George A. Akerlof, An Economic Theorist's Book of Tales, Cambridge University Press, 1984

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The 2001 Nobel Prize for economics went to George A. Akerlof, A. Michael Spence and Joseph E. Stiglitz “for their analyses of markets with information asymmetry”. The theme of information might seem at first sight somewhat marginal to the traditional field of economics. But this is what makes it important.

Economic action in a broad sense (any business or market activity in fact) is based on possession and management of information and on its transparency. Control, use and transparency of information are crucial to any strategic or operational decision or in general any choices in day-to-day life.

Akerlof is known for two concepts in particular. Both concern us directly. The concept of adverse selection is seen mostly clearly in the field of insurance. If an insurer increases the price of a policy, some of its clients may choose not to take out that policy, which has become too costly. This will be the choice of those less likely to suffer the events that give rise to payment by the insurer, while clients more at risk find no advantage in changing their choice, even if they have to pay a higher premium. In modifying contract conditions, the insurer is thus inducing clients less at risk not to underwrite their policies any more, thereby raising the percentage of clients with higher levels of risk. Abandon by less risky clients means that average claim payments per client will increase in relation to a given premium collected. So the insurer, which would benefit by guaranteeing itself a less risky and less expensive clientele, ends up producing the opposite result due to those modifications to the contract conditions. The other concept that has made Akerlof famous is the lemon theory, the classic case being the 2nd hand car market. Buyers of used cars don’t know of they’re buying a dud or a good car, so they’re willing to pay a price somewhere between that of a dud and that of a good car based on the probability that the car put on sale is a dud. If buyers had perfect information, they would be certain of knowing the value of the car and would simply pay a price equal to that value. In conditions of information asymmetry, car salesmen will be less willing to sell good cars because the price is too low and on the other hand will sell more duds because they make good margins on them.

Buyers notice this tendency and are no longer prepared to pay. So prices continue to fall and more and more duds are put on sale. This would logically lead to no good cars being sold at all and the market would be swamped with duds. So, unwise use of information may lead to paradoxical situations in which businesses favour their worst customers, suppliers and stakeholders in general, at the expense of the best.