Nobel Prize, Economics, and Used Cars

Does the Study of Economics Deserve Its Own Nobel Prize?

By: Yuhong Qian

Posted: 1/7/02

H0: Economics does not deserve a Nobel Prize.

Ha: not H0.

In 2001, Akerlof, Spence, and Stiglitz won the Nobel Prize "for their analyses of markets with asymmetric information". Coincidentally, Professor Michael Raith talked about this theory in our Microeconomics class last semester in a vivid manner. After I had seen an online discussion over the Nobel Prize in Economics, I felt that I was obliged to initiate a debate and any comments are welcome.

Asymmetric information and its application

Much of economic analysis assumes that markets are characterized by full information: both buyers and sellers know everything about the product they are buying or selling. However, many markets are characterized by the fact that either the buyer or the seller has considerably more information about the product than does the person or firm on the other side of the transaction.

George Akerlof illustrated the most famous example of asymmetric information in his 1970 paper on "The Market for Lemons". The paper examined the market for used cars to illustrate the importance of informational asymmetries. The scenario is quite simple - the seller of a used car usually knows more about it than does the buyer. They know, for example, how well it runs on the highway, in the snow, when it's hot outside, etc. The buyer knows relatively little. So if a seller offers to sell the car for, say, $5,000, the buyer should be suspicious, since, if the car were worth more than $5,000, the owner would not be selling it at that price. In this case, Akerlof showed that the market might break down completely.

This general idea can be used to explain many issues in many markets. Perhaps the most important market with significant asymmetric information is the market for health care. The buyer knows much more about her health and habits than does the insurance seller. For example, a company that offers a really good (but expensive) health policy will find that only the sick (or likely to be - say the smoker, the skydiver, and the race car driver) will buy that kind of insurance. Only those who expect to get more from the policy than they pay in premiums will be likely to purchase, meaning that the people who buy will be less healthy, and likely to make the policy unprofitable for the firm.

The consequences of asymmetric information can be profound. In the extreme, markets with asymmetric information may simply cease to exist. In other cases, asymmetric information will cause the market to "behave badly" and thus create an opportunity for a government or some external organization to come in and intervene to improve the private market outcome.

Do we need a reason to reject H0? No, we don't. Do we? No, we don't.

Is Economics a Failure?

Here's one comment made by an arts major:

"The Nobel Prize in economics is a joke. It isn't a hard science, the findings, in most cases, can never be proven unequivocally, and the voting system for the Nobel prizes, coupled with the large number of winners from Chicago/MIT, skews the process towards U.S. winners… If Economics were that good, world poverty and wealth inequality would have disappeared a long time ago and the economists on TV who blabber about the world economy and the stock market would have become very wealthy men."

Disagree. Economics is one of the most interesting and popular fields of study in the world. Economics is a "social & behavioral" science coupled with the extensive use of mathematics and statistics. Economics examines the use and relocation of scarce resources. This is a very practical and powerful field of science that can be itemized as global economics, industrial economics, firm-level economics, and home economics etc.

Even more interesting, it gives you a perfect chance to quantify the functioning of our society while not forgetting the "human" aspects. The world still hasn't found a cure for cancer - does that mean biologists and medical researchers are useless people? Yes, the world still hasn't found a cure for "world poverty". While Economics defines the problem and provides an analytical answer, it is up to the world leaders and the appropriate social structure around the world for initiating the cure. The system that we are all living in is defined by Economics...never underestimate it. The game theory, price discrimination, and info asymmetries are all very critical skills for any successful manager. Macroeconomics has tremendous application on policymaking. Every science has its limits, whether it is mathematics, physics or whatever "hard" stuff that you can think of.

Some countries in the world are extremely poor not because the science of economics is weak, but because it normally plays a secondary role to politics. If an efficient way for a society to allocate resources for the development of a country is (for example) to move some resources from the rich to the poor, the rich would not like it and most likely block its implementation. Even when the economists are in power, politics is always what brought them there and their interests/motivations will be above what's right for the society. Politics in many cases interferes with the recommended "rational economic" policy to such extent that it impedes any advance. Thus, to say that the existence of many extremely poor countries in the world shows that economics should not be classified as an important subject of study for societies is inappropriate.

Just Common Sense?

A science major said:

"…Scientific achievements help us to live healthier and more productively, peacemakers help us to live peacefully, and writers help us to live more fulfilling and enriched lives. It's hard for me to ascertain how economists actually make our lives better. In my opinion, economists have never arrived at any important conclusions that were not simply derivatives of common sense.

For example, economics says that when supply is lower, a merchandiser can charge a higher price for her products, but common sense would tell her the same thing... Economics says you should invest in projects that have the highest return for the (same) amount of risk - common sense says the same thing. Economists try to make guesses at when a recession will come, but their predictions are often no better than the common sense of a sales clerk who sees business beginning to decline, hence the maxim, 'economists have predicted 9 of the past 5 recessions.'

As for the 2001 Nobel Prize-winning idea that buying a used car at a fair price is hard because you know less than the seller, did it take a Nobel Prize winner to figure that out? Trust your common sense first, economists second..."

Interesting argument, but those common-sense-like theories are actually the foundations for some complicated works. To get a better understanding of the economic research, I would read some leading economic journals, such as AER (American Economic Review), rather than only the Econ 101 stuff. Furthermore, common sense is hard to follow in reality. For example, managers should focus on economic profit as an end metric, but many don't. People protest in the streets over free trade when we know that it creates wealth, especially in poor countries. People think that famines happen because there is not enough food in the world even though the 1997 Nobel Laureate demonstrated that every famine in the 1900s was caused by a lack of infrastructure instead of a lack of food. We know that price control results in a deadweight loss (DWL), but that is one of the most adamant policies adopted by almost every country in the world.

Economics is similar to physics, anthropology, and all the other social and hard sciences in that it attempts to set up rational theories. They are all grounded in following logic (a.k.a. common sense). While the theories of asymmetrical information may be elegantly straightforward now, they describe what before were seemingly illogical events. Don't most great insights work that way?

On the other hand, what's the definition of common sense? For some people, government's heavy intervention on economy seems to be the sure thing to improve the living standard. It is the economic theory that proves "Government is very unlikely to do it right." (Professor Kevin Murphy, the 1997 recipient of John Bates Clark medal). Even it's proven by immense amount of empirical evidence, those governments in the third world would never listen. And if common sense were followed, the September 11 attack would be a bad thing for economy. But the shocking truth is that "disaster is normally good for the country" (Professor Gary Becker, the 1992 Nobel Prize winner). And it would not be easy to detect those two discoveries just by naked eyes or any simple Econ 101 supply and demand model.

So what is common sense? To me, it depends. Any conventional wisdom out of common sense might be wrong without any proof. Second, what's our common sense based on? Are those based on prior discovery or simply pure common sense? To me, the Earth is not flat. But for those ancient people, they would declare a war on you if you said that the Earth is a ball. Why? Because their common sense tells them that I must be crazy to say that. Thinking of the people in the future, what we think is absolutely true might be totally ridiculous for them simply because they will adopt more advanced knowledge to prove their ancestors wrong.

So if somebody thinks the economics is not a science just because those economists always say some "nonsense" or are impotent to improve the economy, I would disagree. Economics is still a very young science and it's just so hard to come up with any perfect solution when the economists are facing the "Earth village" consisting of human beings with different characteristics (physicians working hard to cure the sick people, lawyers working damn hard to win the case and maniacs working a zillion times harder to bomb Twin Towers just to sooth their envy) instead of just cells or particles.

Third, any briefing from the Nobel Prize Committee is for the general audience. The theory and the attached descriptions behind those one-sentence statements is very complicated and applicable to many aspects of our economy, not just as simple as "when buying a used car, the producer surplus would be far bigger than the consumer surplus."

What are the Tangible Results?

Here's another statement from an engineering major:

"In physics, chemistry, and medicine, the answers are obvious: we have lasers, semiconductors, vaccines, etc. In economics, I am probably 'ignorant' of the practical benefits of economic research. It seems to me that:

1. The economists at the Fed couldn't achieve the "soft landing" this time that they had hoped.

2. The economists at the World Bank haven't managed to do much with the Third World. In essence, we've wasted billions of dollars. Even if the governments in Third World nations were incompetent, I would have expected some marginal benefit from World Bank's action.

3. The economists at the IMF aren't always the best at helping the nations they're supposed to help, e.g. Indonesia in the Asian financial crisis.

4. It seems that nations like South Korea have achieved impressive economic growth while defying the conventional wisdom among economists that government control is bad for the economy. It also seems that South Korea has become a world leader for semiconductors, shipbuilding, steel, and other industries that it was advised not to enter by world economists back when it was mostly an agricultural and textile-producing nation (Economists said Korea's comparative advantage was in cheap labor, and ought to stick to shoes and shirts).

So anyone here who can take me out of my current state of ignorance, please do so..."

I would be happy to do so briefly. For #1, there's a lag between the execution of the policy and its impact on the economy. Just merely after a month since the attack, the stock markets were back to where they had been before the attack. This was partially because of the government's huge stimulus package and aggressive Fed policy on cutting the fund rate. The reason why they cannot act quickly on this bad economic condition is partially because they fear inflation at the same time. Why do they need to worry about inflation while the economy is still in recession and nobody seems like spending money? This issue is too complicated for me to answer in one or two paragraphs. I believe this is still a "soft landing" thanks to the Fed. This recession is one of the mildest in history.

For #2, I believe the World Bank wasted tons of money. This was not because of the economists' wrongdoing but because of the lack of efficient infrastructure and lack of entrepreneurial spirits of those poor countries. Famine is not the reason for them to be poor and be starved to death. The bad government is! Unfortunately, the World Bank didn't see it this way. They are wasting money and giving them food and even free loans. This actually partially hurt them more. There is an old saying, "You'd better be taught how to fish instead of be fed fish by others so that you can fish for yourself." This is exactly what the World Bank is doing - feeding fish to the poor instead of what the economists would say: "Teach them how to fish".

For #3, it's complicated. This financial crisis in Indonesia might be caused by them piggybacking their currency (the rupiah) to the US$, which means that they fixed their exchange rate. This is always a bad thing to do. This crisis also might be caused by their messy financial institutions.

For #4, I believe you are against yourself. Steels, semiconductors or even cars are becoming industries where the countries with cheap labor will prevail. Looking at the Personal Computer (PC) industry, ten years ago the only place producing this luxury good was the U.S. Now, PCs have become something like TVs or DVDs, whose profit margin is very slim. This is partly the definition of the product of cheap labor - lean profit margin.

A Story

Here's a story about Professor Spence (last year's Nobel Laureate):

While a Stanford MBA student was taking an Economics class with another professor, Professor Spence walked in and spent some time going over his theory and its impact. At the end of the explanation, he said "For some reason that was good enough for a medal." His humility at the simplicity of what he had found masked the real value that is present in any great discovery. That is, making the profound obvious (i.e. common sense), and writing the formulas that the rest of us can use to appear smart.

Now I guess that you are most likely committing a Type I error if you accept H0.