The Nobel Prize

George A. Akerlof (b. 1940)

George Akerlof was born in New Haven, Connecticut, USA in 1940. Akerlof’s father, a chemist, held academic and research posts at, among others, Yale University – where he met his future wife (a chemistry graduate student) – and Princeton University. His elder brother followed their father into a career in science but Akerlof developed an interest in social matters such as ‘history and, if children can have such interests, economics’ (Nobel Foundation, 2004). Akerlof recalls that one of his first significant thoughts about the discipline came at the age of 11 or 12 when, prompted by his father’s move from one post to another, he speculated about the wider consequences of his father becoming unemployed and the family having to cut back on its spending. If this caused another father to lose his job, spending to fall further and so on, the economy could falter. Thus Akerlof’s professional commitment to Keynesian macroeconomics was prefigured in pre-adolescent reflections about the interdependency of families in their contribution to the maintenance of aggregate demand.

Akerlof attended Yale as an undergraduate and was awarded a BA in mathematics and economics in 1962. In 1966 he received his PhD at the Massachusetts Institute of Technology (MIT). His PhD thesis developed themes that were Akerlof’s first attempts ‘to base George A. Akerlof (b. 1940) © The Nobel Foundation  Keynesian economics on sound microeconomic foundations’ (Nobel Foundation, 2004). Perhaps even more significantly, he was shortly to use techniques from his thesis in his ‘Market for “Lemons”’ paper (Akerlof, 1970).

After graduating from MIT, Akerlof obtained an assistant professorship at the University of California, Berkeley. In 1967–68 he was visiting professor at the Indian Statistical Institute and he spent the summer of 1969 as a research associate at Harvard University. Akerlof subsequently returned to Berkeley where from 1970 until 1977 he was associate professor. In 1977–78 Akerlof was visiting research economist in the Special Studies Section of the Board of Governors of the Federal Reserve System. From the Fed, Alerlof moved to London where he was Cassel Professor with respect to Money and Banking at the London School of Economics between 1978 and 1980. Since 1980, Akerlof has been Koshland Professor of Economics at Berkeley, and since 1994 he has been Senior Fellow at the Brookings Institution, Washington.

Akerlof’s awards and distinctions include vice presidency of the Executive Committee of the American Economic Association, 1988– 91 and 1995. He is a fellow of the American Academy of Arts and Sciences and has held Guggenheim and Fulbright fellowships. In 2001, Akerlof was awarded the Nobel Memorial Prize in Economics jointly with A. Michael Spence and Joseph E. Stiglitz ‘for their analyses of markets with asymmetric information’ (Nobel Foundation, 2004).

The ‘Market for “Lemons”’ is Akerlof’s best-known paper. Indeed it ‘is probably the single most important contribution to the literature on economics of information’ (Löfgren et al., 2002, p. 197) and is the paper for which Akerlof was awarded the Nobel Memorial Prize. Akerlof wrote this paper – 13 pages long – during his first year at Berkeley in 1966–67 when he was 26 years old. As has been the case for other seminal works by Nobel Memorial Prize recipients (see, for example, the entry on Vernon Smith in this volume), the paper found a home only after a fairly protracted struggle by its author. It was rejected in turn by: the American Economic Review, the Review of Economic Studies and the Journal of Political Economy. The first two rejections were on the grounds of triviality, the last was because the argument Akerlof had advanced was, in the view of the Journal of Political Economy’s referees, simply wrong. The paper was subsequently accepted and published in the Quarterly Journal of Economics in 1970.

Akerlof’s original intention in developing the ‘Lemons’ paper (lemon is an American slang word for a poor-quality car) was to try to show that buyers’ information uncertainties about the quality of cars in the used-car market would tend to push them into the newcar market. Motivated by the problem of unemployment and ‘the financial hardship and the loss of identity that it entails’, Akerlof’s wider purpose was to understand fluctuations in new car sales as a causal factor in the exacerbation of the business cycle (Akerlof, 2002). Although he struggled to realise his ambition to model the business cycle, Akerlof saw that his insights into asymmetric information in the used-car market would allow him to say something important about conditions in that market. Moreover, he was able to generalise his conclusions to other markets characterised by asymmetric information.

The ‘Lemons’ paper demonstrated that the presence of asymmetric information in the used-car market would tend to lower the average quality of cars sold and reduce the size of the overall market: essentially – in what Akerlof noted was a modified version of Gresham’s Law – the bad cars would drive out the good, leaving an ‘adverse selection’ of lemons. Because car buyers have less information than sellers, it is difficult for them to discern whether they are getting a lemon or a car of good quality. Accordingly, prices are depressed given the risk of buying a lemon, and sellers of better cars leave the market because they are unable to realise the ‘true value’ of their cars (Akerlof, 1970).

Akerlof then went on to show that the inferior market outcomes associated with the presence of asymmetric information might arise in the market for insurance, in the employment of minorities and in credit markets in developing countries. He also suggested that his ‘Lemons’ model could be used to illustrate the full costs of dishonesty in economic transactions. Such costs extend beyond those incurred by the cheated purchaser of a good (say) misrepresented in value, and would additionally encompass losses arising from the desertion of the market by honest traders.

Finally, the ‘Lemons’ paper considered the range of institutions that have emerged to offset the effects of information imbalances in markets. Akerlof pointed to product guarantees, branding and licensing as mechanisms of reassurance for the uninformed consumer. Presciently he also noted that skilled labour usually carries ‘some certification indicating the attainment of certain levels of proficiency  … even the Nobel Prize, to some degree, serves this function’ (Akerlof, 1970 p. 500). Akerlof (1976) offers a more discursive review of the implications of asymmetrical information in a range of settings.

Akerlof’s other main contributions to economics have centred on the microtheoretic foundations of New Keynesian behavioural macroeconomics (Akerlof, 2002). He has, for example, produced a number of important papers on efficiency wage theory. This seeks to explain why firms may choose to pay above market-clearing wage rates thereby generating involuntary unemployment (see Akerlof, 1980 and 1982; Akerlof and Yellen, 1990).

Using behavioural macroeconomics, Akerlof has also sought to demonstrate, pace monetarist and other interpretations, that monetary policy does influence the paths of real variables such as output and employment. In joint work with Janet Yellen, Akerlof proposed ‘near-rational’ behaviour by firms following money-supply- induced demand shocks that produces intertial price setting (Akerlof and Yellen, 1985). In the presence of sticky prices there is ‘a robust relation between changes in the money supply and changes in output’ (Akerlof, 2002, p. 418).

Finally, again in joint work, Akerlof has suggested that the behavioural approach to macroeconomics may provide alternative interpretations of the long-run Phillips curve. In particular, when inflation is low it may not be ‘salient’ and thus inflationary expectations have a negligible role in wage bargaining. The result is that there is a permanent trade-off between inflation and unemployment in the presence of low inflation (see Akerlof et al., 1996; 2000). For Akerlof (2002, p. 422), this in turn gives rise to a further important implication for the contemporary ‘rules-based’ conduct of monetary policy: ‘Most of us think of central bankers as cautious, conservative and safe. But I consider them to be dangerous drivers: to avoid the oncoming traffic of inflation, they drive on the far edge of the road, keeping inflation too low and unemployment too high’.

Main Published Works
(1970), ‘The Market for “Lemons”: Quality Uncertainty and the Market Mechanism’, Quarterly Journal of Economics, 84, August, pp. 485–500.
(1976), ‘The Economics of Caste and of the Rat Race and other Woeful Tales’, Quarterly Journal of Economics, 90, November, pp. 599–617.
(1980), ‘A Theory of Social Customs of Which Unemployment May Be One Consequence’, Quarterly Journal of Economics, 94, June, pp. 749–75.
(1982), ‘Labour Contracts as Partial Gift Exchange’, Quarterly Journal of Economics, 97, November, pp. 543–69.
(1984), An Economic Theorist’s Book of Tales, Cambridge: Cambridge University Press.
(1985), ‘A Near Rational Model of the Business Cycle with Wage and Price Inertia’ (with J. Yellen), Quarterly Journal of Economics, 100 (supplement), September, pp. 823–88.
(1990), ‘The Fair Wage Hypothesis and Unemployment’ (with J. Yellen), Quarterly Journal of Economics, 105, May, pp. 255–83.
(1996), ‘The Macroeconomics of Low Inflation’ (with W.T. Dickens and G.L. Perry), Brookings Papers on Economic Activity, 1, pp. 1–59.
 (2000), ‘Near-Rational Wage and Price Setting and the Long-Run Phillips Curve’ (with W.T. Dickens and G.L. Perry), Brookings Papers on Economic Activity, 1, pp. 1–44.
(2002), ‘Behavioural Macroeconomics and Macroeconomic Behaviour’, American Economic Review, 92, June, pp. 411–33.

Secondary Literature
Löfgren, K.-G., T. Persson and J.W. Weibull (2002), ‘Markets with Asymmetric Information: The Contributions of George Akerlof, Michael Spence and Joseph Stiglitz’, Scandinavian Journal of Economics, 104 (2), pp. 195–211.

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