1. Information and the Change in the Paradigm in Economics Nobel Lecture New York May 15, 2002 Joseph E. Stiglitz Columbia Business School

2. 2 Outline 1. The old paradigm 2. Overturning the conventional wisdom 3. Insights into microeconomic behavior and institutions 4. Towards a new paradigm for Macroeconomics 5. Implications for Theory of Policy 6. Implications for Applied Policy 7. Beyond information economics 8. Information and Political Economy

3. 3 The Old Paradigm n Perfectly informed firms and consumers interacting with each other in perfectly competitive markets – Talked about information efficiency of markets – But limited themselves to narrow set of information problems— scarcity – Perfect information about attributes of products, individuals, investments – Once and for all problem—not information processing in “real time” n Everyone knew that there was imperfect information n Hope that a world with information imperfections would be “close to” world with perfect information

4. 4 The Old Paradigm: Failures of standard paradigm (I) n Unemployment—Great Depression n Discrimination—economic forces would ensure that economic discrimination could not exist n Poverty and inequality— standard models had little to say about these issues, and argued that efficiency and equity issues could be separated, so one could simply set these issues aside n Persistence of seemingly distortionary institutions, like sharecropping n Host of more subtle “paradoxes” and puzzles

5. 5 The Old Paradigm: Failures of standard paradigm (II) n Microeconomics: tax paradoxes, closed end mutual fund paradox, excess volatility (of stock market and other asset prices), public and corporate financial structure seemed to matter, risk behavior of firms (risk seemed to mean more than just correlation with the business fro cycle), n Macroeconomics: cyclical movements of consumption, inventories, real product wages, employment and real consumption wages, determinants of investment n Host of unexplained phenomena and institutions (IPOs, payment structures, limited role of new equities in financing new investment)

6. 6 Ptolemaic attempts to defend the old paradigm n Neoclassical synthesis—once government corrects problem of unemployment, standard presumptions hold, include efficiency of markets (Samuelson) n Information costs are just like transactions costs, and once these costs are taken into account, the market for information is just like the market for any other good (Stigler, Chicago School) n If there were perfect information, sharecropping would not be distortionary

7. 7 Four examples of problems related to imperfect information (I) n Influence on my thinking of time I spent in Kenya between 1969 and 1971 n Theory of screening—response to question posed by Kenyan government – How much should they be investing in education – Deficiencies in human capital model – Education was being used to sort out individuals, to determine who got “good” jobs – Key problem was constructing equilibrium theory— education and labor markets

8. 8 Four examples of problems related to imperfect information (II) n Sharecropping – Seemingly inefficient institution—with incentives attenuated by 50% tax – Used because cannot observe inputs (labor efforts), can only observe output – A problem of asymmetric information – Basis of a general theory of incentives (principal agent theory) – Including modern theory of corporations – With trade — offs between incentives and risks – Highlights the importance of wealth inequality—in a society in which wealth is more equally distributed this “agency” problem does not arise

9. 9 Four examples of problems related to imperfect information (III) n Efficiency wage theory and theory of wage distributions – High levels of urban unemployment – Explained by wage differentials between urban and rural sector – Why did these wage disparities persist? – Not caused by government intervention (minimum wages) – Answer: productivity depended on wage, it paid to pay a high wage n But wages were higher than nutritional efficiency wage theory n Labor turnover affected by wages n Quality of labor (selection effects) n Effort of labor (incentive effects) n Had been anticipated by Marshall n Different firms will have different “efficiency” wage—hence wage distribution

10. 10 The Competitive Equilibrium Model: Key assumptions n Information fixed n Technology fixed n Preferences fixed n Convexity (diminishing returns)

11. 11 The Competitive Equilibrium Model: Implications and central theorems (I) n Existence of equilibrium n First welfare theorem—every competitive equilibrium is Pareto efficient n Every pareto efficient outcome can be obtained by means of a competitive market, given lump sum redistributions

12. 12 The Competitive Equilibrium Model: Implications and central theorems (II) n All markets clear n Law of single price n Law of competitive price—price equals marginal cost n Incentives not of much issue—people get paid if and only if they perform contracted for task

13. 13 The Competitive Equilibrium Model: Implications and central theorems (III) n Institutions do not matter—markets see through them n The distribution of wealth does not matter n Knowing preferences and technology and initial endowments, one can describe the time path of the economy—history does not matter

14. 14 The Competitive Equilibrium Model: Policy Implications n No such thing as unemployment n Limited role of government – Limited market failures—public goods, externalities n If there is dissatisfaction with the distribution of income, simply engage in lump sum redistributions – Can separate out completely issues of efficiency and equity n Decentralization

15. 15 Key problems in constructing new paradigm n Modeling “information” and “imperfect information” – Single way in which information is perfect – Infinite number of ways in which information can be imperfect n Modeling equilibrium – Modeling both sides of market—employer and employee, insurance company and insured, borrower and lender…. – Modeling “rational” behavior, including inferences “in equilibrium” and from “out of equilibrium” moves – Modeling a full set of feasible actions – Dangers from oversimplistic models—with limited number of states (characteristics) there can be full information revelation, while in infinite dimensional real world, there never is.

16. 16 New paradigm n Even a small amount of information imperfections can have large effects, destroying all of the central results of economics n The invisible hand may be invisible because it is simply not there, or is at best palsied n Explains phenomena like unemployment—a micro foundation for macroeconomics n Explains other phenomena about which standard theory has little to say n Has important policy implications

17. 17 Central insights of Imperfect information paradigm n Information imperfections are pervasive n Asymmetries of information are one important form of information imperfections – Asymmetric information: different people knowing different things n Workers know more about their ability than firm n Insured knows more about health, smoking, than insurance firm n Owner of car knows more about car than potential buyer n Owner of firm knows more about firm than potential investor n Borrower knows more about his risk and risk taking than lender n Current employer knows more about employee than other potential employees

18. 18 Central insights of Imperfect information paradigm (II) n Asymmetries of information are one important form of information imperfections – Sources of asymmetries of information n Some “natural” n Some created (endogenous) as byproduct of other activities – Employer learns about employee as he watches him work – Consequence: “used labor market” very imperfect, explains problems of labor mobility, but recognition of imperfections affects even “new labor” market n Some created deliberately, to increase market power – Management attempts to entrench itself by reducing threat of replacement through takeovers (reducing competition in the market for management) or by investments which increase asymmetries of information (Edlin and Stiglitz) – Example of problem of corporate governance

19. 19 (Partially) solving the problems created by asymmetric information n There are ways by which they can be (partially) overcome or exacerbated n Two key issues – Incentives – Mechanisms

20. 20 Simple Models (I) n Simple models: simple information problem n Some individuals are more able than others (less prone to accident, more likely to repay a loan…) n Without information, market treats each as if they were average n Talk is cheap—cannot rely on individuals to truthfully reveal ability n Low ability will always claim more able

21. 21 Simple Models (II) n If more able could prove that he is more able, wage would increase – More able has incentive for information disclosure – Less able has incentive to keep information secret n If most able can establish, then others will see a fall in their wage – Gains of information disclosure are redistributive – Some gain at expense of others – But may be social gains from better price signals

22. 22 Simple Models (III) n If most able reveals ability, then the most able of the remainder has an incentive to reveal (verify) ability. n The process continues until all but least able has had ability disclosed. But if all but one establishes ability, then all have established ability. – Unraveling: with costless verification, the market equilibrium will consist of full revelation, even though it is against the interest of the less able to do so

23. 23 Simple Models (IV) n If uninformed (employer) screens individuals, then if others can observe who he hires (or otherwise can obtain information) then they will compete for the more able. n All of returns to information accrue to individual who has been discovered to be more able – Importance of appropriability issue – Burden of information acquisition/verification lies with more able unless there is some monopoly power (limitations on competition)

24. 24 Simple Models (Results) n Mechanisms for obtaining information – Examination (direct observation) – Observing actions n Sorting by examination – With costly information, there can exist multiple equilibria – Separating equilibria—all information revealed – Pooling equilibrium—information not revealed – One equilibrium may Pareto dominate other (everyone is better off) n More information may be worse than less information n General results that hold under much greater set of circumstances n Simplest model countered many of key propositions of standard theory, widely held beliefs

25. 25 Self-selection and signaling models n Information is conveyed by actions n Inferences based on choices (actions) – Willing to walk up five floors to get insurance at a discount – Attractiveness of free fitness center membership n Simple adverse selection (Akerlof) – Willingness to buy insurance, sell car, at particular price conveys information

26. 26 Credit rationing and unemployment n Parallel between dependence of productivity on wages (Shapiro and Stiglitz) and default probability on interest rate (Stiglitz and Weiss) n Can arise either from incentive or selection effects n Similar to adverse selection (Akerlof) model except that firms do not have to be price taker. Employer can set wages, lender can set interest rates—and doesn’t have to do so at market clearing levels n Repeal of the law of supply and demand

27. 27 Self-selection and signaling models (Key issues (I)) n Knowing that inferences can be made on basis of actions, how does it affect behavior of both sides of the market? – Quality of guarantee may convey information about the quality of product—knowing this affects guarantee. – Amount of education may convey information about ability of individual—knowing this affects amount of education. – Size of deductible in insurance may convey information about riskiness of insured—knowing this affect the kinds of insurance policies purchased. – A firm may worry that if it promotes a particularly good individual, it will convey information about the individual’s ability, and therefore result in competitive bidding, impeding its ability to appropriate any returns on investments in screening.

28. 28 Self-selection and signaling models (Key issues (II)) n Some individuals wish to convey information n Some individuals wish not to have information conveyed—conveying information may interfere with their ability to appropriate information rents n In either case, the fact that actions convey information leads people to alter their behavior, and changes how markets function

29. 29 Monopoly and self-selection n Monopolists can structure choices n So, e.g. more risk prone choose insurance policy with greater deductibility, more able choose employment contract with more pay based on performance n Two key issues – Characterizing self-selection constraints – Does it pay for monopolist to “separate” fully n Basis of the theory of (partially) discriminating monopolist

30. 30 Competition and self-selection (I) (Rothschild and Stiglitz) n Central problem: choices confronting individual (and therefore information revealed) are determined by entire market, not by single firm n Equilibrium concept: a set of (insurance) contracts, such that it does not pay anyone to offer an alternative contract

31. 31 Competition and self-selection (II) (Rothschild and Stiglitz) n Characterizing equilibria – Pooling and separating (full information) – Separating: high risk gets full insurance, low risk only partial insurance – Can never exist pooling – But there may not exist a separating equilibrium n E.g. if individuals are very similar n Implying that if there is a continuum of types full separation is not an equilibrium n And implying that equilibrium may not exist (in pure strategies) Search for alternative equilibrium concepts None persuasive or widely accepted n

32. 32 Competition and self-selection (III) (Rothschild and Stiglitz) n Even a little bit of information imperfection can have a large effect. n Information imperfection “destroys” market—less risk person does not get full insurance. n Issues do not require asymmetry of information, only that individuals with different (relevant) characteristics behave differently (make different choices) – Individuals with higher risk may not know that they have higher risk, insurance company in that sense may be “more informed”, knowing correlation between behavior and risk.

33. 33 Repealing other basic “laws of economics” (I) n Law of single price – Wage and price distribution (Salop and Stiglitz) – Markets create “noise”; not just that with costly information markets are not fully arbitraged in response to exogenous noise – With all firms charging same price, it might pay some firm to offer different price – Only equilibrium entails price and wage distribution – Having some well informed people does not ensure that the market will not exploit uninformed

34. 34 Repealing other basic “laws of economics” (II) n Law of competitive price—price equals marginal cost – Rents (price in excess of marginal cost) necessary to maintain reputation (incentives). Shapiro, Shapiro and Stiglitz – With costly information (search) competition is imperfect – Price will be higher than marginal cost – Even a little bit of search cost can lead to monopoly price (Diamond) n Law of diminishing returns – Information acquisition is like a fixed cost; non convexities are pervasive – So long as there is a strictly positive marginal cost of information, it never pays to buy just a little bit of information (Radner and Stiglitz) – In the simplest adverse incentive (moral hazard problem), both preferences and opportunities sets are not convex (Arnott and Stiglitz)

35. 35 The Fundamental Theorem of Welfare Economics (I) n The invisible hand is invisible, because it simply is not there: – Whenever markets are characterized by imperfect information or incomplete markets— essentially always—markets are not constrained Pareto efficient – That is, taking into account of the imperfections of information and the costs of obtaining information and creating markets (Greenwald and Stiglitz) – Implies that market failures are far more pervasive—not just public goods and externalities (like pollution) – Intuition: when information is imperfect, an individual’s actions has affect on others; if everyone takes less care, insurance premium goes up; government, facing the same information constraints, can take actions to reduce impact of this externality

36. 36 The Fundamental Theorem of Welfare Economics (II) n Implications: Limits scope for decentralization n Introduces linkages between markets and over time n Which in turn can reduce the effectiveness of competition n The magnitude of the market failures depends on wealth distribution n Cannot separate out issues of efficiency and distribution

37. 37 Can non-market institutions resolve market failure? n No, not necessarily n Depends on information structure n Dysfunctional non-market institutions—non- market insurance can “crowd out” market insurance (Arnott and Stiglitz)

38. 38 Going beyond negative results (I) n Many phenomena not well explained by neoclassical theory, e.g. Sharecropping, form of compensation n Theory of corporate finance – Modigliani Miller—how firm finances itself doesn’t matter – New paradigm explains limited use of equity n Adverse selection effect—insiders willing to sell shares only if they are overvalued n Debt/equity ratio as sorting/signaling device n Theory of the risk averse firm – Follows from limitations on divesting risk (“equity rationing”) – Explains many aspects of firm behavior

39. 39 Going beyond negative results (II) n Theory of corporate governance (I) – Issue of long standing concern (Marshall, Smith, Berle and Means) – Large corporations different from single owner firm – Separation of ownership and control – Decision making of firm is more than just an engineering problem – Can be viewed as principal-agent problem – Provides a framework for thinking about n Design of incentive schemes – Limitations n Role of takeovers – Limitations n Role for public policy:

40. 40 Going beyond negative results (III) n Theory of corporate governance (II) – Scope of discretion by managers, majority owners depends on legal structures – Key issue in transition –not fully appreciated – Lack of attention explains much of failure

41. 41 Macroeconomics (I) n Micro-foundations for Keynesian economics n Alternative to market-clearing representative agent models – With representative agent models cannot have asymmetries of information – With market clearing models, cannot explain unemployment – Without credit rationing, cannot explain high social cost of unemployment

42. 42 Macroeconomics (II) n Models go beyond explaining equilibrium unemployment to explain dynamics (Greenwald and Stiglitz) – Why the impacts of shocks are sometimes amplified and persist – The real consequences on the level of economic activity of redistributive shocks (e.g. an increase in the price of oil). – Real wealth and cash flow effects have first order importance. – Shocks affect aggregate supply as well as aggregate demand – Explains why price and wage adjustments may be slower than some quantity adjustments (more persuasive explanation than menu cost and alternative explanations). – Explains why wage and price flexibility may exacerbate the magnitude of the downturns (in contrast to theories which suggested that wage and price rigidities were the problem).

43. 43 Macroeconomics (III) n Models provide explanation of key phenomena – Seemingly perverse inventory behavior – Cyclical movements in mark-ups

44. 44 A New Theory of Monetary Economics n Failures of transactions costs theory of money – Money not needed for most transactions (credit is) – Most money is interest bearing—interest rate not opportunity cost – Opportunity cost determined by technology n It is the supply of credit and the terms of credit which are central n Credit depends on information—ascertaining who is credit worthy, monitoring, etc

45. 45 A New Theory of Monetary Economics (Role of Banks) n Banks are central institutions in providing credit n Banks are like risk averse firms n Their willingness and ability to bear risk can be affected by shocks as well as regulatory and monetary policy n Credit interlinkages (again based on information and information asymmetries) are as important as goods market interlinkages traditionally emphasized n In severe downturns, there can be bankruptcy cascades

46. 46 Theory of Policy n Pareto efficient Taxation – Given information structures, what are tax structures such that no one can be made better off without making someone else worse off – Generalization of optimal tax theory (which assume a particular social welfare function and did not make information assumptions explicit) – Strong implications: Ramsey taxation part of Pareto efficient tax structure only under highly restrictive conditions n Theory of Regulation – Focusing on asymmetry of information between regulator and regulated n Theory of Privatization – Highly restricted conditions under which privatization would unambiguously be welfare improving

47. 47 Applied Policy n East Asia Crisis – IMF policies effectively ignored bankruptcy, even though fear of bankruptcy was original source of problem (refusal to roll over loans) – High interest rates, even for short periods, resulted in massive bankruptcies – Exacerbating capital flight, weakening economies – Hysteresis effects: bankrupt firms did not become unbankrupt when interest rates lowered n Undermines intellectual foundations of major pillars of the Washington consensus development strategy which rested on naïve belief in market fundamentalism

48. 48 Beyond Information Economics (I) n Information economics represented the simplest attack on standard paradigm – Changing only one assumption—in ways which were plausible – Showed theory was not robust – And that an alternative paradigm with great explanatory power could be constructed

49. 49 Beyond Information Economics (II) n But there are other limitations: – Fixed technology—R & D changes technology n Knowledge a special form of information n So many of key insights apply to the economics of R & D n Such as those associated with problems of appropriability – Fixed preferences n Development is more than just a matter of accumulating capital and improving the efficiency with which resources are used n It is a transformation of society n An acceptance of change, abandonment of traditional ways of doing things

50. 50 Beyond Information Economics (III) n But there are other limitations: – Interplay between economics and other aspects of society n “Morale” (fairness) theories of efficiency wage n Civil War as an impediment to development n Indonesian riots as an impediment to recovery n Transition from communism to market economy more than just an economic transition

51. 51 Beyond Information Economics (IV) n But there are other limitations: – Dynamics of change may not be well described by equilibrium models n History matters (pervasive hysteresis effects)— information (knowledge) created is not “undone” n Evolutionary processes n A major determinant of each agents environment is the behavior of others’—possible multiple equilibria n No reason to believe that these evolutionary processes are, in any general sense, “optimal.”

52. 52 The Political Economy of Information n Asymmetries of information pervade political processes as they do economic processes n With equally important incentives to increase asymmetries of information (secrecy) – To hide failures, corruption n Secrecy results in an artificially created scarcity of information – Like other artificially created scarcities, gives rise to rents – Rents can be exchanged for “favors”, especially from Press – Resulting in distorted information flows n Importance of right-to-know (freedom of information acts) to reduce scope for creation of asymmetries of information

53. 53 Concluding Remarks n Standard Paradigm had large number of failings n Still explained many phenomena—explains survival n New information paradigm undermined key propositions n Provided explanations for phenomena about which neoclassical theory had little to say n Provided explanations for phenomena that were seemingly inconsistent with standard paradigm n Most importantly, unemployment n Markedly different view of the role of government n Which see government and markets as partners, as complements