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Weierstrass Theorem If f is a realvalued continuous mction on a nonempty compact domain S then there exists an x E S such that fx 2 y for all y in S Notez Minimizing f is the same as maximizing f N dimensional vector x1 x2 xN Euclidean N space lRN all Ndimensional vectors of real numbers 1 lR lR has the least upper bound property Metric d lRN gtlt lRN a lR such that dxy 2 0 dx 0 iff x y dXY dyX dxz g dxy dyz For RN With x X1 X2 a XN and Y Y1 Y2 a YN dXY YI X02 Y2 X2 YN XN212 is a metric s ball Bgx y E lRN dxy lt e A set S is bounded if there exists an e gt 0 suf ciently large so that S Bg0 A set S lRN is open iff for every x E S there exists an e gt 0 suf ciently small so that Bgx S A set S lRN is closed iff its complement lRNS is open also contains its limit points 1 lRN and 21 are both open 2 The union of any collection of open sets is open 3 The intersection of any nite collection of open sets is open Any set collection of subsets of a set X satisfying these conditions is a topology There are topologies for which there is no metric e g the co nite sets in lRN Let f be a mction quotom X to Y If S g Y the inverse image of S under f is f1S x Xfx E S A mction f quotom X lRN to Y lRM is continuous iff the inverse image of each open set in Y is open in X 85 de nition Standard continuous mctions Composition Pasting Given a set S lRN a collection C of sets open in lRN is an open cover of S iff S is a subset of the union of the open sets in C Given an open cover C of S a subcover is a subcollection of C that also covers S A set S lRN is compact iff every open cover of S has a nite subcover The HeineBorel Theorem In lRN a set S is compact iff it is closed and bounded So in lR1 lR a compact set S must contain its least upper bound Theorem The continuous image of a compact set is compact Weierstrass Theorem If f is a realvalued continuous mction on a nonempty compact domain S then there exists an x E S such that fx 2 y for all y in S Examples MaxE1 Ef l E39W39 1 Eon01 Minm E X my on R Minm E lX ml on R MinKL rK wL st K 2 0 L 2 0 K13L23 2 Q gt 0 Pro t maximization problem in moral hazard handout INFORMATION AND THE CHANGE IN THE PARADIGM IN ECONOMICS Prize Lecture December 8 2001 by JOSEPH E STIGLlTZ Columbia Business School Columbia University 1022 International Affairs Building 420 West 118th Street New York NY 10027 USA The research for which George Akerlof Mike Spence and I are being recogr nized is part of a larger research program which today embraces hundred perhaps thousands of researchers around the world In this lecture Iwant to set the particular work which was sited within this broader agenda and that agenda within the broader perspective of the history of economic thought I hope to show that Information Economics represents a fundamental change in the prevailing paradigm within economics Problems of information are central to understanding not only market economics but also po1139t139ca1 economy and in the last section ofthis lecture I explore some ofthe implications of in formation imperfections for political processes INTRODUCTION Many years ago Keynes wrote The ideas of economists and political philosophers both when they are right and when they are wrong are more powerful than is commonly unr derstood Indeed the world is ruled by little else Practical men who be lieve themselves quite exempt from any intellectual influences are usually the slaves of some defunct economist Madmen in authority who hear voices in the air are distilling their frenzy from some academic scribbler of a few years back Keynes 1936 Information economics has already had a profound effect on how we think about economic policy and are likely to have an even greater influence in the future The world is of course more complicated than our simple 7 or even our more complicated models 7 would suggest Many of the major political debates over the past two decades have centered around one key issue the ef ciency of the market economy and the appropriate relationship between the market and the government The argument of Adam Smith 1776 the founder of modern economics that free markets led to ef cient outcomes quotas if by an invisible handquot has played a central role in these debates it sugr gested that we could by and large rely on markets Without government inter vention There was at best a limited role for government The set of ideas that 472 1 will present here undermined Smith s theory and the view of government that rested on it They have suggested that the reason that the hand may be invisible is that it is simply not there 7 or at least that if is there it is palsied When I began the study of economics some forty one years ago lwas struck by the incongruity between the models that l was taught and the world that 1 had seen growing up in Gary Indiana a city whose rise and fall paralleled the rise and fall of the industrial economy Founded in 1906 by US Steel and named after its Chairman of the Board by the end of the century it had der clined to but a shadow of its former self But even in its heyday it was marred by poverty periodic unemployment and massive racial discrimination Yet the theories that we were taught paid little attention to poverty said that all markets cleared 7 including the labor market so unemployment must be nothing more than a phantasm and that the pro t motive ensured that there could not be economic discrimination 1f the central theorems that argued that the economy was Pareto ef cient 7 that in some sense we were living in the best of all possible worlds 7 were true it seemed to me that we should be striving to create a different world As a graduate student 1 set out to try to create models with assumptions 7 and conclusions 7 closer to those that ac7 corded with the world 1 saw with all of its imperfections My rst visits to the developing world in 1967 and a more extensive stay in Kenya in 1969 made an indelible impression on me Models of perfect marr kets as badly flawed as they might seem for Europe or America seemed tru7 ly inappropriate for these countries But while many of the key assumptions that went into the competitive equilibrium model seemed not to t these economies well the ones that attracted my attention was the imperfection of information the absence of markets and the pervasiveness and persistence of seeming dysfunctional institutions like sharecropping With workers hav7 ing to surrender 50 or more of their income to landlords surely if con7 ventional economics were correct incentives were greatly attenuated Traditional economics said not only that institutions like sharecroppingZ did not matter but neither did the distribution of wealth But if workers owned their own land then they would not face what amounted to a 50 tax Surely the distribution of wealth did matter 1 had seen cyclical unemployment 7 sometimes quite large 7 and the hard7 ship it brought as I grew up but 1 had not seen the massive unemployment that characterized African cities unemployment that could not be explained either by unions or minimum wage laws which even when they existed were regularly circumvented Again there was a massive discrepancy between the models we had been taught and what 1 saw See eg Becker 1971 The insight was simple that solong as there were suf cient numbers of for instance unprejudiced employers they would bid up the wage of the discriminated to their marginal productivity 2 There was one brilliant Valiant attempt to show that sharecropping did not matter a thesis by Steven Cheung completed at the University of Chicago see Cheung 1969 The unreasonable assumptions especially concerning information helped convince me of the need for an alterna7 tive theory 473 The new ideas and models were not only useful in addressing broad philor sophical questions such as the appropriate role of the state but also in anar lyzing concrete policy issues In the 70s economists became increasingly crir tical of traditional Keynesian ideas partly because of their assumed lack of microrfoundations The attempts made to construct a new macroreconomics based on uau jtionaIHA 39 with its a limptirm ofwell functioning markets was doomed to failure Recessions and depressions accompanied by massive unemployment were symptomatic of massive market failures The market for labor was clearly not clearing How could a theory that began with the assumption that all markets clear ever provide an explanation lf individr uals could easily smooth their consumption by borrowing at safe rates of in terest then the relatively slight loss of lifetime income caused by an interrupr tion of work of six months or a year would hardly be a problem but the unemployed do not have access to capital markets at least not at reasonable terms and thus unemployment is a cause of enormous stress lf markets were perfect individuals could buy private insurance against these risks yet it is ob vious that they cannot Thus one of the main developments to follow from this line of research into the consequences of information imperfections for the functioning of markets is the construction of macro economic models that help explain why the economy ampli es shocks and makes them persistent and why there may be even in competitive equilibrium unemployment and credit rationing I believe that some of the huge mistakes which have been made in policy in the last decade in for instance the management of the East Asia crisis or the transition of the former communist countries to a market might have been avoided in there had been a better understanding of issues like bankruptcy and corporate governance to which the new information economics called attention And the sorcalled Washington consensus policies3 which have prer dominated in the policy advice of the international nancial institutions over the past quarter century have been based on market fundamentalist policies which ignored the informationrtheoretic concerns and this explains at least in part their widespread failures lnformation affects decision making in every context 7 notjust inside rms and households More recently I have turned my attention to some aspects of what might be called the po1139l739ca1 economyof information the role of informar tion in political processes in collective decision making For two hundred years well before the economics of information became a subdiscipline with in economics Sweden had enacted legislation to increase transparency There are asymmetries of information between those governing and those governed andjust as markets strives to overcome asymmetries of informar tion we need to look for ways by which the scope for asymmetries of inforr mation in political processes can be limited and their consequences mitir gated 3 See Williamson 1990 for a description For a critique see Stiglitz 1998a 474 THE HISTORICAL SETTING I do not want here to review and described in detail the models that were con structed In recent years there have been a number of survey articles even several bookss and interpretative essays7 I do want to highlight some of the dramatic impacts that information economics has had on how economics is approached today how it has provided explanations to phenomena that were previously unexplained how it has altered our views about how the economy functions and perhaps most importantly how it has led to a rethinking of the appropriate role for government in our society In describing the ideas I want to trace out some of their origins to a large extent they were responses to attempts to answer speci c policy questions or to explain speci c pher nomena to which the standard theory provided an inadequate explanation But any discipline has a life of its own a prevailing paradigm with assumpr tions and conventions Much of the work was motivated by an attempt to ex plore the limits of that paradigm 7 to see how the standard models could emr brace problems of information imperfections which turned out not to be very well For more than a hundred years formal modeling in economics has focused on models in which information was perfect Of course everyone recognized that information was in fact imperfect but the hope following Marshall39s dicr tum quotNatura non facit saltumquot was that economies in which information was not too imperfect would look very much like economies in which information was perfect One of the main results of our research was to show that this was not true that even a small amount of information imperfection could have a profound effect on the nature of the equilibrium The reining paradigm of the twentieth century the neoclassical model ignored the warnings of the nineteenth century and earlier masters on how information concerns might alter the analyses perhaps because they could not see how to embrace them in their seemingly precise models perhaps be cause doing so would have led to uncomfortable conclusions about the ef r ciency of markets For instance Smith in anticipating later discussions of ad verse selection wrote that as rms raise interest rates the best borrowers drop out of the market If lenders know perfectly the risks associated with each borrower this would matter little each borrower would be charged an appror priate risk premium It is because lenders do not know the default probabilir ties of borrowers perfectly that this process of adverse selection has such imr portant consequences 5 See for instance Stiglitz 1975b 1985d 1987a 1988b and Riley 2001 There have also been reviews of particular aspects some of which are referenced be ow 5 See forinstance Fudenberg and Tirole 1991 Hirshleifer and Riley 1992 Hart 1995 and MasrColell Whinston and Green 1995 7 See in particular Stiglitz ZOOOd 8 If the legal rate was xed so high the greater part of the money which was to be lent would be lent to prodigals and profectors who alone would be willing to give this higher interest Sober people who will give for the use of money no more than a part of what they are likely to make by the use of it would not Venture into the competitionquot Smith 1776 See also Marshall 1890 Sismondi 1814 and Mill 1848 as cited in Stiglitz 1987a 475 l have already noted in the introduction that something was wrong 7 se7 riously wrong 7 with the competitive equilibrium models which represented the prevailing paradigm when we went to graduate school It seemed to say that unemployment didn t exist that issues of ef ciency and equity could be neatly separated so that economists could neatly set aside problems of in7 equality and poverty as they went about their business of designing more ef 7 cient economic systems But there were a host of other predictions empirical puzzles that were hard to reconcile with the standard theory in microrecor nomics there were tax paradoxes such as why did rms seemingly not take ac7 tions which minimized their tax liabilities security market paradoxes such as why did asset prices seem to exhibit such high volatilityg and behavioral puzzr les such as why did rms respond to risks in ways which were markedly dif7 ferent from that predicted by the theory10 In macroreconomics the cyclical movements of many of the key aggregate variables such as consumption11 in7 ventories12 real product wages real consumption wages and interest rates15 are hard to reconcile with the standard theory and if the perfect market as7 sumptions were even approximately satis ed the distress caused by cyclical movements in the economy would be much less than seems to be the case16 The problems that we saw with the models that we were taught was not on7 ly that they seemed wrong but that they left a host phenomena and institu7 tions unexplained 7 why were lPO39s typically sold at a discount Why did equities which provided far better risk diversi cation than debt play such a limited role in nancing new investment There were to be sure some Ptolemaic attempts to defend and elaborate 9 There was so many of these that the fournal ofEtonozm39t Perspectives ran a regular column with each issue highlighting these paradoxes See Thaler 1987 and Thaler eta 1989 1990 1991 1995 1997 The problem of excess Volatility of asset prices has recently been highlighted in the work of Shiller 2000 m In the discussion below I elaborate on several of these paradoxes and show how the new par radigm helps explain them According to Hall 1978 consumption should be a random walk responding only to new news The evidence does not support this conclusion 2 Inventories should be used to smooth the economy so that they should move in a counter cyclical manner In fact they move prorcyclically See for instance Blinder and Fisher 1981 Blinder 1986 Kahn 1987 Blinder and Maccini 1991 Bernanke and Gertler 1995 and Bils and Kahn 2000 3 lf r rns operated along their production functions then when employment fell the marginal product of labor and hence the real product wage should rise Yet in cyclical downturns it often does not For empirical evidence on these and other seeming quandan39es see Greenwald and Stiglitz 1988b lf workers operate along theirlabor supply curves and if as most empirical evidence suggests labor supply curves especially for primary workers is highly inelastic then when employment goes down the real consumption wage should go down a great deal Yet in many cyclical downr turns that does not happen Though observed behavior can be reconciled with the theory simply by assuming that there is a simultaneous shift in the labor supply schedule such an ex7 planation is hardly satisf 39ng 5 See eg Stiglitz 1995a 1999a 5 Remarkably Lucas 1987 won the Nobel prize in 1995 uses the perfect markets model with a representative agent to try to argue that these cyclical uctuations in fact have a relatively small welfare costs 7 See for instance Mayer 1990 476 on the old model Some like George Stigler while recognizing the imporr tance of information argued that once the real costs of information were taken into account even with imperfect information the standard results of economics would still hold lnformation wasjust a transactions cost In the apr proach of many Chicago economists information economics was like any other branch of applied economics one simply analyzed the special factors determining the demand and supply for information just as agricultural ecor nomics analyzed those factors affecting the market for wheat For the more mathematically inclined information could be incorporated into production functions of say goods by inserting an quotIquot for the input quotinformationquot andl itself could be produced by inputs like labor Our analysis showed that that this approach was wrong as were the conclusions derived from it Practical economists who could not ignore the bouts of unemployment which had plagued capitalism since its inception talked of the neoclassical synthesis using Keynesian interventions to ensure that the economy re mained at full employment and once that was done the standard neoclassir cal propositions would once again be true But while the neoclassical synther sis19 had enormous intellectual influence by the 1970s and 80s it came under attack from two sides It was an assertion not based on a coherent view of the economy One side attacked the underpinnings of Keynesian economics its microrfoundations why would rational actors by out of equilibrium 7 with unr employment persisting 7 in the way that Keynes had suggested This side efr fectively denied the phenomena which Keynes was attempting to explain Worse still some saw unemployment as largely reflecting an interference eg by government in setting minimum wages or trade unions in using their monopoly power to set too high wages with the free workings of the market with the obvious implication unemployment would be eliminated if markets were made more exibIE that is unions and government interventions were eliminated Even if wages fell a third in the Great Depression they should have in this view fallen even more There was an alternative perspective articulated more fully in Greenwald and Stiglitz 1987a 1988b why shouldn39t we believe that massive unemployr ment wasjust the tip of the iceberg of more pervasive market ef ciencies that are harder to detect lf markets seemed to function so badly some ofthe time certainly they must be malperforming in more subtle ways much of the time The economics of information bolstered the latter view Similarly given the nature of the debt contracts the falling wages and prices led to bankruptcy and economic disruptions actually exacerbating the economic downturn Had there been more wage and price exibility matters might have been even worse Moreover neither government nor unions imr posed the limitations on wage and price dynamics in many sectors ofthe ecor nomy at the very least those who argued that the problem was wage and price rigidities had to look for other market imperfections and any policy 3 Stigler 1961 who won the Nobel Prize in 1982 9 See Samuelson 1947 He won the Nobel Prize in 1970 477 remedy including a call for greater exibility had to take those factors into account In the next section 1 shall explain how it was notjust the discrepancies be7 tween the standard competitive model and its predictions which lead to its be7 ing questioned The model was not robust 7 even slight departures from the underlying assumption of perfect information had large consequences But before turning to those issues it may be useful to describe some ofthe concrete issues which underlay the beginnings of my research program in this area Key in my thinking on these issues was the time between 1969 and 1971 I spent at the Institute for Development Studies at the University of Nairobi with the support of the Rockefeller Foundation Education as a screening device20 The newly independent Kenyan government was asking questions that have never seemingly been raised by their colonial masters as it attempted to forge policies which would promote their growth and development How much should it invest in education It was clear that a better education got one bet7 terjobs 7 the credential put one at the head of the job queue Gary Fields a young scholar working at the Institute of Development Studies there de7 veloped a simple model21 suggesting that the private returns to education 7 the enhanced probability of getting a goodjob 7 differed from the social return and that it was possible that as more people get educated the private returns got higher it was even more necessary to get the credential even though the social return might decline Here education was performing a markedly dif7 ferent function than it did in traditional economics literature where it simply added to human capital and improved productivity 23 The analysis had im7 portant implications for Kenya39s decision about how much to invest in higher education The problem with Fields39 work was that it did not provide a full equilibrium analysis wages were xed rather than competitively determined This led me to ask what would the market equilibrium look if wages were set equal to mean marginal products conditional on the information that was available And this in turn forced me to ask what were the incentives and mech7 anisms for employers and employees to acquire or transmit information Within a group of otherwise similar job applicants who therefore face the same wage the employer has an incentive to identify who is the most able to nd some way of sorting or screening among them if he could keep that informa7 tion private But he often can39t and if others nd out about the true ability the wage will be bid up and he will be unable to appropriate the return to the in7 formation At the very beginning of this research program we had thus idenr 2 Stiglitz 1975c 2 Subsequently published as Fields 1972 22 See eg Schultz 1960 who won the Nobel Prize in 1979 and Mincer 1974 23 At the time there was other ongoing work criticizing the human capital formulation focusing on the role of education in socialization and credentialization See for instance Bowles and Gintis 1976 478 ti ed one of the key issues in information economics the dif culty of apprai priatingthe returns On the other hand the employee ifhe knewhis ability that is if there were asymmetries afinfarmatian between the employee and the employer and he knew that his abilities were above the average of those in the market had an incentive to convince the employer of his ability But someone at the bottom of the abir lity distribution had an incentive not have the information revealed Here was a second principle that was to be explored in subsequent years there are in centives on the part of individuals for information not to be revealed for secrecy or in modern parlance for a lack oftransparency This raised a quesr tion how did the forces for secrecy and for information disclosure get bar lanced What was the equilibrium that emerged 1 will postpone until the next section a description of that equilibrium Ef ciency Wage theory That summer in Kenya I began three other research projects related to inforr mation imperfections At the time lwas working in Kenya there was heavy urr ban unemployment My colleagues at the Institute for Development Studies Michael Todaro and John Harris had formulated a simple model of labor mir gration from the rural to the urban sector which accounted for the unemr ployment High urban wages attracted workers and they were willing to risk unemployment for the chance of those higher wages Here was a simple general equilibrium model of unemployment but again there was one misr sing piece how could you explain the high wages which were well in excess ofthe minimum wage It did not seem as if either government or unions were forcing these high wages One needed an equilibrium theory of wage deter mination I recalled during an earlier stint at Cambridge discussions with Harvey Leibenstein who had postulated that in very poor countries higher wages lead to higher productivity It might not pay rms to cut wages if pro ductivity was cut more than proportionately even if there was an excess sup ply of labor The key insight was to recognize that there were a variety of other reasons why when information and contracting were imperfect pro ductivity might depend on wages26 In that case it might pay rms to pay a higher wage than the minimum necessary to hire labor such wages I referred to as ef ciency Wages With ef ciency wages there could exist an equilibrium level of unemployment l explored four explanations for why productity might depend on wages besides through nutrition The simplest was that 2 See Harris and Todaro 1970 Todaro 1969 I developed these ideas further in Stiglitz 1969b 25 See Leibenstein 1967 There were of course historical antecedents to this idea as to many of the other ideas discussed below see eg Marshall in Marshall 1920 wrote highly paid labour is generally ef cient and therefore not dearlabour a fact which though it is more full of hope for the future of the human race than any other that is known us will be found to exercise a Very complicating in uence on the theory of distribution 25 Others were independently coming to the same insight in particular Ned Phelps in Phelps 1968 Phelps and Winter also realized that the same issues applied to product markets in their theory of customer markets See Phelps and Winter 1970 479 lower wages lead to higher turnover and therefore higher turnover costs which the rm boreZ7 It was not until some years later than we were able to explain more fully 7 based on limitations of information 7 why it was that rms had to bear these turnover costs But there was another version of the ef ciency wage related to the work I was beginning on asymmetric information Any manager will tell you that you attract better workers by paying them higher wages This wasjust an applica7 tion of the general notion of adverse selection which played a central role in earlier insurance literature where rms had long recognized that as they charge a higher premium the best risks stopped buying insurance29 Firms in a market do not passively have to accept the quotmarket wagequot Even in comper titive markets rms could if they wanted offered higher wages than others Market clearing was not a constraint on rms If all rms were paying the marketrclearing wage it might pay a rm to offer a higher wage to attract more able workers The ef ciency wage theory meant that there could exist unemployment in equI39II39bn39um It was thus clear that the notion that had underlay much oftraditional com7 petitive equilibrium analysis 7 that markets badto clear 7 was simply not true if information were imperfect The formulation of the ef ciency wage theory that has received the most attention over the years however has been that which has focused on prob7 lems of incentives Many rms claim that paying high wages induces their workers to work harder The problem that Carl Shapiro and l 1984 faced was to try to make sense of this claim If all workers are identical and paid workers the same wage then if it paid one rm to pay a high wage it would pay all of them But if a worker was then red for shirking and there was full employment he could immediately get another job at the same wage The high wage would provide no incentive But if there was unemployment then there was a price for shirking We showed that in equib39brium there had to be unemployment unemployment was the discipline device that forced workers to work30 The model had strong policy implications some ofwhich I shall de7 scribe below Our work illustrated the use of highly simpli ed models to help 2 ln Nairobi in 1969 I wrote a long comprehensive analysis of ef ciency wages entitled Alternative Theories ofWa e 39 39 V in l DC s Given t t f writing relatively short papers focusing on one issue at a time rather than publishing the paper as a whole I had to break the paper down into several parts Each of these had a long gestation od The labor turnover paperwas published as Stiglitz 1974a the adverse selection model as Stiglitz 1982a 199Zh a revision of a 1976 unpublished paper l elaborated on the nutri tional ef ciency wage theoryin Stiglitz 1976c Various Versions of these ideas have subsequent 1y been elaborated on in a large number of papers including Weiss 1980 Nalebuff Rodriguez and Stiglitz 1993 Rodriguez and Stiglitz 1991a 1991b Stiglitz 198Zf 1986b 1987a 1987i Sah and Stiglitz 1992 Akerlof and Yellen 1986 and Rey and Stiglitz 1996 28 See Arnott and Stiglitz 1985 and Arnott Hosios and Stiglitz 1988 29 For an early recognition of the importance of this concept in the economics literature see Arrow 1965 3 The idea was recast in a more standard principle agent problem but embedded within a ge7 neral equilibrium model of the economy in unpublished work with Patrick Rey see Rey and Stiglitz 1996 480 clarify thinking about quite complicated matters In practice of course work ers are not identical so problems of adverse selection become intertwined with those of incentives being red does convey information 7 there is tyin cally a stigma There was a fourth version of the ef ciency wage where productivity was related to morale effects perceptions about how fairlythey were being treated While I briefly discussed this version in my earlier work it was not until almost twenty years later that the idea was fully developed in the important work of Akerlof and Yellen 1986 Shalecmpping and the general theory of incentives This work on the economics of incentives in labor markets was closely related to the third research project that I began in Kenya In traditional economic theory while considerable lip service was paid to incentives there was no real incentive issue With perfect information individuals are paid to perform a particular service if they perform it they receive the contracted for amount if they do not they do not With imperfect information rms have to motir vate and monitor rewarding them for observed good performance and punishing them for bad My interest in the issues was rst aroused by thinking about sharecropping a common form of land tenancy in developing country where the worker surrenders half sometimes two thirds of the produce to the landlord in return for the use of his land At rst blush this seemed a highly inef cient arrangement it was equivalent to a 50 tax on workers labor But what were the alternatives The worker could rent the land but that meant he had to bear all the risk of fluctuations in output and beside he often did not have the requisite capital He could work as wage labor but that meant that the landlord would have to monitor him to ensure that he worked Sharecropping represented a compromise between risk bearing and incentives The underlying inbrmal ian problem was that the input of the worker could not be observed but only his output and his output was not perfectly correlated with his input The sharecropping contract could be thought of as a combination of a rental contract plus an insurance contract in which the landlord quotrebatesquot part of the rent if crops turn out badly There is not full insurance which would be equivalent to a wage contract because such insurance would attenuate all incentives The adverse effect of insurance on incentives to avoid the insured against contingency is referred to as moral hazard32 ln Stiglitz 1974b 1 analyzed the equilibrium sharecropping contract In that paper I recognized that the incentive problems 1 explored there were isomorphic to those facing modern corporations eg in providing incentives 3 In particular in the context of the economics of discrimination Stiglitz l974d 32 This term like adverse selection originates in the insurance literature lnsurance rms recog nized that the greater the insurance coverage the less incentive there was for the insured to take care if a property was insured for more than 100 of its Value there was even an incentive to have an accident a re Not takin appropriate care was thought to be immoral hence the name Arrow s work in moral hazard 1963 1965 was among the most important precursors as it was in the economics of adverse selection 481 to their managers33 and there followed a large literature on optimal and equi7 librium incentive schemes in labor capital and insurance markets Conr tracts had to be based on observables like processes or which crops were grown and abservabIE inputs like fertilizers Many of the results obtained earlier in the work on adverse selection had their parallel in this area of quotad7 verse incentivesquot35 For instance with Richard Arnott I analyzed the equilir brium 1988a 1988b which entail partial insurance Equib39bn39um Wage and price distributions The fourth strand of research looked at the issue of wage differentials that I had observed from a different perspective The work on labor turnover had suggested that rms that faced higher wages might pay higher wages But one of the reasons that individuals quit was to obtain a higher payingjob The turnover rate depended on the wage distribution The challenge was to for7 mulate an equib39bn39um model in which there was a wage distribution which led rms to charge different wages 7 the distribution of wages that had origi7 nally been postulated More generally ef ciency wage theory said that it paid rms to pay a higher wage than necessary to obtain workers but the level of the ef ciency wage could vary across rms for instance rms with higher turnover costs or where worker inef ciency could lead to large losses of capital or where monitor ring was more dif cult might nd it desirable to pay higher wages The implir cation was that similar labor might receive quite different compensation wage discrepancies might not be explicable solely in terms of differences in abilities I was to return to these four themes repeatedly in my research over the fol lowing three decades FROM THE COMPETITIVE EQUILIBRIUM PARADIGM TO THE INFORMATION PARADIGM In the previous section I described how my experiences especially in Kenya 7 the disparities between the models used and the world that I saw 7 had mor tivated a search for an alternative paradigm But there was another motivar tion driven more by the internal logic and structure of the competitive mor del itself which was the dominant paradigm thirty years ago The model virtually made economics a branch of engineering with no as7 persions to that noble profession and the participants in the economy bet7 ter or worse engineers Each was solving a maximization problem with full in7 formation households maximizing utility subject to budget constraints rms maximizing pro ts market value and the two interacting in competitive product labor and capital markets One ofthe peculiar implications was that 33 A problem which came to be called the pdncipalragent problem See Ross 1973 3 For a classic reference see Hart and Holmstrom 1987 In addition see Stiglitz 1975a Murphy 1985 Jensen and Murphy 1990 Haubn39sch 1994 and Hall and Liebman 1998 35 Arrow s lectures See Arrow 1965 were an important precursor in this area as they were in the area of adverse selection See also Arrow 1964 482 there never were disagreements about what the rm should do alternative management teams would presumably come up with the same solution to the maximization problems Another peculiar implication was the meaning of risk when a rm said that a project was risky that should have meant that it was highly correlated with the business cycle not that it had a high chance of failure36 I have already described some of the other peculiar implications of the model the fact that there was no unemployment or credit rationing that it focused on only a limited subset ofthe information problems facing society that it seemed not to address key issues 7 like incentives and motivation But much of the research in the profession is directed not at these big lar cunae but at seemingly more technical issues 7 at the mathematical struc7 tures The underlying mathematics required assumptions of convexity and con7 tinuity and with these assumptions one could prove the existence of equilir brium and its Pareto ef ciency The standard proofs of these fundamental theorems of welfare economics did not even list in their enumerated asr sumptions those concerning information the perfect information assump7 tion was so ingrained it did not have to be explicitly stated The economic asr sumptions to which the proofs of ef ciency called attention concerned the absence of externalities and public goods The market failures approach to the economics of the public sector37 discussed alternative approaches by which these market failures could be corrected but these market failures were highly circumscribed There was moreover a curious disjunction between the language econor mists used to explain markets and the models they constructed They talked about the information ef ciency of the market economy though they focused on a single information problem that of scarcity But there are a myriad of other information problems faced by consumers and rms every day con7 cerning for instance the prices and qualities ofthe various objects that are for sale in the market the quality and efforts of the workers they hire the returns of investment projects In the standard paradigm the competitive general equilibrium model there were no shocks no unanticipated events at the beginning of time the full equilibrium was solved and everything from then on was an unfolding over time of what had been planned in each of the con7 tingencies In the real world the critical question was how and how well do markets handle these information problems There were other aspects of the standard paradigm which seemed hard to accept lt argued that institutions did not matter 7 markets could see through them and equilibrium was simply determined by the laws of supply and de7 mand It said that the distribution of wealth did not matter39 And it said that 3 See Stiglitz 1989g 3 See Bator 1958 38 For which Kenneth Arrow and Gerard Debreu got the Nobel Prizes in 1972 and 1983 respec7 tively 3 A central proposition of standard neoclassical theory was that issues of distribution and ef 7 ciency could be separated the second welfare theorem and the ef ciency of the market out7 come did not depend on the distribution of wealth so long as there were well de ned property rights see Coase 1960 who received the Nobel prize for his work in 1991 483 by and large history did not matter 7 knowing preferences and technology and initial endowments one could describe the time path of the economy40 Work on the economics of information began by questioning each of the underlying premises each of the central theorems Consider to begin with the mathematical structures that had underlay some much of the formalizar tion of economics of the latter half of the twentieth century the convexity asr sumptions which corresponded to long standing principles of diminishing rer turns With imperfect information and the costs of acquiring it these assumptions were no longer plausible It was not just that the cost of acquirr ing information could be viewed as xed costs 1 Work with Roy Radner Radner and Stiglitz 1984 showed that there was a fundamental naniconcavii yin the Value ofinformatian that is under quite general conditions it never paid to buyjust a little bit of information Work with Richard Arnott Arnott and Stiglitz 1 988a showed that such problems were pervasive in even the simplest of moral hazard problems where individuals had a choice of alter native actions eg the amount of risk taking to undertake While we had not repealed the law of diminishing returns we had shown its domain to be more limited than had previously been realized 2 Michael Rothschild and I showed that under natural formulations of what might be meant by a competitive market with imperfect information equir librium often did not exist43 7 even when there was an arbitrarily small amount of information imperfection While subsequent research has looked for alternative de nitions of equilibrium45 we remain unconvinced most of Strictly speaking this was not an inevitable consequence of the neoclassical assumptions eg it would not hold 39 L 39 39L 39 t t b 39 was 39 39 f more widely use In the natural spaces 39 indifference curves and iso pro t curves were ill behaved The nonr convexities which naturally arose implied in turn for instance that equilibrium might be char racterized by randomization Stiglitz 1975b or that Pareto ef cient tax and optimal tax poli cies mi ht be characterized b randomization See Arnott and Stiglitz 1988a Brito Hamilton Slutsky and Stiglitz 1995 and Stiglitz 1982g V xed costs of search of nding out about characteristics of differentinvestments of obtaining information about relevant technology imply that markets will not be perfectly comr petitive they wi 1 be better described by models of monopolistic competition see Dixit and Stiglitz 1977 Salop 1987 Stiglitz 1979a 1979b 1989f though the basis of imperfect competition was markedly different from that originally envisioned by Chamberlain 1933 2 e sure critics of modern capitalism had argued that in many of its central industries rer turns to scale were suf ciently large that many industries would be characterized by either mor nopolies or oligopolies 3 No rco Vexities naturally give rise to discontinuities and discontinuities to problems of exis tence but the nonexistence problem that Rothschild and I had uncovered was of a different and more fundamental nature The problem was in part that a single action of an individual 7 a choice of one insurance policy over another 7 discretely changed beliefs eg about his type and that a slight change in the actions of say an insurance king available a new insurance policy 7 could lead to discrete changes in actions and thereby beliefs Dasgupta and Maskin 1986 have explored mixed strategy equilibria in game theoretic formulations but these seem 39 39 t an t 39 r f competition i the existence problems described below Other problems of nonexistence were explored in the context of moral hazard problems in work with Richard Arnott 1987 1991b This had a particularly inconvenient implication when there was a continuum of types such as in the Spence 1973 1974 rmodels a full equilibrium never existed 5 See forinstance Riley 1979 484 them violate the natural meaning of competition ie where each participant in the market is so small that he believes that he will have no effect on the be7 havior of others Rothschild and Stiglitz 1997 The new information paradigm went further in undermining the foundar tions of competitive equilibrium analysis the basic quotlawsquot of economics which include the law of demand and supply holding that market equilibrium was characterized by market clearing the law of the single price holding that the same good sold for a single price throughout the market the law of the competitive price holding that in equilibrium price equaled marginal cost the ef cient markets hypothesis holding that in stock markets prices convey all the relevant information from the informed to the uninformed Each of these cornerstones was rejected or was shown to hold under much more re7 strictive conditions 0 We have shown how when prices affect quotqualityquot 7 either because of incenr tive or selection effects 7 equilibrium may be characterized by demand not equaling supply rms will not pay lower wages to workers even when they can obtain such workers because doing so will raise their labor costs rms will not charge higher interest rates even when they can do so because of an excess demand for credit because doing so will increase the average der fault rate and thus lower expected returns 0 We have shown that the market will be characterized by wage and price dis7 tributions even when there is no exogenous source of quotnoisequot in the eco7 nomy even when all rms and workers are otherwise identical 0 We have shown that in equilibrium rms will charge a price in excess ofthe marginal costs or workers are paid a wage in excess of their reservation wage The quotsurplusquot is required to provide the incentive for maintaining a reputation46 Even in situations where reputation rents were not required information imperfections gave rise to market power 7 there is imperfect com7 petition 7 which resulted in rms charging prices in excess of marginal cost 7 0 The ef cient markets hypothesis held that prices in the stock market fully reflected all information But if that were the case then there would be no incentive for anyone to expend money to collect information Work with Sanford Grossman 1976 1980 showed that the price system both imperr fectly aggregated information and that there was an equilibrium amount of quotdisequilibriumquot The most fundamental reason why markets with imperfect information difr fer from those in which it does is that actions including choices convey informa7 tion market participants know this and this affects their behavior A decision by a rm to provide a guarantee is notjust a matter that the rm is better able to absorb the risk of a product failure his willingness to provide 5 See also Shapiro 1983 and Klein and Lef er 1981 7 As I noted earlier the models ofimperfect competition were more akin to Chamberlinian mor nopolistic competition models than other Versions of imperfect competition See eg Stiglitz 1979b 3 See eg Fama 1970 1991 485 a guarantee conveys information about his con dence in the product An in sured is willing to take a policy with a large deductible not because he is not risk averse but because this action conveys information to the insurance comr pany that he is willing to bear the risk because he thinks the likelihood of an accident is low A rm may at the same time not assign an employee to a highly visiblejob because it knows that the assignment will be interpreted as an indication that the employee is good making it more likely that a rival will try to hire the person away Even if he fails the current employer will have to pay a higher salary One of the early insights Akerlof 1971 was that markets may be thin or absent One of the standard assumptions of the old paradigm was that there was a complete set of markets 7 including intertemporal markets capital markets and risk markets The absence of particular markets eg for risk has profound implications for how athermarkets function The fact that work ers and rms cannot by insurance against many of the risks which they face affects labor and capital markets it leads for instance to labor contracts in which the employer provides some insurance But the design of these more complicated but still imperfect and incomplete contracts affects the ef r ciency and overall performance of the economy Perhaps most importantly under the standard paradigm markets are Pareto ef cient except when there one of a limited number of market failr ures occurs Under the imperfect information paradigm markets are almost never Pareto ef cient While information economics thus undermined these long standing prinr ciples of economics it also provided explanations for many phenomena that had long been unexplained Earlier I mentioned the seemingly inef cient inr stitution of sharecropping for which information economics provided an ex planation Before turning to these appb39cal ians I want to present a somewhat a more systematic account of the prina39pIes of the economics of information Some prabIEms in constructing an aIternative paradigm The fact that information was imperfect was of course well recognized by all economists While they may have hoped that economies with imperfect inforr mation behaved much like economies with perfect information they real reason that models with imperfect information were not developed was that it was not obvious how do to so There were several problems that had to be overcome while there was a single way in which information is perfect there are an in nite number of ways in which information can be imperfect One of the keys to success was formulating simple models in which the set of relr evant information could be fully speci ed 7 and so the precise ways in which information was imperfect could also be fully speci ed But there was a danr ger in this methodology as useful as it was in these over simplistic models there were sometimes ways in which there could be full information revelar tion the information problems could be fully resolved In the real world of course this never happens which is why in some of the later work eg 486 Grossman and Stiglitz 1976 1980a we worked with models with an in nite number of states49 Perhaps the hardest problem was modeling equilibrium It was important to think about both sides of the market 7 employers and employees in7 surance company and the insured lender and borrower Each had to be mod7 eled as quotrationalquot in some sense making inferences on the basis of available information Each side s behavior too had to be rational based on beliefs about the consequences of their actions and those consequences in turn der pended on what inferences others would draw from those actions I wanted to model competitive behavior where each actor in the economy was small and believed he was small 7 and so his actions could not or would not affect the equilibrium though others39 inferences about himself might be affected Finally one had to think carefully about what was the feasible set of actions what might each side do to extract or convey information to others As we shall see the variety of results obtained and much of the confusion in the early literature arose partly from a failure to be as clear as one might about the assumptions For instance the standard adverse selection model had the quality of the good offered in the market say of used cars or riskir ness of the insured depending on price The car buyer the seller of in7 surance knows the statistical relationship between price and quality and this affects his demand The market equilibrium is the price at which demand equals supply But that is an equilibrium if and only if there is no way by which the seller of a good car can convey that information to the buyer 7 so that he can earn a quality premium 7 and if there is no way by which the buyer can sort out good cars from bad cars Typically there are such ways and it is the attempt to elicit that information which has profound effects on how markets function To develop a new paradigm we had to break out from long established premises to ask what should be taken as assumptions and what should be derived from the analysis Market clearing could not be taken as an assumption neither could the premise that a rm sells a good at a particular price to all comers One could not begin the analysis even by assuming that in competitive equilibrium there would be zero pro ts In the standard theory if there were positive pro ts a rm might enter bidding away existing cus7 tomers In the new theory the attempt to bid away new customers by slightly lowering prices might lead to marked changes in their behavior or in the mix of customers in such a way that the pro ts of the new entrant actually be7 came negative One had to rethink all the conclusions from rst premises We made progress in our analyses because we began with highly simpli ed 9 Similarly in many of the incentive models there may be ways of resolving the problem in he 39 39 39 39 but i will not 39 model Below for in7 stance we describe a model in which higher interest rates lead individuals to take more risks and so the expected return to the lender may actually decrease As a result the optimal interest rate may be lower than that at which markets clear they can be credit rationing In the simpli ed models the problem could be resolved by requiring collateral Bester 1985 but in models in which there are both adverse selection andincentive problems this is no longer true since those most willing to provide collateral may be wealthy individuals more willing to undertake risky pror jects See Stiglitz and Weiss 1985 487 models ofpan icular markets that allowed us to think through carefully each of the assumptions and conclusions From the analysis of particular markets whether the insurance market as in Rothschild Stiglitz the education mar ket the labor market or the land tenancysharecropping market we at tempted to identify general principles to explore how these principles oper rated in each of the other markets In doing so we identi ed particular features particular informational assumptions which seemed to be more reler vant in one market or another The nature of competition in the labor mar ket is different than that in the insurance market or the capital market though they have much in common This interplay between looking at the ways in which such markets are similar and dissimilar proved to be a fruitful research strategy50 SOURCES OF ASYMMETRIES OF INFORMATION lnformation imperfections are pervasive in the economy indeed it is hard to imagine what a world with perfect information would be like Much ofthe re search 1 will describe below focuses on asymmetries of information that fact that different people know different things workers know more about their ability than does the rm the person buying insurance knows more about his health whether he smokes and drinks immoderately than the insurance rm the owner of a car knows more about the car than potential buyers the owner of a rm knows more about the rm that a potential investor the borr rower knows more about his risk and risk taking than the lender The essential feature of a decentralized market economy is that different people know different things in this sense economists had long been thinkr ing of markets with information asymmetries But the earlier literature had neither thought about how they were created or what their consequences might be Moreover while much of the earlier literature focused on simple situations of information asymmetry 7 such as those described in the previous paragraphs the problems of information imperfections run deeper and the re search described below discusses some of these more general results The in dividual may know little about his true health condition the insurance comr pany through a simple examination might even become more informed at least concerning relevant aspects eg implications for life expectancy Some of these information asymmetries are inherent the individual natur rally knows more about himself than does anyone else Some of the asymmer tries arise naturally out of economic processes The current employer knows more about the employee than other potential employers a rm knows may 5 Some earlier work especially in general equilibrium theory by Radner 1972 Hurwicz 1972 and Marschak 1972 among others had reco nized the importance of problems of inr forTnation and had even identi ed some of the ways that limited information af ected the nature of the market equilibrium eg one could only have contracts that were contingent on states of nature that were observable by both sides to the contract But the attempt to modify the abstract theory of general equilibrium to incorporate problems of information imperfects proved in the end less fruitful than the alternative approach of beginning with highly simpli ed quite conr crete models 488 nd out a great deal of information in the process of dealing with his supplier that others may not know the owner of a car naturally knows the faults of the car better than others 7 and in particular he knows whether or not he has a lemon While such information asymmetries inevitably arise the extent to which they do so and their consequences depend on how the market is strucr tured and the recognition that they will arise affects market behavior For in7 stance one of the important insights of work in this area is to show how in7 formation asymmetries lead to thin or nonexistent markets Akerlof l 970 But this means that even if an individual has no more information about his ability than potential employers the moment he goes to work for an employr er an information asymmetry has been created 7 the employer may know more about the individual39s ability than others The consequence is that the quotused laborquot market does not work well Others will be more tame in bidding for his services knowing that they will succeed in luring him away from his current employer only if they bid too much If they bid less than his producr tivity his current employer will match Labor mobility is impeded But that gives market power to the rst employer which he will be tempted to exer7 cise The recognition of this naturally affects even the quotnew laborquot market Because an individual is locked into ajob he will be more risk averse in ac7 cepting an offer The terms of the initial contract have to be designed to re7 flect the diminution of the workers bargaining power and his reduced labor mobility that occurs immediately after signing 52 To take another example it is natural that in the process of oil exploration a company nds out information that is relevant for the likelihood that there will be oil in a neighboring tract There is an informational externality53 The existence ofthis asymmetric information affects the nature ofthe bidding for oil rights on the neighboring tract Bidding where there is known to be asymr metries of information will be markedly different from that where such asymr metries do not exist54 Those who are uninformed will presume that they will win only if they bid too much 7 information asymmetries exacerbate the problem of the winners curse55 The government or other owners of large 5 There are other incentives for the creation of information asymmetries Individuals might orir ginally not know their abilities but if the market pays higher wages to an individual who is more able it may pay an individual to ascertain whether e is or is not more able See Stiglitz 1984a 52 If individual s productivity were the same on all jobs and there were not other reasons for changingjobs eg nonrpecuniary preferences there would be no labor mobility The fact that here is somelabor productivity does not undermine the central result information asymmetries tial leases bidders know that should they win the lease they will be a e to win auctions on neighr oring tracts at more favorable terms and this will affect the size of the initial bids 5 Wilson 1977 55 The winners curse is a manifestation of imperfectinformation If different individuals get in7 dependent estimates of the amount of oil in a tract the one with the most positive estimate will bid the highest He knows that if he wins others information is less positive and he takes this in7 to account in forming his bid See Cappen Clapp and Campbell 1971 for the rst empirical and Very in uential study of the winner s Curse and Wilson 1969 for a theoretical treatment In the case of asymmetric information an uninformed bidder knows that he is more likely to outbid the informed bidderifhe bids more thanitis worth and this decreases his willingness to make a bid even further 489 tracts to be developed should take this into account in its leasing strategy And the bidders in the initial leases too will take this into account part of the value of winning in the initial auction is the information rent that will accrue in later rounds Creating asymmetries and imperfections afinfarmatian While early work in the economics of information dealt with how markets overcame problems of information asymmetries and information imperfecr tions more generally later worked turned to how markets create information problems partly in an attempt to exploit market power Managers of rms attempt to entrenclz themselves increasing their bargaining power eg vis a vis alternative management teams and one of the ways that they do this is to take actions which increase information asymmetries Edlin and Stiglitz 1995 Doing so effectively reduces competition in the market for manage ment This is an example ofthe general problem of corporate governance to which 1 alluded earlier and to which 1 will return later Similarly the presence of information imperfections give rise to market power and rms can exploit this market power through quotsalesquot and other ways of differentiating among individuals who have different search costs Salop 1977 Salop and Stiglitz 1976 1982 Stiglitz 1979a The price disperr sions which exist in the market are createdby the market 7 they are notjust the failure of markets to arbitrage fully price differences caused by shocks that afr fect different markets differently OVERCOMING INFORMATION ASYMM ETRIES 1 now want to discuss briefly the ways by which information asymmetries are dealt with how they can be partially overcome Incentives for gathering and disclosing infarma tian There are two key issues what are the incentives for obtaining information and what are the mechanisms My brief discussion of the analysis of education as a screening device suggested the fundamental incentives more able in dividuals lower risk individuals rms with better products will receive a higher wage will have to pay a lower premium will receive a higher price for their products if they can establish that they are more productive lower risk higher quality We noted earlier that while some individuals have an incentive to disclose information those who are less able have an incentive not to have the inforr mation disclosed Was it possible that in market equilibrium only some of the information would be revealed One of the early important results was that if the more able are able costlessly to establish that they are more able then the market will be fully revealing even though all of those who are below average would prefer that no information be revealed 1n the simplest mo 55 See Shleifer and Vishny 1989 490 dels I described a process of unraveling if the most able could establish his ability he would but then all but the most able would be grouped together receiving the mean marginal product ofthat group and the most able of that group would have an incentive to reveal his ability And so on down the line until there was full revelation57 What happens if those who are more able cannot credibly convince poten7 tial employers of their ability or if those who are low risk cannot convince po7 tential insurance companies The other side of the market has an incentive too to gather information an employer that can nd a worker that is better than is recognized by others will have found a bargain his wage will be deter7 mined by what others think of him The problem as we noted is that if what he knows becomes known to others the wage will be bid up and he will be unable to appropriate the returns on his investment in information acquisir tion The fact that if there was competition it would be dif cult for the screenerto appropriate the returns had an important implication in markets where for one reason or another the more able the rms with the better investment projects the more able workers cannot fully convey their attributes if there is to be investment in screening there must be imperfect competition in sczeen7 ing The economy in effect has to choose between two different imperfecr tions imperfections of information or imperfections of competition Of course in the end there will be both forms of imperfection5MB This is but one of many examples of the interplay between market imperr fections Earlier for instance we discussed the incentive problems associated with sharecropping which arise when workers do not own the land that they till This problem could be overcome if individuals could borrow money to buy their land But capital market imperfections 7 limiations on the ability to borrow which themselves arise from information imperfections 7 explain why this quotsolutionquot does not work There is another important consequence if markets were fully informar tionally ef cient 7 that is if information disseminated instantaneously and perfectly throughout the economy 7 then no one would have any incentive to gather information so long as there was any cost of doing so That is why marr kets cannot be fully informationally ef cient See Grossman and Stiglitz 1976 1980a Mechanisms n elimina ion of reducing infarma ion asymmetries In simple models where individuals know their own ability or the insured knows his own risk or the borrower knows his own likelihood of repaying there might seem an easy way to resolve the problem of information asymr 5 ljokingly referred to this as Walras Law of Sortingquot 7 if all but one group sorts itself out from the others then the last group is also identi ed 53 And there is no reason to believe that the market balances these two forms of imperfection optimally 5 See Stiglitz 1975baffee and Stiglitz 1990 7This perhaps helps explain why competition in anki g b n 7 which is essentially concerned with screening among borrowers 7 is so imper ect 491 metry let each person tell his true characteristic The underlying problem arose from the fact that individuals did not necessarily have the incentive to tell the truth Assume employees knew their abilities An employer might ask what is your ability The more able might answer honestly As we have seen the least able would have an incentive to lie to say that he was more able than he was Talk was cheap There had to be some other ways by which informar tion could be credibly conveyed Screening by examination The simplest way by which that could be done was an exam As 1 constructed a simple competitive equilibrium model two further general principles be came apparent the gains of the more abIe were arger at the expense of the 1ess abIe by establishing that an individual is of higher ability thereby leading in equir librium to higher wages he simultaneously establishes that others are of low er ability The private returns to expenditures on education exceed the social returns It was clear that there were important externah39ties associated with in formation a theme which was to recur in later work But a more striking result emerged there could exist multiple equilibria one in which information was fully revealed the market identi ed the high and low ability people and the other of which it was not called a pooling equilibrium The pooling equilibrium Pareto dominated the equilibrium with full revelation This work done some thirty years ago established two re sults of important policy import which remarkably have not been fully ab sorbed into policy discussions even today First markets do not provide apr propriate incentives for information disclosure There is in principle a role for government And secondly expenditures on information may be too great61 The simpIest adverse se1ect139an made But much of the information rms glean about their employees banks about their borrowers insurance companies about their insured comes not from exr aminations but from making inferences based on their behavior This was a commonplace in life 7 but not in our economic models As 1 have already noted the early discussions of adverse selection in insurance markets recogr nized that as an insurance company raised its premiums those who were least likely to have an accident decided not to purchase the insurance the willing ness to purchase insurance at a particular price conveyed information to the insurance company62 George Akerlof recognized that this phenomenon was far more general the willingness to sell a used car for instance conveyed in formation about whether the car was or was not a lemon Bruce Greenwald 1979 1986 took the idea one important step further 5 Stiglitz 1974a Arrow 1973 simultaneously developed a theory of education which looked at it from much of the same perspective 5 This point was independently arrived at by Hirschliefer 1971 and is elabofratged on in more detail below Arrow 1965 492 showing how adverse selection applied to labor and capital markets the wily lingness of an employer not to match the bid of a competitor conveyed in formation about the current employer39sjudgment of that individual39s ability the willingness of insiders in a rm to sell stock at a particular price conveyed information about the insider s view of the price relative to the expected re turn Akerlof39s insight that the result of these information asymmetries was that markets would be thin or absent helped explain why labor and capital markets often did not function well It provided part of the explanation for why rms raised so little of their funds through equity Mayer 1990 Stigler was wrong imperfect information was notjust like a transactions costs The consequences go well beyondjust an absent or missing market Weak equity markets meant that risks could not be divested leading rms to act in a risk averse manner explaining some of what would otherwise seem to be anomalous aspects of rm behavior These capital market imperfections in turn played a central role in the macroeconomic theories to be described below We have already described how the labor market imperfections 7 the limited mobility of labor and the rm s market power that results 7 affects the labor market both before the asymmetry of information is created in the process of hiring and after The simplest adverse incentive mode In the adverse selection model individuals differed There was a single action which conveyed information they either entered or did not enter the partir cular market But information imperfections also relate to Whatpeople do A worker can work harder a borrower can undertake greater risk and the in sured can undertake greater care The employer would like to know how hard his worker is working if he could he would specify that in the contract the lender would like to know the actions which borrower will undertake if he could we would specify that in the contract These asymmetries of inforr mation about actions are as important as the earlier discussed asymmetries Just as in the adverse selection model the seller of insurance may try to over come the problems posed by information asymmetries by examination so too in the adverse incentive model he may try to monitor the actions of the in sured But examinations and monitoring are costly and while they yield some information typically there remains a high level of residual information imr perfection Just as in the adverse selection model the seller of insurance rer cognizes that the average riskiness of the insurance applicants is affected by the terms of the insurance contract so too the level of risk taking can be afr fected And similar results hold in other markets Borrowers39 risk taking is afr fected by the interest rate charged Stiglitz and Weiss 1981 53 See also CvreenWald Stiglitz and Weiss 1984 and Myers and Maljuf 1984 5 See discussion in subsection The Theory of Corporate Finance 493 Ef ciency Wage theory credit rationing While the early work in adverse selection explored the equilibrium in markets where the seller of insurance the employer the buyer of used cars the lender was rational enough to recognize the dependence of quality on price he was not rational enough to exploit as fully as he could the information While the law of supply and demand had been assumed to be a law of eco7 nomics there is in fact no law that require the insurance rm to sell to all who apply at the premium he announces the lender to lend to all who apply at the interest rate he announces the employer to employ all those who apply at the wage he announces So ingrained was the competitive equilibrium model in the mindset of economists that they simply assumed pricertaking be7 havior With perfect information and perfect competition any rm that charged a price higher than the others would lose all of his customers and at the going price one faced a perfectly elastic supply of customers In adverse selection and incentive models what mattered was not just the supply of cus7 tomers or employees or borrowers but their quotqualityquot 7 the riskiness ofthe inr sured or the borrower the returns on the investment the productivity of the worker Since quotqualityquot may increase with price it may pay to pay a higher wage than the market clearing wage for the lender to lend at an interest rate which exceeds the market clearing interest rate This is true whether the depen7 dence on quality arises from adverse selection or adverse incentive effects or in the labor market because of morale or nutritional effects And what matr ters is that there be imperfect information not asymmetries of information The healthy who decide not to buy insurance at a high premium do not need to know that they are healthy they could be as uninformed as the insurance company but simply 7 perhaps because of their health 7 have different prer ferences eg they prefer to spend more of their money on recreational sports The consequence as we have noted is that market equilibrium may be characterized by demand not equaling supply in equilibrium the interest rate is lower than that at which the demand for loans equals the supply 7 there is credit rationing Stiglitz and Weiss 1981 Keeton 1979 the wage rate is higher than that at which the demand for labor equals the supply 7 there is unemployment65 Conveying information through actions There is a much richer set of actions which convey information beyond those on which traditional adverse selection models have focused An insurance company wants to attract healthy applicants It might realize that by locating 55 This is the ef ciency wage theory discussed earlier Constructing equilibrium models is more dif7 cult than might seem to be the case at rst since each agents behavior depends on opportuni ties elsewhere ie the behavior of others The workers that l attract at a particular wage depend on the wage offers of other rms Rey and Stiglitz 1996 Shapiro and Stiglitz 1984 and Rodriguez and Stiglitz 1991a 1991b represent attempts to come to terms with these general equilibrium problems 494 itself on the fth floor of a walk up building only those with a strong heart would apply The willingness or ability to walk up ve floors conveys informa7 tion More subtly it might recognize that how far up it needs to locate itself if it only wants to get healthy applicants depends both on the premium charged and how high it locates itself Or it may decide to throw in for free a membership in a health club but charge a higher premium Those who value a health club 7 because they will use it 7 willingly pay the higher premium But these individuals are likely to be healthier There are a host of other actions which convey information The quality of the guarantee offered by a rm can convey information about the quality of the product only rms that believe that their product is reliable will be wilr ling to offer a good guarantee The guarantee is desirable not just because it reduces risk but because it conveys information The number of years of schooling may convey information about the ability of an individual More able individuals may go to school longer in which case the increase in wages associated with an increase in schooling may not be a consequence of the hu7 man capital that has been added but rather simply be a result of the sorting that occurs66 The size of the deductible that an individual chooses in an in7 surance policy may convey information about his view about the likelihood of an accident or the size of the accidents he anticipates 7 an average those who are less likely to have an accident may be more willing to accept high der ductibles The willingness of an entrepreneur to hold large fractions of his wealth in a rm or to retain large fractions of the shares of the rm conveys information about his beliefs in the rm39s future performance If a rm pror motes an individual to a particularjob it may convey information about the rm s assessment of his ability The fact that these actions may convey information affects behavior In some cases the action will be designed to obfuscate to limit information disclosure The rm that knows that others are looking at who it promotes and that it will compete more vigorously for those may affect the willingness of the rm to promote some individuals or assign them to particularjobs Waldman 1984 In others the action will be designed to convey information in a credible way to alter beliefs The fact that customers will treat a rm that issues a better guarantee as if its product is better 7 and therefore be willing to pay a higher price 7 may affect the guarantee that the rm is willing to issue Knowing that his selling his shares will convey a negative signal concerning his views of the future prospects of his rm an entrepreneur may retain more ofthe shares of the rm he will be less diversi ed than he otherwise would have been and accordingly he may act in a more risk averse manner A simple lesson emerges some individuals wish to convey information 5 Sorting out empirically the relative importance of human capital and sorting effects turns out to be quite dif cult In arguing that education sorts I did not argue that it does not at the same time enhance productivity See Weiss 1995 There are a number of aspects of the education market which are consistent with the sorting hypothesis for instance wages 0 up markedly upon graduation It could be that the knowledgejustjells in the nal days before graduation but the more likely hypothesis is that the completion of four years and the successful passing of all the relevant examinations conveys a considerable amount of information 495 some individuals wish not to have information conveyed either because such information might lead others to think less well of them or because conveyr ing information may interfere with their ability to appropriate rents In either case the fact that actions convey information leads people to alter their behavior and changes how markets function This is why information imperfections have such profound effects Once one recognizes that actions convey information two results follow First in making decisions about what to do individuals will not only think about what they like as in traditional economics but how it will affect others39 beliefs about them If I choose to go to school longer it may lead others to believe that I am more able and I will therefore decide to stay in school longer not because I value what is being taught but because I value how it changes others39 beliefs concerning my ability This means of course that we have to rethink completely rm and household decision making Secondly we noted earlier that individuals have an incentive to quotliequot 7 the less able to say that they are more able Similarly if it becomes recognized that those who walk up to the fth floor to apply for insurance are more healthy then I might be willing to do so even if I am not so healthy simply to fool the insurance company If it becomes recognized that those who stay in school longer are more able then I might be willing to do so even ifl am less able simply to fool the employers Recognizing this one needs to look for ways by which information is conveyed in equilibrium The critical insight in how that could occur was provided in a paper with Michael Rothschild 1976 If those who were more able less risk prone more credit worthy actedin some observable way had different preferences than those who were less able less risk prone less credit worthy then it might be possible to design a set of choices which would result in those with different characteristics in efr fect identifying themselves through their sel selec an One of the reasons that they might behave differently is that they know they are more able less risk prone more creditworthy 7 that is there is asymmetric information But it is only one of the bases for selfrselection The particular mechanism which we explored in our insurance model ilr lustrates how selfrselection mechanisms work People who know they are less likely to have an accident will be more willing to accept an insurance policy with a high deductible so that an insurance company that offered two polir cies one at a high premium and no deductible one with a low premium and high deductible would be able to sort out who were high risk and who low It is an easy matter to construct choices which thus separate Monopoly and sel selectian Analyzing the choices which arise in full equilibrium behavior turned out however to be a dif cult task The easiest situation to analyze was that of a monopolist67 He could construct a set of choices that would differentiate among different types of individuals and analyzed whether it was pro t maxi 5 Stiglitz 1977a 496 imizing for him to do so fully or to partially quotpoolquot 7 that is offer a set of contracts such that several types might choose the same one This work laid the foundations of a general theory of price discrimination Under standard the7 ories of monopoly with perfect information rms would have an incentive to price discriminate perfectly extracting the full consumer surplus from each If they did this then monopoly would in fact be nonrdistortionary Yet most models assumed no price discrimination that is the monopolist of7 fered the same price to all customers without explaining why they did not do so and argued that monopoly was distortionary This work showed how given limited information rms could price discriminate but could do so only imperfectly Subsequent work by a variety of authors such as Salop 1977 and Adams and Yellen 1976 explored a variety of ways by which a monopolist might nd out relevant characteristics of his customers 7 the ex7 tent of discrimination limited by his ability to identify each person s quotsurplusquot the maximum they would be willing to pay For an insurance company the relevant characteristics are not only the likelihood of having an accident but also the degree of risk averse the premium that an individual would be wilr ling to pay to divest himself of risk The economics of information thus pro7 vided the rst coherent theory of monopoly Sel selection and competitive equilibrium The reason that analyzing monopoly was easy is that the monopolist could structure the entire choice set facing his customers The hard question is to de7 scribe the full competitive equilibrium that is a set of insurance contracts such that no one can offer an alternative set which would be pro table Each rm could control the choices that he offered but not the choices offered by others and the decisions made by customers depended on the entire set of choices available In our 1976 paper Rothschild and I succeeded in analyzing this case Three striking results emerged from this analysis The rst I have already mentioned under plausible conditions given the natural de nition of equi7 librium equilibrium might not exist There were two possible forms of equir libria pooling equilibria in which the market is not able to distinguish among the types and separating equilibria in which it is The different groups quotseparate outquot by taking different actions We showed that there never could be a pooling equilibrium 7 if there were a single contract that everyone bought there was another contract that another rm could offer which would quotbreakquot the pooling equilibrium On the other hand there might not exist a separating equilibrium The cost of separation was too great Any pu7 tative separating equilibrium could be broken by a pro table pooling con7 tract a contract which would be bought by both low risk and high risk types Second even small amounts of imperfections of information can change the standard results concerning the existence and characterization of equilibrium Equilibrium for instance never exists when the two types are very near each other As we have seen the competitive equilibrium model is simply not robust Thirdly and relatedly we now can see how the fact that actions convey in7 formation affects the equilibrium In particular our analysis here reinforced 497 the earlier analysis of adverse selection about markets not functioning well In perfect information models individuals would fully divest themselves of the risks which they face and accordingly would act in a risk neutral manner We explained why insurance markets would not work well 7 why most risk averse individuals would buy only partial insurance There were numerous subse quent applications to other markets reinforcing for instance the earlier conclusions concerning the limitations on equity markets The reason that the original owners of a rm might want to sell his shares was to quotinsurequot himr self against the risk of a bad outcome an owner that believed that there was a smaller probability of a bad outcome would be willing to buy less insurance ie to divest himself of fewer of his shares Retention of shares can thus be thought of as a market sorting mechanism the willingness to keep these shares a quotsignalquot of the owners con dence The result was important not only for the insights it provided in the work ings of an important set of markets in the economy but because there are imr portant elements of insurance in many transactions and the general principle that actions convey information and that market transactions are greatly af fected by this fact has implications in a still wider variety of contexts The re lationship between the landlord and his tenant or the employer and his emr ployee can be viewed as containing in it an insurance component limitations on the ability to divest oneself of risk are important in explaining a host of contractual relationships Sorting screening and signaling In equilibrium both buyers and sellers employers and employees insurance company and insured lender and creditor are aware of the informational consequences of their actions Each side of the market needs to consider the consequences eg of acting in a different way or of confronting the other side of the market with different choices In the case where say the insurance company or employer or employee takes the initiative for sorting out applir cants selfrselection is an alternative to examinations as a sorting device In the case where the insured or employee or borrower takes the initiative for identifying himself as a better risk a better employee a borrower more likely to repay then we say he is signaling69 But of course in equilibrium both sides are aware of the consequences of alternative actions and the differences be tween signaling and selfrselection screening models lie in the technicalities of game theory and in particular whether the informed or uninformed emr ployee or employer insured or insurance company moves rst70 Still some of the seeming differences between signaling and screeing 58 See Stiglitz 1983 Ross 1973 and Leland and Pyle 1977 5 Spence 1973 7 See in particular Stiglitz and Weiss 1983a 1994 and Yabushita 1983 As we point out in the real world who moves rst ought to be Viewed as an endogenous variable In such a context it appears that the screening equilibria are more robust than the signaling equilibirum Assume for instance that there were some signaling equilibrium that differed from the screening equi librium eg there were a pooling equilibrium sustained because of the outrofrequilibrium ber liefs of rms Then such an equilibrium could be broken by a prior or later move of rms 498 models arise because of a failure to specify a fuIquuilibrium We noted earlier that there were many separating contracts but a unique separating equilibrir um We argued that if one considered any other separating set of contracts then say in the insurance market a rm could come in and offer an alterna7 tive set of contracts and make a pro t the original set of separating contracts could not have been an equilibrium The same is true in say the education signaling model There are many educational systems which quotseparatequot 7 that is the more able choose to go to school longer and the wages at each level of education correspond to the productivity of those who go to school for that length of time But all except one are not full equilibrium Assume for in7 stance there were two types of individuals a low ability and a high ability Then if the low ability goes to 12 years of schooling then any education sys7 tem in which the high ability went suf ciently long 7 say more than 14 years 7 might separate But the low ability would recognize that if it went to school for ll years it would still be treated as low ability The unique equilibrium level of education for the low ability is that which maximizes his net income taking into account the productivity gains and costs of education and the unique equilibrium level of education for the high ability is the lowest level of education such that if his wage corresponds to his productivity at that level of education the low ability will still prefer to remain at his low level of educa7 tion rather than pretend to be more able by staying in school longer71 The education system of course was particularly infelicitous for studying market equilibrium The structure of the education system is largely a matter of public choice not of market processes Different countries have chosen markedly different systems The minimum level of education is typically not a matter of choice but set by the government Within educational systems examinations play as important a role as selfrselection or signaling though given a certain standard of testing there is a process of selfrselection involved in deciding whether to stay in school to try to pass the examination72 For the same reason the problems of existence which arise in the insurance market are not relevant in the education market 7 the quotcompetitivequot supply side of the market is simply absent But when the signaling concepts are translated into contexts in which there is a robust competitive market the problems of existence cannot be so easily ignored73 7 More accurately the level of education of the more able is the minimum of that and the level of education w 39ch aximizes the individual s net income discounted income minus expendi7 tures on education 72 Moreover even were the educational system not dominated by the government there would be a coordination problem a single rm cannot propose an alternative set of contracts 7 different wages corresponding to different levels of education 7 to break an inef cient separating equi7 librium because the employee does not know that he will necessarily remain with the rm for his entire workinin e 73 In particular when there is a continuum of types as in the Spence 1973 model there never exists a screening equilibrium The intuition is provided by Rothschild and Stiglitz w o showe then when the types were close to each other then the equilibrium would not exist the costs of separating exceed the bene ts a pooling equilibrium could always break the separating equilibrium With a continuum of types there are always types that are arbitrarily close to each other At the bottom the highest risk individuals itis always possible to nd a contract which made a pro t and attracted the worst types 499 Existence of equilibrium in the insurance market What are we to make of the problem of that problem Clearly insurance marr kets exist even if they are far from complete To some extent the market does exhibit instability Rates vacillate enormously as rates sometimes skyrocket and coverage is curtailed the public clamors for reforms Such periods are of ten followed by periods of relative stability to be followed by another quotcrisisquot in the market Most states regulate rate setting though at least partly for prur dential reasons and this may help stabilize the market Moreover though there is considerable evidence for the kinds of selection processes discussed above there is also considerable evidence that the market is far from as rational as the theory would suggest Most health insurance polir cies do not base premia on the number of children though that is an easily observable variable which clearly affects the risk exposure Many insurance companies do not use past experience as heavily as one would have expected in setting premia ie there is less experience rating My own suspicion however is that the major limitation of Rothschild Stiglitz is its assumption of perfect competition competition is far more lir mited than we postulated there are for instance signi cant search costs and considerable uncertainty about how easiy it is to get the insurance rm to pay on a claim Selfrselection is still relevant but the model of monopoly or some version of monopolistic competition may be more relevant than the model of perfect competition Theory afcantracts and incentives The work with Rothschild was related to the earlier work that I had done on incentives sharecropping besides in the obvious way that both were con cerned with problems of limited information One focusing on selection efr fects one on incentives Both entailed an equilibrium in quotcontractsquot The contracts that had characterized economic relations in the standard comper titive model were extraordinarily simple I will pay you a certain amount if you do such and such If you did not perform as promised the pay was not given But with perfect information individuals simply didn t sign contracts that they did not intend to ful ll lnsurance contracts were similarly simple a pay ment occurred if and only if particular speci ed events occurred The work on sharecropping and on equilibrium with competitive insur rance markets showed that with imperfect information a far richer set of con tracts would be employed and thus began a large literature on the theory of contracting In the simple sharecropping contracts of Stiglitz 1974b the contracts in volved shares xed payments and plot sizes and75 more generally optimal 7 See for instance Stiglitz and Weiss 1983b 1986 1987 Even with these additional instrur ments there could still be nonrmarket clearing equilibria Bester 1985 concludes that by inr creasing collateral requirements one can eliminate credit ratioining is wrong simply because he ignores the interaction between selection and incentive effects 75 Though even here there were subtleties eg whether individuals exerted their efforts before they knew the realization of the state of nature and whether there were bounds on the penalties that could be imposed in the event of bad outcomes 500 payment structures related payments to observables inputs processes outr puts7639quot39 Because what went on in one market affect others the credit labor and land markets were interlinked one could not decentralize in the way hypothesized by the standard perfect information model The theory thus served as the basis of the rura organizatitan7B in developing countries The basic principles were subsequently applied in a variety of other market contexts The most obvious was the design of labor contracts Stiglitz 1975a Payments can depend too on IEIative performance relative performance may convey more relevant information than absolute performance If a par ticular company39s stock goes up when all other companies39 stock goes up it may say very little about the performance of the manager In Nalebuff and Stiglitz 1983a 1983b we analyzed the design of these relative performance compensation schemes contests One of the strong arguments for comper titive decentralized structures is that they provide information on the basis of which one can design better incentive pay structures than those which rely on the performance of a single individual only Credit markets too are characterized by complicated contracts Lenders would specify not only an interest rate but also impose other conditions colr lateral requirements equity requirements which would have both incentive and selection effects0 Indeed the simultaneous presence of both selection and incentive effects was important in the absence ofthe former it might be possible to increase the collateral requirement and raise interest rates still enr suring that the borrower undertook the safe projectngZ 5 There was in this sense a close relationship between the equilibrium analysis of Rothschild and Stiglitz 1976 and Stiglitz 1974b Both explored equilibriain the space of contracts where contracts imposed stipulations on actions and payments that were based on observables 7 ln Stiglitz 1974b the contracts were highly linear In principle generalizing payment struc tures to nonlinear functions was sim 1e Though even here there were subtleties eg whether individuals exerted their efforts before they knew the realization of the state of nature and whether there were bounds on the penalties that could be imposed in the event of bad outcomes Stiglitz 1975a Mirrlees 1975b Mirrlees 1976 The literature has not fully resolved the rea son that contracts are often much simpler than the theory would have predicted eg payments are linear functions of output and do not adjust to changes in circumstances See eg Allen 1985 and Gale 1991 3 ln work with Avi Braverman 1982 1986a 1986b 1989 we explored for instance stipulations concerning what was to be grown and the use of inputs like fertilizers and t e interlinkages be tween credit land and labor contracts For an earlier survey of sharecropping see Stiglitz 1987g For a more recent survey see Chuma Hayami and Otsuka 1992 79 See in particular Braverman Hoff and Stiglitz 1993 a See for instance Stiglitz and Weiss 1983b 1986 198 Even with these additional instrur ments there could still be nonrmarket clearing equilibria 8 Venture capital rms represent an interlinkage of capital and management markets See Hellmann 1998 82 As another application contracting 7 including provisions for risk sharing 7 came to play an imnnrtant 39 39 39 39 39 39 quot 39 ee forinstance Werin and Wijkander 1992 the papers of the symposium in Quarterlyournal 0 Economics 1983 and the survey article by Rosen 1985 Azariadis and Stiglitz 1983 and Arnott Hosios and Stiglitz 1988 501 Incentives and reputation in market equilibrium Incentives are based on rewards and punishments In modern economies the most severe punishment that one can impose is to re an individual3 But if the individual could get ajob just like his current one then there would be no cost Good behavior is driven by earning a surplus over what one could get elsewhere Thus in labor markets the wage must be higher than what the worker could get elsewhere which may be zero if there is unemployment in the goods market rms must feel a loss when they lose a customer because of a shoddy product so the price must exceed the marginal cost of producr tion Thus the long standing presumption that in competitive equilibrium price equals marginal cost cannat be true in markets with imperfect informar tion See Shapiro and Stiglitz 1984 Shapiro 1983 and Klein and Leffler l 981 Equilibrium Wage and price distributions One of the most obvious differences between the predictions of the model with perfect information and what we see in every day life is the conclusion that the same good sell for the same price everywhere We all spend a considr erable amount of time shopping for good buys The differences in prices rer present more than just differences in quality service There are real price differences Since Stigler s classic paper 1961 there has been a large literar ture exploring optimal search behavior Stigler and most of the search literar ture took however the price or wage distribution as given They did not ask how did it arise Given the search costs could it be sustained For instance if search costs are relatively low one might have thought if one bought the old er theories that markets would look very much like they would with zero search costs in which case there would be no price or wage distribution It is not surprising that given that information is costly if there are shocks to the economy 7 the demand for a good goes up in some locale so price there rises 7 that prices are not fully arbitraged instantaneously But much of the wage and price dispersion cannot be related to such quotshocksquot Our analysis of ef ciency wage theory provided an alternative explanation We showed that it paid rms to pay more than they had to eg to reduce labor turnover costs But it might pay some rms to pay higher wages than others As I began to analyze these models an important insight occurred there could be a wage distribution even if all rms were identical eg faced the same search costs It was clear that even small search costs could make a large differ rence to the behavior of product and labor markets This was a point that Diamond 1971 had independently made in a highly influential paper which serves to illustrate powerfully the lack of robustness ofthe competitive equilibr rium theory Assume as in the standard theory all rms were charging the 83 This is not quite accurate if individuals can post a bond then they can be forced to forfeit the bond But individuals may not have the wealth to post a bond and there may be moral hazardquot issues 7 with a good bond the rm may have an incentive to say the worker shirked when he did not 502 competitive price but there were an epsilon cost of searching of going to any other store Then any rm which charged epsilon2 greater would lose no cusr tomers It would thus pay him to increase his price And it would similarly pay all other rms to increase their prices But at the higher price it would again pay each to increase his price And price increases until the price charged is the monopoly price Even small search costs thus lead even a market with many rms to charge monopoly prices Work with Salop Salop and Stiglitz 1977 1982 1987 Stiglitz l979b l989c showed that in situations where there were even small search costs markets would be characterized by a price distrir bution If everyone were charging the same price it would pay some rm either to raise his price to exploit the high search costs customers who he would not lose or to lower his price to steal customers away from his rivals The standard wisdom that said that not everyone had to be informed to ensure that the mar ket acted perfectly competitive was simply not in general true EFFICIENCY OF THE MARKET EQUILIBRIUM AND THE ROLE OF THE STATE Perhaps the most important single idea in economics is that competitive economies lead as if by an invisible hand to a Pareto ef cient allocation of resources and that every Pareto ef cient resource allocation can be achieved through a competitive mechanism provided only that the appropriate lump sum redistributions are undertaken It is these fundamental theorems of welfare economics which provide both the rationale for the reliance on free markets and the belief that issues of distribution can be separated from issues of ef ciency allowing the economist the freedom to push for reforms which increase ef ciency regardless of their seeming impact on distribution if so ciety does not like the distributional consequences it should simply redir stribute income The economics of information showed that neither of these results was in general true To be sure economists over the preceding three decades had identi ed important market failures 7 such as the externalities associated with pollution 7 which required government intervention5 But the scope for mar ket failures was limited and thus the arenas in which government intervenr tion was required were limited Early work already referred to had laid the foundations for the idea that economies with information imperfections would not be Pareto ef cient even taking into account the costs of obtaining information There were interventions in the market that could make all parties better off We had shown for instance that incentives for the disclosure and acquisition of information were far from perfect imperfect appropriability meant that there might be insuf r cient incentives but the fact that much of the gains were quotrentsquot gains by a For a survey see Stiglitz 1989c 85 Though even ere some economists suggested that in the absence of transactions costs the market could handle the problem ef ciently See Coase 1960 But this analysis too depended on assumptions of perfect information as Farrell 1987 forcefully showed 503 some at the expense of others suggested that there might be excessive exr penditures on information One of the arguments for unfettered capital mar7 kets was that there were strong incentives to gather information if one dis7 covered that some stock was more valuable than others thought if you bought it before they discovered the information then you would make a capital gain This price discovery function of capital markets was often adverr tised as one of its strengths But the issue was while the individual who dis7 covered the information a nanosecond before any one else might be better off was society as a whole better off if having the information a nanosecond earlier did not lead to a change in real decisions eg concerning invest7 ment then it was largely redistributive with the gains ofthose obtaining the information occurring at the expense of others Another example illustrates what is at issue Assume hundred dollar bills were to fall one each at the left foot of each student in my class They could wait to the end of the lecture then pick up the money but that is not a Nash equilibrium If all students were to do that it would pay any one to bend down and quickly scoop up what he could Each realizing that immediately picks up the dollar bill at his foot The equilibrium leaves each no better off than if he had waited 7 and there was a great social cost the interruption of the lecture6 There are potentially other inef ciencies associated with information ac7 quisition Information can have adverse effects on volatility And informa7 tion can lead to the destruction of markets in ways which lead to adverse ef7 fects on welfare We described earlier how the existence of asymmetries of information can destroy markets lndividuals sometimes have incentives to obtain information creating an asymmetry of information which then leads to the destruction of insurance markets and an overall lowering of welfare Welfare might be increased if the acquisition of this kind of information could be proscribed Recently such issues have become sources of real policy concern in the arena of genetic testing Even when information is available there are issues concerning its use with the use of certain kinds of informa7 tion having either a discriminatory intent or effect in circumstances in which such direct discrimination itself would be prohibited Moreover asymmetries of information were shown to be related to absent or imperfect markets They help explain why the market for lemons or the credit or labor or equity markets worked imperfectly The fact that markets with imperfect information worked differently 7 and less well 7 that markets with perfect information was not by itself a damning criticism of markets After all information is costly and taking into account the costs of informa7 tion markets might be fully ef cient Stigler had essentially argued for this perspective but without proof Our research showed that this assertion 7 or hope 7 was simply not correct Earlier work had established that when mar7 85 See Stiglitz 1989k 87 For a discussion in the context of the East Asia crisis see Furman and Stiglitz 1998 83 See eg Rothschild and Stiglitz 1982 1997 For models of statistical discrimination and some of their implications see Stiglitz 1973a 1974d Arrow 1972 and Phelps 1972 504 kets are absent or imperfect market equilibrium might be constrained Pareto inef cient that is taking into account the absence of the market everyone could be made better off89 Moreover since asymmetries of information give rise to market power and perfect competition is required if markets are to be ef cient it is perhaps not surprising that markets with information asymmer tries and other information imperfections are far from ef cient But while it was thus not surprising that markets might not provide appror priate incentives for the acquisition and dissemination of information the market failures associated with imperfect information are far more profound The intuition can be seen most simply in the case of models with moral hazard There the premium charged is associated with the average risk and therefore the average care taken by seemingly similar individuals The moral hazard problem arises because the level of care cannot be observed Each in dividual ignores the effect of his actions on the premium but when they all take less care the premium increases The lack of care by each exerts a negar tive externality on others The essential insight of Greenwald and Stiglitz 198690 was to recognize that such externalityrlike effects are pervasive whenever information is imr perfect or markets incomplete 7 that is always 7 and as a result markets are essentially never constrained Pareto ef cient91 In short market failures are pervasive There were two other implications The rst was the nonrdecentralizability of ef cient market solutions The notion that one could decentralize decision making to obtain Pareto ef cient resource allocation is one of the fundar mental ideas in economics Greenwald and Stiglitz showed that that was not in general possible Again a simple example illustrates what is at issue An in surance company cannot monitor the extent of smoking which has an ad verse effect on health The government cannot monitor smoking any better than the insurance company but it can impose taxes not only on cigarettes but also on other commodities which are complements to smoking and sub sidies on substitutes which have less adverse effects92 Earlier work with Braverman 1982 had shown the consequences ofthis decentralizability the a At rst blush the result might seem obvious but interestingly a number of economists had tried to show that the Arroerebreu results on the ef ciency of the market were more robust than they seemed that is even if there were not a complete set of securities markets the market was constrained Pareto ef ciency See eg Diamond 1967 But these results were shown to de pend on the overly simplistic nature of the models eg involving a single commodity See Stiglitz 1972a 1982b Newbery and Stiglitz 1982 1984 Grossman and Stiglitz 1977 1980b 9 Greenwald and Stiglitz 1986 focus on models with adverse selection and incentive problems Greenwald and Stiglitz 1988a showed that similar results hold in the context of search and other models with imperfect information Earlier work with Shapiro 1984 had shown in the context of a speci c model that quilibria in an econom with an agenc or principal agent prob lem was not constrained Pareto ef cient Laterwork with Arnott 1990 explored in more der tail the market failures that arise with moral hazard 9 Arnott Greenwald and Stiglitz 1994 provide a simple exposition using the standard selfrser lection and incentive compatibility constraints 92 These ideas are extended and generalized in Arnott and Stiglitz 1991b In Stiglitz 1998c I explore the role of corrective taxation correcting for externalities in the presence of imperfect inforTnation 505 interlinkage of land labor and credit markets in agrarian markets of develr oping countries Markets are also interlinked over time Intertemparal linkages impair the ef r cacy of competitive processes as we have already noted Standard theory has it that if an employer does not treat an employee well he simply moves to any other rm But informational asymmetries impair labor mobility partially locking the employee into his employer or the borrower into his creditorgg While with perfect information and perfect markets some of the conse quences of this reduction in ex post competition could be corrected by the intensity of ex ante competition there is little reason to believe that is in fact the caseBA One of the sources of the market failures is agency problems such as those which arise when the owner of land is different from the person working the land The extent of agency problems 7 and therefore of market failures 7 thus depends on the distribution ofwealth as we noted earlier in our discussion of sharecropping It is simply not the case that one can separate out issues of equity and ef ciency95 Moreover the notion that one could separate out issues of equity and ef r ciency also rested on the ability to engage in lump sum redistributions But as Mirrlees 1971 had earlier pointed out with imperfect information this was not possible all redistributive taxation was distortionary But this had imporr tant implications for a wider range of policies beyond simply the design of tax structures It meant that interventions in the market which changed the be fore tax distribution of income could be desirable because they lessened the burden on redistributive taxation Again the conclusion the second welfare theorem effectively asserting the ability to separate issues of distribution and ef ciency was not true97 In effect the ArrowDebreu model had identi ed the single set of assumpr tions under which markets were Pareto ef cient There had to be perfect information or more accurately information beliefs could not be enda genaus they could not change either as a result of the actions of any indivir dual or rm including investments in information But in an information economy a model which assumes that information is xed seems increasingly irrelevant Dysfunction institutions As the theoretical case that markets in which information was imperfect were not ef cient became increasingly clear several arguments were put forward against government intervention One we have already dealt with the govr 9 See Stiglitz and Weiss 1983b 9 See for instance Stiglitz 1987h 95 A point that had also been made earlier in Shapiro and Stiglitz 1984 9 See Stiglitz 1998c 9 The second welfare theorem also requires other mathematical assumptions eg concerning convexity which typically may not be satis ed in models with imperfect and endogenous infor mation Other problems with decentralizibility were raised in Arnott and Stiglitz 1991b 506 ernment too faces informational imperfections For our analysis had shown that the incentives and constraints facing government differed from those facing the private sector so that even when government faced exactly the same informationaconstraints welfare could be improved upon98 There was another argument which held up no better The existence of market failures 7 absent or imperfect markets 7 does give rise to nonrmarket institutions The absence of death insurance gave rise to burial societies Families provide insurance to their members against a host of risks for which they either cannot buy insurance or for which the insurance premium is viewed to be too high But in what I call the functionah39st faIIacy it is easy to go from the observation that an institution arises to ful ll a function to the con7 clusion that actually in equih39bn39um it serves that function Those who sucr cumbed to this fallacy seemed to argue that there was no need for govern7 ment intervention because these nonmarket institutions would quotsolvequot the market failure or at least do as well as any government Richard Arnott and I 1991 showed that to the contrary nonrmarket institutions could actually make matters worse Insurance provided by the family could crowd out mar7 ket insurance insurance companies would recognize that the insured would take less risk because they had obtained insurance from others and accord7 ingly cut back on the amount of insurance that they offered But since the nonrmarket family institutions did a poorjob of divesting risk welfare was decreased99 The Arnottrstiglitz analysis reemphasized the basic point made at the end of the last subsection it was only under very special circumstances that marr kets could be shown to be ef cient Why then should we expect an equilir brium involving nonrmarket institutions and markets to be ef cient APPLICATIONS OF THE NEW PARADIGM The new theory of the rm and the foundations of modern macroeconomics Of all the market failures the extended periods of underutilization of re7 sources 7 especially human resources 7 is of the greatest moment the conse7 quences of which in turn are exacerbated by capital market imperfections which means that even if future prospects of an unemployed individual are good he cannot borrow to sustain his standard of living We referred earlier to the dissatisfaction with traditional Keynesian explar nations in particular the lack of microrfoundations This gave rise to two schools of thought One sought to use the old perfect market paradigm re7 lying heavily on representative agent models While information was not per7 fect expectations were rational But the representative agent model by con7 struction ruled out the information asymmetries which are at the heart of 98 For a more extensive discussion of the economic role of the state see Stiglitz 1989a 99 Whether nonrmarket insurance increased or decreased welfare depended on what was observr able monitorable by other members of the family If they had no more information than did the insurance company then the nonmarket insurance lowered welfare if they had access to more information then in effect the insurance company could free ride on this inforTnation and welfare could actually be enhanced 507 macroeconomic problems Only if an individual has a severe case of schizor phrenia is it possible for such problems to arise If one begins with a model that assumes that markets clear it is hard to see how one can get much insight into unemployment the failure of the labor market to clear The construction of a macroreconomic model which embraces the conse7 quences of imperfections of information in labor product and capital marr kets has become one of my major preoccupations over the past fteen years Given the complexity of each ofthese markets creating a general equilibrium model 7 simple enough to be taught to graduate students or used by policy makers 7 has not proven to be an easy task At the heart of that model lies a new theory of the rm for which the theory of asymmetric information pro7 vides the foundations The modern theory of the rm in turn rests on three pillars the theory of corporate nance the theory of corporate governance and the theory of organizational design The theory of corpora te nance Under the older perfect information theory it made no difference whether rms raised capital by debt or equity in the absence of tax distortions100 This was the central insight of the ModiglianirMiller theorem101 We have noted how the willingness to hold or to sell shares conveys information so that how rms raise capital does make a difference102 Firms rely heavily on debt r nance and bankruptcy resulting from the failure to meet debt obligations matters Both because of the cost of bankruptcies and limitations in the de7 sign of managerial incentive schemes103 rms act in a risk averse manner104 7 with risk being more than just correlation with the business cycle105 N For early explorations of the implications of taxes for corporate nance see Stiglitz 1973b 6a See Modigliani and Miller 1958 They won the Nobel Prize in 1985 and 1990 respectively In Stiglitz 1969a I showed that there result was in some respects considerably more general than their proof would have led one to believe it did not require for instance risk classes and held in general equilibrium but there was one critical assumption bankruptcy which they had ignored quot392 The term equity rationingquot is used loosely to refer to the fact that rms do not rely on the issuance of equity to divest themselves of the risks which they face in the way that perfect infor7 mation theories predict the issuance of equi as we have noted sends a signal that the owners managers of the rm think the market has overvalued the shares and the market responds by lowering price Thus the cost of raising funds through equity is extremely high For empirical evidence showing that relatively little new investment is nanced by equity see Mayer 1990 for empirical evidence concerning the adverse price effects of share issuance see Asquith and Mullins 1986 for the general theory see Greenwald Stiglitz and Weiss 1984 and Myers and Maljuf 1984 Other information based theories that help explain the limited use of equity marr kets in spite of their advantages in risk sharing are derived from signalingselfrselection models referred to earlier and on models of costly state Veri cationquot Townsend 1979 Equity marr kets give each shareholder a prorrata share of the pro ts but this requires that pro ts be ob7 servable There are a Variety of ways by which pro ts can be diverted to managers and dominant shareholders Legal structures and accounting practices are designed to circumscribe such be7 havior Greenwald and Stiglitz 1992 and only where these have become well developed have strong equity markets with diversi ed share ownership developed Shleifer and Vishny 1997 quot393 That is we noted earlier that optim 39 i 439 J 39 th bearing some risk In some cases incentive schemes can actually lead managers to act in a risk7 loVin wa m See in particular Greenwald and Stiglitz 1991 quot395 For an elaboration of this point see Stiglitz 1987c 1989g 508 Moreover with credit rationing or the potential of credit rationing not only does the rm s net worth the market value of its assets matter but so does its asset structure including its liquidity 06 While there are many impli7 cations of the theory of the risk averse rm facing credit rationing some of which are elaborated upon in the next section one example should suf ce to highlight the importance of these ideas In traditional neoclassical investment theory investment depends on the real interest rate and the rm s percepr tion of expected returns The rm s cash flow or its net worth should make no difference The earliest econometric studies of investment by Kuh and Meyer 1957 suggested that that was not the case But under the strength of the theoretical strictures that these variables could not matter they were ex7 cluded from econometric analysis for two decades following the work of Hall and Jorgenson 1967 It was not until work on asymmetric information had restored theoretical respectability to introducing such variables in investment regressions that it was acceptable to do so and when that was done it was shown that especially for small and medium sized enterprises these variables were crucial107 Moreover in the traditional theory there is no corporate veil individuals can see perfectly what is going on inside the rm it makes no difference whether the rm distributes or retains its pro ts other than for taxes 108 But if there is imperfect information about what is going on inside the rm then there is a corporate veil which cannot be easily pierced Corporate governance 1n the traditional theory rms simply maximized the expected present disr counted value of pro ts which equaled market value 09 and with perfect in7 formation how that was to be done was simply an engineering problem Disagreements about what the rm should do were of little moment In that context corporate governance 7 how rm decisions were made 7 mattered little as well But again in reality corporate governance matters a great deal There are disagreements about what the rm should do110 7 partly motivated by differences in judgments partly motivated by differences in objectives Managers can take actions which advance their interests at the expense of that of shareholders and majority shareholders can advance their interests at quot395 The Very concept of liquidity 7 and the distinction between lack of liquidity and insolvency 7 rests on informa 39on asymmetries If there were perfect information any rm that was liquid would be able to obtain nance and thus would not face a liquidity problem quot397 T ere is now a Vast literature in this area See for instance Blanchard Lopezrdersilanes and Schliefer 1994 Hubbard 1990 Calorniris and Hubbard 1990 and Fazzari Hubbard and Peterson 1988 For a survey of this literature see Hubbard 1998 quot398 ln Stiglitz 1974c I again showed that the result was in some respects far more general than their analysis suggested but that it was in fact undermined by the capital market imperfections which arose from imperfect information quot399 It was also assumed that rm Value maximization would lead to ef cient outcomes When there are not a complete set of Arroerebreu securities this is in general not the case See Stiglitz 1972a 1982b Newbery and Stiglitz 1982 Grossman and Stiglitz 1977 1980b For an early analysis of these issues see Stiglitz 1972b For a general theorem see Grossman and Stiglitz 1977 509 the expense of minority shareholders The owners who in the language of Steve Ross 1973 came to be called the principal not only could not monir tor their workers and managers the agents because of asymmetries of in formation they typically did not even know what these people who were supr posed to be acting on their behalf should do That there were important consequences for the theory of the rm of the separation of ownership and control had earlier been noted by Berle and Means 1932 but it was not until information economics that we had a coherent way of thinking about the implications The problem of corporate governance of course arises both from the problems of information imperfections and the public good nature of mar nagementoversight if a shareholder engages in expenditures on oversight and succeeds in improving the rm s performance all shareholders bene t equally similarly with creditors See Stiglitz 1 985b Some who still held to the view that rms would maximize their market value argued that takerovers and the threat of takeovers would ensure that competition in the market for managers would ensure stock market value maximization 1f the rm were not maximizing its stock market value then it would pay someone to buy the rm and change its actions so that its value would increase Early on in this debate I raised questions on theoretical grounds about the ef cacy ofthe takerover mechanism See Stiglitz 1972b The most forceful set of arguments were subsequently put forward by Grossman and Hart 1980 who observed that any small shareholder who be lieved that the takeover would subsequently increase the market value would not be willing to sell his shares Only takerovers that were expected to be value decreasing would be successful112 The subsequent work by Edlin and Stiglitz 1995 referred to earlier showed how existing managers could take actions to reduce the effectiveness of competition for management ie the threat of takerovers by increasing asymmetries of information That the standard model of the theory of the rm 7 where there was a single owner concerned with maximizing the rm s Value 7 did not t well the modern theory of the corporation had been noted even earlier by Alfred Marshall 1897 There was a large subsequent literature on the managerial theory of the rm See eg Marris 1964 Baumol 1959 and March and Simon 1958 Even earlier Adam Smith 1776 had noted the problem of corporate goverr nance The directors of such companies however being the managers rather of other people s money than their own it cannot well be expected that they should watch over it with the same anxious Vigilance with which the partners in a private copartnery frequently watch over their n 39 the stewards of a rich man they are apt to consider attention to small matters as not for their masters honour and Very easily give themselves a dispensation from having it Negligence and profusion therefore must always prevail more or less in the management of the affairs of such a companyquotpp 2 47265 Marshall 1897 in his review of the advances of economics in the nineteenth century and the challenges facing the discipline cited the problems of in modern parlance corporate goverr nance of what motivates a manager to act in the interests of the owners of the rm 2 There has subsequently developed a large theoretical and em irical literature on takerovers See for instance Manne 1965ensen and Rubac 1983 Stulz 1988 and Singh 1998 For a surveys of the literature on takeover see Hirshleifer 1995 For a survey of the broader litera ture on corporate governance see Shleifer and Vishny 1997 510 Proving that a rm does not maximize their stock market value is of course dif cult since it is hard to ascertain its opportunity set and the con7 sequences of alternative actions However there are a large number of in7 stances in which it is clear that rms do not maximize market value For in7 stance closed end mutual funds regularly sell at a discount there would be a simple action 7 dissolution of the rm 7 which would increase market value There are a large number of tax paradoxes113 7 actions which rms could take which would reduce the total tax bill corporate plus individual though there remains some dispute about the extent to which such paradoxes are due to irrationality on the part of investors or nonrvalue maximizing behavior on the part of managers Organiza lion design So far we have discussed two of the three pillars of the modern theory of the rm corporate nance and corporate governance The third is organiza7 tional design In a world with perfect information organizational design too is oflittle moment In practice it is of central concern to businesses We have already extensively discussed the issue of incentives how on the one hand in7 formation imperfections limit the extent of ef cient decentralizability and how on the other organizational design 7 by having alternative units perform comparable tasks 7 can enable a rm to glean information on the basis of which better incentive systems can be based Nalebuff and Stiglitz 1983a b But there is another important aspect of organization design Even if indi7 viduals are well intentioned with limited information mistakes get made To err is human Raj Sah and l in a series of papers 1985 1986 1988a 1988b 1991 explored the consequences of alternative organizational design and de7 cision making structures for organizational mistakes for instance where good projects get rejected or bad projects get accepted We suggested that in a variety of circumstances especially when there is a scarcity of good projects decentralized polyarchical organizational structures have distinct advan7 tages Macroeconomics The central macroreconomic issue is that of unemployment The models 1 de7 scribed earlier explained why there could exist unemployment in equilibrium But much of macroreconomics is concerned with dynamics with uctuations with explaining why sometimes the economy rather than absorbing shocks seems to amplify them and why their effects often persist ln joint work with Bruce Greenwald and Andy Weiss we have shown how the theories of asymr metric information can help provide explanations of these macroreconomic phenomena The imperfections of capital markets 7 the phenomena of 3 See eg Stiglitz 1973b 1982d m In addition see Sah 1991 These papers arejust beginning to spawn a body of research See for instance Bhid 2001 Viser 1998 and Christensen and Knudsen 2002 511 credit and equity rationing which arise because of information asymmetries 7 are key They lead to risk averse behavior of rms and to households and rms being affected by cash flow constraints Standard interpretations of Keynesian economics emphasized the imporr tance of wage and price rigidities but without a convincing explanation of those rigidities For instance some theories had shown stressed the imporr tance of costs of adjustment of prices but what was at issue was why markets seemed to adjust quantities rather than prices and the relative costs of ad justment of quantities seemed greater than those of prices The Greenwaldr Stiglitz theory of adjustment 1989b provided an explanation based on car pital market116 imperfections arising from information imperfections it argued that at least for commodities for which inventory costs were reason ably low the risks arising from informational imperfections were greater for price and wage adjustments than from quantity adjustments Risk averse rms would make smaller adjustments where to variables the consequences of which were more uncertain But even though wages and prices were not perfectly flexible neither were they perfectly rigid and indeed in the Great Depression they fell by a con siderable amount There had been large fluctuations in earlier periods and in other countries in which there had been a high degree of wage and price flexibility Greenwald and l 1987a 1987b 1988b 1988c 1988d 1988e 1989b 1990b 1993a 1993b 1995 argued that it was other market failures in particular the imperfections of capital markets and the incomplete contractr ing which provided part of the explanation of key observed macroreconomic phenomena In debt contracts tipically not indexed for changes in prices whenever prices fell below the level expected or in variable interest rate con tracts when real interest rates rose above the level expected there were transfers from debtors to creditors In these circumstances excessive down ward price flexibility notjust price rigidities could give rise to problems 7 These and other redistributive changes had large real effects and could not be insured against because of imperfections in capital markets Large shocks could lead to bankruptcy and with bankruptcy especially when it results in rm liquidation there was a loss of organizational and informational capir 5 Mankiw 1985 Akerlof and Yellen 1985 5 Our theories did not provide a complete explanation for such incomplete contracting While part of the explanation may lie in the lack of observability Veri ability of the relevant Variables n which contracts should be contingent still it seems t at t ere should be more indexing t an is observed Theories of asymmetric information did however provide part of the explanation for why inef cient contractual arrangements might persist In a complex economy if one party proposes a change to a standard contract the other party might reasonably infer that the alter ration bene ts the party proposing the change in a world which is close to zero sum the gains for that party are at the expense 0 e other and so he will be reluctant to concur with the change unless he can be persuaded that there is scope for a Pareto improvement Because of limitations on information knowledge this may be hard to do See Stiglitz 1992c 7 The importance of these phenomena had been emphasized earlier by Irving Fisher 1933 Stiglitz 1999d emphasizes the consequences of diffezentes in the speeds of adjustments of dif ferent prices 512 tal Even if such large changes could be forestalled until there was a resor lution the rm s access to credit would be impaired and for good reason moreover without quotclear ownersquot those in control would in general not have incentives to maximize the rm s value Even when the shocks were large enough to lead to bankruptcy they had impacts on rms ability and willingness to take risks Since all production is risky shocks affect aggregate supply as well as the demand for investment Because rm net worth would only be restored over time the effects of a shock persisted By the same token there were hysteresis effects associated with por licy an increase in interest rates which depleted rm net worth had impacts even after the interest rates were reduced If rms were credit rationed then reductions in liquidity could have particularly marked effects119 Every aspect of macroeconomic behavior was affected the theories helped explain for in stance the seemingly anomalous behavior of inventoriesrather than using in ventories to smooth production which would result in countercyclical changes in inventories inventories moved prorcyclically because of the imr portance of cash constraints leading to a high shadow price of money in re cessions and pricing with the quotshadow pricequot of capital being high in a recesr sion rms did not invest as much in acquiring new customers and were less concerned about losing workers so that markrups increased so that real pror duct wages could fall even though the marginal productivity of labor was rising In short our analysis emphasized the supply side effects of shocks the in terrelationships between supply and demand side effects and the importance of nance in propagating fluctuations Theory ofmoney120 A particularly important aspect of our reformulation of macroreconomics for cused on monetary economics Traditionally it was postulated that the in terest rate was set to equate the demand and supply for money with money being largely required for transactions purposes and the with interest rate representing the opportunity cost of money In modern economies however credit not money is required and used for most transactions and most transactions are simply exchanges of assets and therefore not directly related to GDP Moreover today most money is interest bearing with the difference between the interest rate paid say on a money market account and T bill rates having little to do with monetary policy and related solely to transacr tions costs What is important is the availability of credit and the terms at which it is available this in turn is related to the certi cation of credit worr thiness by banks and other institutions In short information is at the heart of a In traditional economic theories bankruptcy played little role partly because control who made decisions did not matter and so t e change in contro that was consequent to bankruptcy was of little moment partly because with perfect information there would be little reason for lenders to lend to someone rather than extending funds through equity especially if there were signi cant probabilities of and costs to bankruptcy For an insightful discussion about control rights see Hart 1995 9 For discussions of credit rationing and macroeconomic activity see Stiglitz and Weiss 1992 2 The ideas set forth in this section are developed at greater length in Greenwald and Stiglitz 1990b19911999 513 monetary economics But banks are like other risk averse rms their ability and willingness to bear the risks associated with making loans depends on their net worth121 Because of equity rationing shocks to their net worth can not be instantaneously undone and the theory thus explains why such shocks can have large adverse macroreconomic consequences The theory shows how not only traditional monetary instruments like reserve requirements but regulatory instruments like risk adjusted capital adequacy requirements can be used to affect the supply of credit interest rates charged and the bank s risk portfolio The analysis also showed how excessive reliance on capital adequacy requirements could be counterproductive122 The theory has important policy implications It provides a new basis for a quotliquidity trapquot explaining why in severe economic downturns monetary por licy may be relatively ineffective It explains some ofthe recent policy failures both in the inability ofthe Fed to forestall the 1991 recession and the failures of the IMF in East Asia in 1997 It shifts emphasis from looking at the Fed Funds rate or the money supply to variables of more direct relevance to ecor nomic activity the level of credit123 and the interest rates charged to rms and it explains the movement in the spread between that rate and the Federal Funds rate The theory predicts that there is scope for monetary por licy even in the presence of dollarization We also analyzed the importance of credit interlinkages Many rms receive credit from other rms at the same time that they provide credit to still others violating Polonius39 injunction quotneither a lender nor a borrower bequot by being both The disperse nature of information in the economy provides an explanation of this phenomena which has important consequences As a re sult ofthese general interlinkages in some ways every bit as important as the commodity interlinkages stressed in standard general equilibrium analysis a shock to one rm gets transmitted to others and when there is a large enough shock there can be a cascade of bankruptcies Gmwt 25 and development While most of the macroeconomic analysis focused on exploring the implir cations of imperfections of credit markets arising out of information probr 2 The special nature ofinformation also helps explain the link between the acquisition and pro cessing of information and the provision of funds If information were like any other good inr formationquot rms could sell their information to providers of funds so that shocks which adr Versely affect the net worth of the information processors would have minimal effects on credit supply While there is some sale ofinforrnation in most lending markets such information conr stitutes only a small part of the information that affects lending decisions 2 See also Hellman Murdoch and Stiglitz 2000 3 There is now a large literature arguing that these are the crucial Variables of concern For an early discussion see Blinder and Stiglitz 1983 2 See Stiglitz 2001d 5 This section is based in part on Greenwald Kohn and Stiglitz 1990 and Stiglitz 1992e 1994a 1994b 5 This section is based on Stiglitz 1986a 1987d 1988a 1988e 1989 1990b 1993b 1995b 1996a 1997a 1997b 1998a 1999b 2001a b Hoff and Stiglitz 1997 2000 Stern and Stiglitz 1997 and Stiglitz and Yusuf 2000 in addition to the work on the theory of rural organization with Braverman and Hoff cited earlier 514 lems for cyclical variations another strand of our research program focused on growth The importance of capital markets for growth had long been re7 cognized without capital markets rms have to rely on retained earnings But how rms raise capital is important for their growth In particular quotequity rar tioningquot 7 especially important in developing countries where informational problems are even greater 7 impedes rms willingness to invest and under7 take risks and thus slows down growth Changes in economic policy which enable rms to bear more risk eg by reducing the size of macroeconomic fluctuations or which enhance rms equity base by suppressing interest rates which result in rm s having larger pro ts enhance economic growth Conversely policies such as associated with IMF interventions in which in7 terest rates are raised to very high levels discourage the use of debt forcing rms to rely more heavily on retained earnings The most challenging problems for growth lie in economic development Typically market failures are more prevalent in less developed countries and these market failures are often associated with information problems 7 the very problems that inspired much of the research described in this paper While these perspectives help explain the failures of policies based on assuming perr fect or well functioning markets they also direct attention to policies which might remedy or reduce the consequences of informational imperfections127 Research One of the most important determinants of the pace of growth is for develr oped countries the investment in research and for less developed countries efforts at closing the knowledge gap between themselves and more developed countries Knowledge is of course a particular arm of information and many of the issues that are central to the economics of information are also key to understanding research 7 such as the problems of appropriability the xed costs associated with investments in research which give rise to imperfections in competition and the public good nature of information It was thus nat7 ural that 1 turned to explore the implications in a series of papers that looked at both industry equilibrium and the consequences for economic growth While it is not possible to summarize briefly the results one conclusion does stand out that market economies in which research and innovation play an important role are not well described by the standard competitive model and that the market equilibrium without government intervention is not in ger neral ef cient 7 See in particular the discussion in the World Bank 1999 8 There were of course several precursors to what has come to be called endogenous growth theory See in particular the collection of essays in Shell 1967 and Atkinson and Stiglitz 1969 For later work see in particular Dasgupta and Stiglitz 1980a 1980b 1981 1988 Dasgupta Gilbert and Stiin 1982 Stiglitz 1987e 1990a 515 POLICY FRAMEWORKS The fact that when there are asymmetries of information markets are not in general constrained Pareto ef cient implies there is a potentially important role for government The new paradigm has important implications for polir cy going well beyond addressing how to prevent the creation of and over7 come asymmetries of information As we have seen asymmetries of informa7 tion give rise to a host of other market failures 7 such as missing markets and especially capital market imperfections leading to rms that are risk averse and cash constrained 7 and policy has to deal with these indirect conse7 quences as well An analysis for instance of the incidence of taxation which is predicated on perfectly competitive markets with perfectly informed conr sumers and risk neutral rms is likely to go astray But beyond this the new information paradigm helps us to think about policy from a new perspective one which recognizes the pervasiveness of im7 perfections of information Pareto ef cient taXa 1017129 Information asymmetries of course arise among all participants in society 7 including between citizens and their government In the nal section of this paper 1 wish to explore one side the dif culties citizens have of controlling their government Here 1 want to briefly note the other side the problems posed to government in the conduct of its quotbusinessquot that arise from infor7 mation asymmetries in three key areas taxation regulation and production One of the functions of government is to redistribute income even if it did not wish to redistribute actively it has to raise revenues to nance public goods and there is a concern that the revenue be raised in an equitable man7 ner eg that those who are more able to contribute or who bene t more do so But government has a problem of identifying these individuals Just as those who a monopolist would like to charge more do not readily disclose that they might be willing to pay more for the product andjust as those who are less able less likely to pay back a loan or more likely to have an accident do not readily disclose that information to those with whom they deal so too in the public sector And the selfrselection mechanisms for information rever lation that Rothschild and 1 had explored in our competitive insurance model or that 1 had explored in my paper on discriminating monopoly can be used here The problem of the government maximizing social quotpro tquot welfare subject to the information constraints is closely analogous to that of the monopolist maximizing private pro t subject to information constraints This is why Mirrlees39 1971 paper on optimal taxation though not couched in informationrtheoretic terms was an important precursor to the work de7 scribed here The critical question for the design of a tax system thus becomes Whatis ab servabIe In older theories in which information was perfect lump sum taxes 9 The discussion of this section draws upon Atkinson and Stiglitz 1976 Stiglitz 1982e 1987f and Mirrlees 1975a and Brito eta 1990 1991 1995 516 and redistributions made sense If ability is not directly observable the go vernment had to rely on other observables 7 like income 7 to make inferr ences but as in all such models market participants as they recognize that inferences are being made alter their behavior In Mirrlees 1971 only in come was observable But in different circumstances either more or less in formation might be available It might be possible to observe hours worked in which case wages would be observable It might be possible to observe the quantity of each good purchased by any particular individual or it might be possible to observe only the aggregate quantity of goods produced For each information structure there is a Pareto ef cient tax structure that is a tax structure such that no one group can be made better off without makr ing some other group worse off The choice among such tax structures der pends on the social welfare function attitudes towards inequality130 While this is not the occasion to provide a complete description of the results two are worth noting What had been thought of as optimal commodity tax strucr tures Ramsey 1927 were shown to be part of a Pareto ef cient tax system only under highly restricted conditions eg that there was no income tax see Sah and Stiglitz l 992 On the other hand it was shown that in a cenr tral benchmark case it was not optimal to tax interest income Theory afregula ion and pn39Va tiza ion The government faced the same problem posed by information asymmetries in regulation that it faced in taxation Over the past quarter century a huge literature has developed making use of selfrselection mechanisms131 allowing far better and more effective systems of regulation than had existed in the pastltsz 1n the 1980s there was a strong movement towards privatizing state enterr prises even in areas in which there was a natural monopoly in which case government ownership would be replaced with government regulation While it was apparent that there were frequently problems with government ownership the theories of imperfect information also made it clear that even the best designed regulatory systems would work imperfectly This raised natr urally the question of under what circumstances could we be sure that privar tization would enhance economic welfare As Herbert Simon 1991 the 1978 Nobel Prize winner had earlier emphasized both public and private sectors 3 In that sense Mirrlees work confounded the two stages of the analysis He described the point along the Pareto frontier that would be chosen by a government with a utilitarian social welfare function Some of the critical properties eg the zero marginal tax rate at the top were however characteristics of anyPareto ef cient tax structure though that particular property was not mbusl that is it depended strongly on his assumption that relative wages e een individuals of differ rent abilities were xed See Stiglitz 2002 and the papers cited there 3 See eg Laffont and Tirole 1993 and Sappington and Stiglitz 1987a 32 A sector in which government regulation was of particular importance is banking We noted earlier that information problems are at the heart of nancial markets and it is thus not surprisr ing that market failures be more pervasive and the role of the government more important See eg Stiglitz 1993a Regulatory design needs to take into account explicitly the limitations inin formation See eg Stiglitz 2001c Honahan and Stiglitz 2001 Greenwald and Stiglitz 1999 and Hellman Murdock and Stiglitz 2000 517 face information and incentive problems there was no compelling theoretir cal argument for why large private organizations would solve these incentive problems better In work with David Sappington 1987b we showed that the conditions under which privatization would necessarily be welfare enhancing were extremely restrictive and closely akin to those under which competitive markets would yield Pareto ef cient outcomes See Stiglitz 1993d 1994c for an elaboration and applications KEY POLICY DEBATES APPLYING BASIC IDEAS The perspectives provided by the new information paradigm not only shaped theoretical approaches to policy but in innumerable concrete issues also led to markedly different policy stances from those wedded to the old paradigm Washington consensus Perhaps most noted were the controversies concerning development strater gies where the Washington consensus policies based on market fundamenr talism 7 the simplistic view of competitive markets with perfect information inappropriate even for developed countries but particularly inappropriate for developing countries 7 had prevailed since the early 1980s within the in ternational economic institutions Elsewhere I have documented the failures ofthese policies in development as well as in managing the transition from Communism to a market economy134 and in managing crises Ideas matters and it is not surprising that policies based on models that depart as far from reality as those underlying the Washington Consensus so often led to failure Bankruptcy aggregate supply and the East Asia crisis This point was brought home perhaps most forcefully by the management of the East Asia crisis which began in Thailand on July 2 1997 While I have writ ten extensively on the many dimensions of the failed responses here Iwant to note the close link between these failures and the theories put forward here Our work had 39 l the impuuauce of 39 39 39 the credit supply and the risks of especially poorly managed bankruptcy Poorly der signed policies could lead to an unnecessarily large reduction in credit avail ability and unnecessary large increases in bankruptcy both leading to large adverse effects on aggregate supply exacerbating the economic downturn But this is precisely what the IMF did by raising interest rates to extremely high levels in countries where rms were already highly leveraged it forced massive bankruptcy and the economies were thus plunged into deep recesr sion and depression capital was not attracted to the country but rather fled Thus the policies even failed in their stated purpose which was to stabilize the exchange rate There were strong hysteresis effects associated with these 33 See for instance Stiglitz 1998a 3 See for instance Stiglitz 2001e 2000a Hussein Stem and Stiglitz2000 35 See in particular Furman and Stiglitz 1998 and Stiglitz 1999e 518 policies when the interest rates were subsequently lowered the rms that had been forced into bankruptcy did not become unbankrupt and the rms that had seen their net worth depleted did not see an immediate restoration There were alternative policies available debt standstills followed by corpor rate nancial restructurings which while they might not have avoided a downturn would have resulted in the downturns being shallower and shorter Malaysia whose economic policies conformed much more closely to those that our theories would have suggested not only recovered more quickly but was left with less of a legacy of debt to impair its future growth than did neighboring Thailand which conformed more closely to the IMF39s recomr mendation Corporate governance open capita markets and the transition to a market economy The transition from communism to a market economy represents one of the most important economic experiments of all time and the failure so far in Russia and the successes in China shed considerable light on many ofthe is sues which I have been discussing The full dimension of Russia s failure is hard to fathom Communism with its central planning requiring more in formation gathering processing and dissemination capacity than could be managed with anytechnology its lack of incentives and its system rife with distortions was viewed as highly inef cient The movement to a market it was assumed would bring enormous increases in incomes Instead incomes plummeted a decline con rmed not only by GDP statistics and household surveys but also by social indicators The numbers in poverty soared from 2 to upwards of 50 depending on the measure used While there were many dimensions to these failures one stands out the privatization strategy which paid little attention to the issues of corporate governance which we stressed earlier Empirical work con rms136 that countries that privatized rapidly but lacked quotgoodquot corporate governance did not grow more rapidly As Sappington and my paper warned privatization might not lead to an in crease in social welfare rather than providing a basis for wealth creation it led to asset stripping and wealth destruction BEYOND INFORMATION ECONOMICS We have seen how the competitive paradigm that dominated economic thinkr ing for two centuries not only was not robust not only did not explain key economic phenomena but also led to misguided policy prescriptions My research over the past thirty years has focused however on only one as pect of my dissatisfaction with that paradigm It is not easy to change views of the world and it seemed to me the most effective way of attacking the para digm was to keep within the standard framework as much as possible I only 35 See Stiglitz 2001e 37 For fuller discussions of these issues see Hussein Stern and Stiglitz 2000 and Stiglitz 2000a 519 varied one assumption 7 the assumption concerning perfect information 7 and in ways which seemed highly plausible Early on some objected that opening up the model to the possibilities of imperfect information was open7 ing up a Pandora s box there were so many ways in which information could be imperfect But while there might be only one way in which information was perfect surely it was better to understand the consequences of different forms of information imperfections that might exist in the real world If the competitive model was not robust against all these different forms of infor7 mation imperfections which existed in the world surely it was not a model upon which we could rely As time evolved it became clear that imperfect in7 formation paradigm itself was highly robust there were some quite general principles while the workings out of the models in detail in different situa7 tions might well differ We succeeded in showing not only that the standard theory was not robust 7 changing only one assumption in ways which were to7 tally plausible had drastic consequences but also that an alternative robust paradigm with great explanatory power could be constructed There were other de ciencies in the theory some of which were closely connected The standard theory assumed that technology and preferences were xed But changes in technology R 81 D are at the heart of capitalism The new information economics 7 extended to incorporate changes in know7 ledge 7 at last began to address systematically these foundations of a market economy As I thought about the problems of development I similarly became in7 creasingly convinced of the inappropriateness of the assumption of xed preferences I have criticized the Washington consensus development strategies partly on the grounds that they perceived of development as no7 thing more than increasing the stock of capital and reducing economic di7 stortions But development represents a far more fundamental transforma7 tion of society including a change in quotpreferencesquot and attitudes an accep7 tance of change and an abandonment of many traditional ways of thinking139 Especially during the last few years as l have become more deeply im7 mersed in the problems of development I have felt more strongly these and some of the other de ciencies of the standard paradigm for instance its at7 tempt to separate out economics from broader social concerns A major im7 pediment to development in Africa has been the civil strife which has been endemic there itself in part a consequence of the economic circumstances These perspectives have strong policy implications For instance some poli7 cies are more conducive to effecting a development transformation Many of the policies of the IMF 7 including the manner in which in interacted with governments basing loans on conditionality 7 were counterproductive A fun7 damental change in development strategy occurred at the World Bank in the 38 In addition much of recent economic theory has assumed that beliefs are in some sense rar tional As noted earlier there are many aspects of economic behavior that seem hard to reconcile with this hypothesis 39 See eg Stiglitz l995b 1998a D See Collier and Gunning 1999 Collier 1998 and Collier 2000 520 years 1 was there one which embraced this more comprehensive approach to development By contrast policies which have ignored social consequences have frequently been disastrous The IMF policies in Indonesia including the elimination of food and fuel subsidies for the very poor just as the country was plunging into depression with wages plummeting and unemployment soaring predictably led to riots the economic consequences are still being felt In some ways as l pursued perspectives l was returning to a theme 1 had raised thirty years ago during my work on the ef ciency wage theory in Kenya where 1 had suggested how psychological factors 7 morale reflecting a sense that one is receiving a fair wage 7 could affect efforts an alternative and in some cases more persuasive reason for the ef ciency wage theory that has subsequently been developed further by Akerlof and Yellen 1986 It is curious how economists have almost studiously ignored factors which are not only the center of day to day life but even of business school education Surely if markets were ef cient such attention would not be given to such matters to issues of corporate culture and extrinsic rewards unless they were of some considerable importance1A2 And if such issues are of importance within a rm they are equally important within a society Finally 1 have become convinced that the dynamics of change may not be well described by equilibrium models that have long been at the center of economic analysis lnformation economics has alerted us to the fact that his7 tory matters there are important hysteresis effects Random events 7 the black plague 7 have consequences that are irreversible Dynamics may be bet7 ter described by evolutionary processes and models than by equilibrium processes And while it may be dif cult to describe fully these evolutionary processes this much is already clear there is no reason to believe that they are in any general sense quotoptimalquot143 Many of the same themes that emerged from our simpler work in informa7 tion economics applied here For instance repeatedly in the information theoretic models discussed above we showed that multiple equilibria some of which Pareto dominated others could easily arise So too here Stiglitz l995b This in turn has several important consequences beyond the ob7 servation already made that history matters First it means that one cannot simply predict where the economy will be by knowing preferences and tech7 nology and initial endowments There can a high level of indeterminacy Secondly as in Darwinian ecological models the major determinant of one s environment is the behavior of others and their behavior may in turn de7 pend on their beliefs about others behavior Hoff and Stiglitz 2000 As Darwin noted after his visit to the Galapagos islands Stiglitz 1973a 1974d 2 r a discussion with references to the literature see Stiglitz 2000d 3 There is a large and growing literature on evolutiona economics See for instance Ma nard Smith and Price 1973 Nelson and Winter 1982 1990 Weibull 1996 Mailath 1992 Aoki and Feldman 1999 Stiglitz 1975b 1992i and Sah and Stiglitz 1991 Some of this work em phasized the importance of capital constraints for evolutionary processes 521 The plants and animals of the Galapagos differ radically among islands that have the same geological nature the same height climate etc This long appeared to me a great dif culty but it arises in chief part from the deeply seated error of considering the physical conditions of a country as the most important for its inhabitants whereas it cannot I think he disputed that the nature of the other inhabitants with which each has to compete is at least as important and generally a far more important element of success Darwin 1959 1993 540 Thirdly government intervention can sometimes move the economy from one equilibrium to another and having done that continued intervention might not be required THE POLITICAL ECONOMY OF INFORMATION Information imperfections and asymmetries ofinformation are pervasive in every aspect of life and society Here I want to talk about three of the ways in which information affects political processes First we have already noted the distributive consequences of information disclosures Not surprisingly then the quotinformation rules of the gamequot both for the economy and for political processes can become a subject of intense political debate The United States and the IMF argued strongly that lack of transparency was at the root ofthe 1997 nancial crisis and said that the East Asian countries had to become more transparent The recognition that quanr titative data concerning capital flows outstanding loans by the IMF and the US Treasury could have been taken as a concession of the inappropriateness of the competitive paradigm in which prices convey all the relevant informar tion but the more appropriate way ofviewing the debate was paII39tI39caI a point which became clear when it was noted that partial disclosures could be of only limited value and could possibly be counterproductive as capital would be induced to move through channels involving less disclosure channels like off shore banking centers which were also less well regulated When demands for transparency thus went beyond East Asia to Western hedge funds and off shore banking centers suddenly the advocates of more transparency became less enthralled and began praising the advantages of partial secrecy in en hancing incentives to gather information The United States and US Treasury then opposed the OECD initiative to combat money laundering through greater transparency of off shore banking centers 7 these institutions served particular paII39tI39cal and economic interests 7 until it became clear that terrorists might be using them to help nance their operations at that point the bar lance of American interests changed and the US Treasury changed its posir tion Political processes inevitably entail asymmetries of information our politir cal leaders are supposedto know more about threats to defense about our ecor nomic situation etc than ordinary citizens There has been a delegation of responsibility for dayrtorday decision making just as there is within a rm 522 The problem is to provide incentives for those so entrusted to act on behalf of those who they are supposed to be serving 7 the standard principle agent problem Democracy 7 contestability in political processes 7 provides a check on abuses of the powers that come from delegation just as it does in eco7 nomic processes but just as we recognize that the takeover mechanism pro7 vides an imperfect check so too we should recognize that the electoral process provides an imperfect check Just as we recognize that current man7 agement has an incentive to increase asymmetries of information in order to enhance its market power increase its discretion so to in public life Andjust as we recognize that disclosure requirements 7 greater transparency 7 and speci c rules of the game eg related to corporate governance can affect the effectiveness of the takeover mechanism and the overall quality of cor7 porate governance so too the same factors can affect political contestabilty and the quality of public governance In the context of political processes where quotexitquot options are limited one needs to be particularly concerned about abuses If a rm is mismanaged 7 if the managers attempt to enrich themselves at the expense of shareholders and customers and entrench themselves against competition the damage is limited customers at least can switch But in political processes those who see the quality of public services deteriorate cannot do so as easily If all indivir duals were as mean spirited and sel sh as economists have traditionally modeled them matters would indeed be bleak as l have put it elsewhere enr suring the public good public management is itself a public good But there is a wealth of evidence that the economists39 traditional model of the indi7 vidual is too narrow 7 and that indeed intrinsic rewards eg of public service can be even more effective than extrinsic rewards eg monetary compensa7 tion which is not to say that compensation is not of some importance This public spiritedness even if blended with a modicum of selfrinterest is manir fested in a variety of civil society organizations through which V01untan391yin7 dividuals work caHecl iVEIy to advance their perception of the collective in7 terests There are strong forces on the part of those in government to reduce transr parency More transparency reduces their scope for action 7 it not only exr poses mistakes but also corruption as the expression goes sunshine is the strongest antiseptic Government of cials may try to enhance their power by trying to advance specious arguments for secrecy and then saying in effect to justify their otherwise inexplicable or selfrserving behavior quottrust me if you only knew what I knewquot There is a further rationale for secrecy secrecy is an arti cially created scarcity of information and like most arti cially created scarcities it gives rise to rents rents which in some countries are appropriated through outright corruption selling information but in others are part of a quotgift exchangequot in which reporters not only provide puff pieces praising the government of r Senator Patrick Moynihan in his powerful book Moynihan 1998 shows how secrecy was abused during the Cold War in ways which led to unnecessarily large military expenditures 523 cial who has given the reporter privileged access to information particularly in ways which are designed to enhance the of cials in uence and power but distort news coverage I was in the unfortunate position of watching closely this process work and work quite effectively Without unbiased information the effectiveness of the check that can be provided by the citizenry is limited without good information the contestability of the political processes can be undermined One of the lessons of the economics of information is that these problems cannot be fully resolved but there are laws and institutions which can der cidedly improve matters Rightrtorknow laws demanding transparency have been part of governance in Sweden for two hundred years they have become an important if imperfect check on government abuses in the United States over the past quarter century In the last ve years there has become a grow7 ing international movement with some countries such as Thailand going so far as to include them in their new Constitution Regrettably these principles have yet to be endorsed by the international economic institutions CONCLUDING REMARKS In this talk I have traced the replacement of one paradigm with another The de ciencies in the neoclassical paradigm 7 both the predictions which seemed counter to what was observed some so glaring that one hardly needed re ned econometric testing and the phenomena that were left un7 explained 7 made it inevitable that it was simply a matter oftime before it be7 came challenged One might ask how can we explain the persistence of the paradigm for so long Partly it must be because in spite of its de ciencies it did provide insights into many economic phenomena There are some marr kets in which the phenomena which we have discussed are not important 7 the market for wheat or corn 7 though even here pervasive government in7 terventions make the reining competitive paradigm of limited relevance The underlying forces of demand and supply are still important though in the new paradigm they become only part of the analysis they are not the whole analysis But one cannot ignore the possibility that the survival of the para7 digm was partly because the belief in that paradigm and the policy prescripr tions has served certain interests As a social scientist I have tried to follow the analysis wherever it might lead As any researcher we know that our ideas can be used or abused 7 or ignored Understanding the complex forces that shape our economy is of value in its own right there is an innate curiosity about how this system works But quotAll the world39s a stage and all the men and women merely playersquot Shakespeare 1599 Each of us in our own way if only as voters is actor in this grand drama And what we do is affected by our perceptions of how this complex system works I entered economics with the hope that it might enable me to do some7 thing about unemployment poverty and discrimination As an economic rer searcher l have been lucky enough to hit upon some ideas that I think do enr 524 hance our understanding of these phenomena As an educator I have been lucky enough to have had the opportunity to reduce some ofthe asymmetries of information especially concerning what the new information paradigm and other developments in modern economic science have to say about these phenomena and to have had some rst rate students who themselves have pushed the research agenda forward As an individual I have however not been content just to let others translate these ideas into practice I have had the good fortune to be able to do so my self as a public servant both in the American government and at the World Bank We have the good fortune to live in democracies in which individuals can ght for their perception of what a better world might be like We as acar demics have the good fortune to be further protected by our academic free dom With freedom comes responsibility the responsibility to use that free dom to do what we can to ensure that the world ofthe future be one in which there is not only greater economic prosperity but also more socialjustice REFERENCES Adams W J and J L Yellen Commodity Bundling and the Burden of Monopolyquot Quan erlyjaurnal afEcanatnics 903 August 1976 pp 475498 Akerlof G A The Market for Lemons Quality Uncertainty and the Market Mechar nismquot Quarterlyjauinal afEcanatnics 84 1970 pp 4887500 7 The Economics ofCaste and of the Rat Race and Other Woeful Talesquot Quarterlyjauinal afEcanatnics 90 November 1976 pp 488500 Akerlof G A and J L Yellen A NearrRational Model of the Business Cycle with Wage and Price Inertiaquot QuarterlyjauinaJ afEcanatnics 100 Supplement 1985 pp 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D W Jor enson Tax Policy and Investment Behaviorquot American Ecanamic Review573 June 1967 pp 391414 all R E Stochastic Implications of the Life CyclerPermanent Income Hypothesis Theory and Evidencequot Jaurnal afPalitical Ecanamy 86 6 December 1978 pp 971987 Harris J and Todaro M Migration Unemployment and Development A TworSector Analysisquot American Ecanamic Review 60 1970 pp 1267142 Hart O D and B Holmstrom The Theory of Contractsquot In Advances afEcanamic Theary Fifth Warld Cangress ed T Bewley Cambridge University Press 1987 Hart O D Firms Cantracts and Financial Structure Oxford Oxford University Press 1995 Haubrich J Risk Aversion Performance Pay and the Principaergent Problemquotaurnal 0f Palitical Ecanamy102 1994 pp 2587276 Hellman T K Murdock and J E Stiglitz Deposit Mobilization Through Financial Restraintquot In Financial Develapment and Ecanamic Grawth N Hermes and R Lensink eds Routledge 1996 pp 219746 7 Liberalization Moral Hazard in Banking and Prudential Regulation Are Capital Requirements Enough7quot American Ecanamic Review90 1 2000 pp 1477165 Hellman T and J E Stiglitz Credit and Equity Rationing in Markets with Adverse Selectionquot in Eumpean Ecanamic Review 442 February pp 2817304 Hellmann T F quotThe Allocation of Control Rights in Venture Capital Contractsquot The Rand Jaurnal afEcanamics 291 Spring 1998 pp 57776 Hirshleifer J Mergers and Acquisitions Strategic and Informational Issuesquot in Jarrow R A Makismovic V and Ziemba W T eds Handbooks in Operatians Research and Manage ment Science Chapter 26 of Finance NorthrHolland Volume 9 1995 529
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