george-akerlof

George Akerlof

Thinker

The mind behind identity economics and the theory of asymmetric information

Intro

George Akerlof is an American economist who, throughout his career, has continuously emphasized the importance of integrating psychology and economics. The importance of incorporating factors such as emotion and cognitive bias into economic models has been increasingly acknowledged over the past decades. With his theories of asymmetric information, the role of identity in economics, and animal spirits, the psychological factors that influence our economic decision-making, it is clear that Akerlof has played a key role in bringing these two fields together.

 

I think it’s natural to combine psychology and macroeconomics. Actually, if you don’t take psychology into account, I think it’s fairly hard to give a model of the economy that explains a great deal of the economic fluctuations that are going on.

– George A. Akerlof in an interview with Conor Clarke for The Atlantic in 2009

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Innovative Ideas

Asymmetric information – A discrepancy in the information available to buyers and sellers

Akerlof pioneered this theory in 1970, in his paper “The Market for Lemons: Quality Uncertainty and the Market Mechanism”. The word “lemon” is a slang term referring to a car with several defects. He used the example of cars to illustrate his theory, claiming that buyers are often unable to differentiate a lemon from a good car.1 This allows sellers to get away with selling low-quality products at high prices. Economist Michael Spence built upon the idea presented by Akerlof in his 1973 paper, “Job Market Signaling.” Spence suggests that this theory applies not only to buyers and sellers but to employees and employers. When an employer hires a new employee, it is as though they are playing the lottery; they cannot be certain of how productive the new hire will be.2 Joseph Stiglitz is credited with popularizing the theory of asymmetric information.3

Akerlof used the example of cars to illustrate the information gap between sellers and buyers.4 He argues that the reason buyers cannot tell the difference between a lemon and a good car is that they do not have access to the information necessary to do so. Sellers, on the other hand, do have access to this information. Therefore, car salespeople are able to sell cars for more than they are worth. Akerlof also points out that, because buyers are not privy to the information that allows them to differentiate between a lemon and a premium car, they may be willing to pay nothing above the average price. While this can benefit sellers of low-quality cars, who would otherwise have to sell their cars for well below the average price, it may be to the disadvantage of sellers of premium cars who should be able to sell their cars for well above the average price.5

The theory of asymmetric information has been used to explain market failures, which are defined as “an inefficient distribution of goods and services in a free market, in which prices are determined by the law of supply and demand.”6


“The difficulty of distinguishing good quality from bad is inherent in the business world; this may indeed explain many economic institutions and may in fact be one of the more important aspects of uncertainty.”

― George A. Akerlof in “The Market for Lemons: Quality Uncertainty and the Market Mechanism”

Identity economics – How our economic lives are influenced by our view of ourselves

Economics cannot be understood without taking human agency into consideration. This is something Rachel E. Kranton pointed out to Akerlof in a letter in 1995. Kranton, who obtained her Ph.D. in Economics from the University of California, Berkeley in 1993, is particularly interested in the study of the ways in which social settings impact economic outcomes.7 One of her principal lines of research is on the role of identity, something she argued that Akerlof was wrong to omit in his own work. Kranton’s letter, in which she insisted that Akerlof’s oversight made the conclusions drawn in his most recent paper wrong, gave way to a longstanding and incredibly productive collaboration.8 Their collaborative efforts culminated in the 2010 release of their book, Identity Economics. The term “identity economics” refers to the study of how one’s identity influences the decisions they make. It explains in part why many of us make different economic choices even when in the same circumstances.

Akerlof and Kranton’s study of identity economics examines not only the influence of identity on decision-making but also the influence of social norms. The concept of identity is closely linked to our conceptions of what is and is not proper, and together these factors constrain the choices we make in regard to our finances.9 How we view ourselves and the ways we envision ourselves carrying out our jobs can incentivize us to perform, in the same way that the prospect of making money does.10 For example, research has shown that when employees incorporate their job into their identity, a concept referred to as organizational identification, they perform better at work.11 In other words, this means that they define themselves, to some extent, as by their association with the organization for which they work. For instance, a professor at a big university may identify as both an educator and a member of that university. These may be important aspects of how they view themselves and, because of how important their job and the organization for which they work are to their identity, they will be motivated to work harder and set higher standards for themselves. Additionally, because of how it incentivizes employees to enhance their performance, organizational identification is indirectly linked to increased customer satisfaction and the company’s overall performance.12

Economists have come to recognize that psychology and economics are inherently intertwined. We cannot truly understand the decisions people make about their economic lives without examining the role of their identity and the influence of societal norms. By furthering this line of research, Akerlof and Kranton have given us a more accurate understanding of why people make the economic decisions they do.


“The idea is that in any situation, people have a notion as to who they are and how they should behave. And if you don’t behave according to your identity, you pay a cost.”

― George A. Akerlof

Animal spirits – How psychology drives the economy

In their 2009 release, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, Akerlof and co-author, fellow economist Robert Shiller, built upon the work of John Maynard Keynes to describe how psychology and emotion, the so-called “animal spirits,” drive the economy. They also provide recommendations for mitigating the often detrimental consequences that result from this. Keynes, a famous twentieth-century British economist, coined the term “animal spirits” in reference to the psychological and emotional factors that influence people’s economic decisions in times of uncertainty.13 Specifically, it refers to the factors that underlie investor’s confidence, which may spur them into action when faced with volatility within the economy.14 Keynes applied this concept to the Great Depression, noting the gloom and pessimism that preceded the economic crash, and the positive shift in the psychology of the general populous that emerged alongside financial recovery.15 Akerlof and Shiller brought the concept of animal spirits back into the mainstream with the publication of their book, offering up modern applications of the concept and putting forth their own recommendations.


“The thought experiment of Adam Smith correctly takes into account the fact that people rationally pursue their economic interests. Of course they do. But this thought experiment fails to take into account the extent to which people are also guided by noneconomic motivations. And it fails to take into account the extent to which they are irrational or misguided. It ignores the animal spirits.”

― George A. Akerlof and Robert Shiller in Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism

Specifically, Akerlof and Shiller apply the concept of animal spirits, which are the psychological factors that drive our economic decision-making, to the 2008 stock market crash. They argue that when there is no government intervention to mitigate the influence of these animal spirits, the result is a financial crisis, just like the Great Recession in 2008.16 They suggest that the government needs to take an active role in economic policymaking in order to keep the animal spirits under control.17


“Yet we are currently not really in a crisis for capitalism. We must merely recognize that capitalism must live within certain rules. Indeed our whole view of the economy, with all of those animal spirits, indicates why the government must set those rules. It may be true that in the classical model there is full employment. But in our view the waves of optimism and pessimism cause large-scale changes in aggregate demand. Since wages are determined largely by considerations of fairness, these changes in demand translate not into shifts in wages and prices but into shifts in employment. When demand goes down, unemployment rises. It is the role of the government to mute those changes.”

― George A. Akerlof and Robert Shiller in Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism

Historical Biography

Born in 1940 in New Haven, Connecticut, George Akerlof received a Bachelor of Arts from Yale in 1962 and a Ph.D. from the Massachusetts Institute of Technology in 1966.18 Upon obtaining his Ph.D., Akerlof became an assistant professor at the University of California, Berkeley and in 1978 he became a full professor.19 In addition to the University of California, Akerlof has taught at the London School of Economics and Georgetown University.20 He is principally interested in macroeconomics. Not only is it the subject he teaches, but he claims that he has been “concerned with it since he was very young.”21 He also stresses the importance of bringing psychology into economics. Akerlof and his colleagues have made valuable contributions to the study of the ways in which psychology and economics intersect. The integration of these fields has been ongoing for many years and is gaining considerable traction due to the increasing acceptance of the realization that the fluctuations in the economy cannot be understood without psychology.22


“We discussed the focus on identity: how people think they and others should behave; how society teaches them how to behave; and how people are motivated by these views, sometimes to the point of being willing to die for them.”

― George A. Akerlof and Rachel E. Kranton in Identity Economics: How Our Identities Shape Our Work, Wages, and Well-Being

Akerlof’s most famous contribution to the field of economics is the concept of asymmetric information. In fact, it was this theory that won him the Nobel Prize in Economic Sciences in 2001.23 He famously introduced his theory in his article, “The Market for Lemons: Quality Uncertainty and the Market Mechanism”, which was published in Quarterly Journal of Economics in 1970. In this article, he used the example of the automobile industry to illustrate the disparity between the information available to sellers and the information available to buyers.24 This theory is used by economists as a possible means of explaining market failures. Akerlof shared his Nobel Prize with Michael Spence and Joseph Stiglitz, both of whom are also credited with the development of this theory.25


“We have shown that a great deal of what makes people happy is living up to what they think they should be doing.”

― George A. Akerlof and Robert Shiller in Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism

Akerlof has collaborated with many other great minds in the field of economics. Since 1995, he has been collaborating with Rachel E. Kranton, a professor of economics at Duke University, in the study of identity economics, an area of research that they pioneered together. He and Robert Shiller, a professor of economics at Yale, joined forces in the study of animal spirits and the role of psychology in economics. Together, they wrote the book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.


“To understand the economy then is to comprehend how it is driven by the animal spirits. Just as Adam Smith’s invisible hand is the keynote of classical economics, Keynes’ animal spirits are the keynote to a different view of the economy — a view that explains the underlying instabilities of capitalism.”

― George A. Akerlof and Robert Shiller in Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism

Published Works

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism

In this book, Akerlof and fellow economist, Robert Shiller, examine the psychological forces – or, animal spirits – driving the economy and their role in the global financial crisis. In this 2009 publication, they draw on the work of John Maynard Keynes to outline the psychological shift required for economic recovery and offer guidance for economic policymaking.

Phishing for Phools: The Economics of Manipulation and Deception

Akerlof and Shiller also collaborated in the writing of Phishing for Phools, which was released in 2015. They argue against the long-standing assumption that the invisible hand of the market supplies us with material well-being. They propose that we are often duped by the market and that is it important to acknowledge the rampant manipulation and deception that occurs.

Identity Economics: How Our Identities Shape Our Work, Wages, and Well-Being

Written by Akerlof and economist Rachel E. Kranton in 2010, this book explores the role of our identity in our economic lives. The seeds of this book were sowed in 1995, when Kranton sent Akerlof a letter in which she argued that his most recent publication was incorrect, as it failed to account for identity. Their collaboration culminated in the writing of Identity Economics.

An Economic Theorist’s Book of Tales

This collection of essays was published in 1984. The essays included in this publication revolve around the somewhat taboo topic of introducing new assumptions into the field of economics.

References

  1. Ross, S. (2020). Theory of Asymmetric Information in Economics. Investopedia. https://www.investopedia.com/ask/answers/042415/what-theory-asymmetric-information-economics.asp
  2. See 1
  3. See 1
  4. See 1
  5. Chen, J. (2020). Lemons Problem Definition. Investopedia. https://www.investopedia.com/terms/l/lemons-problem.asp
  6. See 1
  7. Rachel E. Kranton. Duke.edu. https://sites.duke.edu/rachelkranton/
  8. Identity Economics. Princeton University Press. https://press.princeton.edu/books/paperback/9780691152554/identity-economics
  9. See 8
  10. Identity economics. Behavioral Economics. https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/identity-economics/
  11. See 10
  12. See 10
  13. Tardi, C. (2020). Animal Spirits Definition. Investopedia. https://www.investopedia.com/terms/a/animal-spirits.asp
  14. See 13
  15. Animal Spirits. Princeton University Press. https://press.princeton.edu/books/hardcover/9780691142333/animal-spirits
  16. See 13
  17. See 15
  18. George A. Akerlof. (2020). Encyclopaedia Britannica. https://www.britannica.com/biography/George-Akerlof
  19. Faculty Profile. Berkeley Economics University of California. https://www.econ.berkeley.edu/faculty/803
  20. See 18
  21. Clarke, C. (2009). An interview with George Akerlof. The Atlantic. https://www.theatlantic.com/politics/archive/2009/02/an-interview-with-george-akerlof/676/
  22. See 21
  23. George A. Akerlof – Facts. The Nobel Prize. https://www.nobelprize.org/prizes/economic-sciences/2001/akerlof/facts/
  24. See 1
  25. See 23

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