Joseph Stiglitz, george akerlof, and michael spence shared the 2001 Nobel Prize “for their analyses of markets with asymmetric information.” The particular market with asymmetric information that Stiglitz analyzed was the insurance market. In 1976, Stiglitz and coauthor Michael Rothschild started from the plausible assumption that people buying insurance know more about their relevant characteristics than the insurance company selling it. They then showed that it would be in the insurance company’s interest to “sort” its customers by risk category by offering a range of insurance products to all and letting the customers self-select. A low-premium, high-deductible health insurance policy, for example, would be attractive to healthy customers and unattractive to unhealthy customers. The unhealthy customers would be more likely to purchase a high-premium, low-deductible policy. In this way, the market would lead to what the authors called a “separating” equilibrium—that is, a market in which people’s risk category determined the kind of insurance they bought. Stiglitz and Rothschild also showed certain conditions under which there would be no equilibrium and the market would simply not exist.
Stiglitz realized that information asymmetry applies not just to insurance contracts, but also to much economic behavior. If there were no asymmetries in credit markets, for example—that is, if borrowers knew no more about their probability of repaying than lenders knew—then lenders would simply charge higher interest rates to higher-risk borrowers. But in 1981 and 1983, Stiglitz and Andrew Weiss showed that, to reduce losses, lenders have an incentive not only to charge higher rates to high-risk borrowers, but also to ration credit to them. In fact, such rationing is widely observed in credit markets.
Stiglitz’s work with Carl Shapiro on “efficiency wages” (see New Keynesian Economics) is another major contribution to the economics of asymmetric information. The basic idea is that firms may want to pay a wage higher than otherwise to give workers an incentive not to shirk. If wages are set so that there is no unemployment, a worker who is fired for shirking can simply get a job at the same pay elsewhere. So firms set wages higher than that. At a higher wage, each firm wants to employ fewer people, but more workers want to work at a higher wage than at a lower wage. The result: unemployment, even in the long run.
Stiglitz has also contributed to the theory of optimal taxation. In 1978, for example, he showed that, under reasonable assumptions, an estate tax will make incomes more, not less, unequal. His basic argument is that the estate tax may reduce savings, and the reduction in savings and capital accumulation will lead to a lower ratio of capital to labor; this greater scarcity of capital will increase the return to capital and, under certain assumptions, increase the share of income that goes to capital. Assuming that capital is more unequally distributed than labor, the result will be higher inequality of income.
From 1993 to 2000, Stiglitz entered the political arena, first as a member and then as chairman of President Bill Clinton’s Council of Economic Advisers, and then as the chief economist of the World Bank. In this latter role he had major conflicts with economists at the International Monetary Fund (IMF) and at the U.S. Treasury over their views of government economic policy in Indonesia and other poor countries. Stiglitz objected to their advocacy of tax increases and tight monetary policy during times of recession, a policy that he called “market fundamentalism.”
Over the years, Stiglitz has been critical of free markets), mainly because of the information asymmetries that exist in many markets. Stiglitz often called for government intervention to correct these market failures, but his arguments for these interventions were always what might be called “possibility theorems.” He showed how it is possible for government to improve on markets but never explained the incentives that would lead government officials to do so. Possibly because of his experience in Washington, Stiglitz started to consider the incentives of government officials. In his conflict with IMF economists, for example, Stiglitz said, “Intellectual consistency should lead them to ask themselves, ‘If we believe that government bureaucrats are always incompetent, then why are we an exception?’” Stiglitz continued to question the incentives of government officials. In his Nobel lecture he took up the issue again:
The problem is to provide incentives for those so entrusted to act on behalf of those who [sic] they are supposed to be serving—the standard principal agent problem. Democracy—contestability in political processes—provides a check on abuses of powers that come from delegation just as it does in economic processes; but just as we recognize that the take-over mechanism provides an important check, so too should we recognize that the electoral process provides an imperfect check. Just as we recognize that current management has an incentive to increase asymmetries of information in order to enhance its market power, increase its discretion, so to [sic] in public life.
Stiglitz went on to compare government monopolies and private competitive firms:
In the context of political processes, where “exit” options are limited, one needs to be particularly concerned about abuses. If a firm is mismanaged—if the managers attempt to enrich themselves at the expense of shareholders and customers and entrench themselves against competition, the damage is limited: customers can at least switch. But in political processes, those who see the quality of public services deteriorate cannot do so as easily.
While Stiglitz still puts his faith in government officials, it is a tempered faith. He suggests that getting rid of government secrecy would be a partial solution toward limiting the abuses of government.
Stiglitz earned his B.A. in economics at Amherst College in 1964 and his Ph.D. in economics from MIT in 1967. He has been a professor at MIT, Yale, Oxford, Princeton, Stanford, and Columbia. He is currently a professor at Columbia University.
1976 (with Michael Rothschild). “Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information.” Quarterly Journal of Economics 90: 629–649.
1978. “Notes on Estate Taxes, Redistribution, and the Concept of Balanced Growth Path Incidence.” Journal of Political Economy 86 (April): S137–S150.
1981 (with Andrew Weiss). “Credit Rationing in Markets with Imperfect Information.” American Economic Review 71: 393–410.
1983 (with Andrew Weiss). “Incentive Effects of Terminations: Applications to the Credit and Labor Markets.” American Economic Review 73: 912–927.
1984 (with Carl Shapiro). “Equilibrium Unemployment as a Worker Discipline Device.” American Economic Review 74: 433–444.
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Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information
Joseph E. Stiglitz; Michael Rothschild
- Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information
- Stiglitz, Joseph E.
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- This paper analyzes competitive markets in which the characteristics of the commodities exchanged are not fully known to at least one of the parties to the transaction and suggests that the comforting myth that serious consideration of costs of communication, imperfect knowledge, and the like complicate without informing is false. Some of the most important conclusions of economic theory are not robust to considerations of imperfect information. We are able to show that not only may a competitive equilibrium not exist, but when equilibria do exist, they may have strange properties.
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- Joseph E. Stiglitz, Michael Rothschild, 1976, Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information, Columbia University Academic Commons, https://doi.org/10.7916/D8P277RB.