalism” in economics that undergirded the financial deregulation of the 1990s. And that misguided deregulation brought us the financial and economic crisis of 2008 which continues to this day.
Examples are everywhere. Unequal bargaining and informational power in labor markets contributes to massive inequality. Lack of consumer information leads to exploitation in housing finance, retirement investing, and health care. And unequal information and power in financial markets spurs inequality and massive concentrations of wealth, which in turn are used to distort economic rules in favor of further inequality.
But there is another essential part of the Akerlof story—the narrow-minded nature of academic economics. The paper was rejected from several major economics journals. His graduate students at Berkeley had to read the paper in mimeographed form, as Akerlof had trouble getting it published. He testifies that the American Economic Review and The Review of Economic Studies both rejected the paper on the grounds that the subject was trivial.
But the paper’s rejection from the Journal of Political Economy was the most telling. According to Akerlof, one reviewer recognized the profound issues in the paper, and rejected it on the basis that “if this paper was correct, economics would be different.”
We at INET are great admirers of these three great economists. They have spoken at INET conferences and we consult with them regularly. (Here are selected video links on INET’s web site to Akerlof, Stiglitz, and Spence.)
Their spirit of critical inquiry informs not only INET’s work but all economists who strive to make the discipline both more rigorous and more realistic. But while it is good that The Economist and others recognize the power of Akerlof’s ideas, the story of “The Market for Lemons” also must remind us about how hard it was—and still is—for new economic thinking to be heard and accepted by most economists.