George Akerlof (b. 1940)

George Akerlof was born in Newhaven (Connecticut, USA) on 17 June 1940. His father was a Swedish immigrant and his mother was from a family that had immigrated from Germany. He received his BA at Yale University in 1962, and his PhD at the Massachusetts Institute of Technology (MIT) in 1966.

He spent the whole of his career at the University of California at Berkeley, with some breaks at the Indian Statistical Institute (1967-68), the Council of Economic Advisors (1973-74), the Federal Reserve Board (1977-78) and the London School of Economics (1978-80). He was a joint recipient of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 2001, with Michael Spence and Joseph Stiglitz.

Akerlof is one of the most original economic theorists in recent times - beginning with “The market for lemons” (1970), the paper for which he received the above mentioned Nobel prize, to his last book Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism (co-authored with Robert Shiller 2009). What is remarkable is the gradual emergence of a new paradigm in economics, which is by now quite explicit but which could not be expected, when reading his 1970 paper. The importance of information asymmetries (of which he was one of the three modern “discoverers”, as the 2001 Bank of Sweden Prize committee rightly acknowledges) could have driven him towards the waters of the nowadays standard mainstream economics, with its extreme hypotheses on calculative rationality and sophisticated equilibria. However, it was, as his readers gradually discovered when reading the subsequent steps in Akerlof’s work, upon the methodological (rather than substantial) foundations of the “lemons” paper that he built his research programme towards the “pragmatic economics” and the “behavioural macroeconomics”, which he now advocates.

Theoretical Contributions

The theoretical contributions of Akerlof could be retrospectively summarized in an intellectual pilgrimage with four main steps, consisting in four discoveries: the importance of asymmetric information, the possibility of code equilibria, the presence of an identity component within utility, and the macroeconomic negative consequences of norms.

The importance of asymmetric information

On the used car model (Akerlof 1970), it is obvious that the sellers know more about the quality of their cars than the buyers:

If good and bad cars are sold at the same price, owners are more likely to offer a bad car for sale than a good one. Potential buyers of used cars suspect that the cars on the market are bad. Accordingly they reduce the price they are willing to pay, reducing further the incentive to put a good car up for sale. In a vicious circle, such interactions between the buyers and the sellers may even cause a total market collapse. (Akerlof 2005: 4)

The next point to understand is that this problem is a general one, potentially pervading all kinds of markets (credit, products, labour, and so on). However, perhaps the right conclusion is not so much a problem about information, as about the quality of information. Markets with quality as an unknown are a much more fragile machinery than markets without.

The existence of code equilibria

We should pay attention to the following warning, if we are tempted to think that Akerlof’s subsequent discoveries are not as important as the first discovery: “The truth we see from caste regarding economic equilibrium are as fundamental as those in ‘Lemons’” (Akerlof 2005: 6). Codes of caste behaviour - to be retrospectively read as a generic term for any norm-dependent economic equilibrium - modify demand and supply decisions, in a sense that prevents the equality of supply and demand as determined by economic considerations. Obedience to the codes of caste behaviour is contrary to economic motivation, but not to self-interest, if our conceptions of costs and benefits are enlarged to include those that are non-economic.

People may fear to be outcast or boycotted for breaking the code (Akerlof 1976, 1985).

In another line of research, to follow the code of the group may be economically profitable for each member of the group, as when workers reward their employer who gives them more than the minimum wage (and/or who demands less than the maximum effort), by giving their employer a counter-gift of an effort above the minimum level. It still remains that this kind of “efficiency wage” may be too high to clear the labour market (Akerlof 1982), confirming that market equilibria with quality are a much more fragile machinery.

The presence of an identity component within utility

The next step was to go further into the re-definition of standard homo wconomicus. “Self-interest” had just been enlarged by extending the field of this “interest”: now it will be changed through a revision of the “self”: but formally as an extension, too, in order to preserve the mathematics of the utility function. Up to a certain extent, people can choose their identity by choosing the social category to which they belong. Also, “social categories have ideal-types that exemplify how people in those social categories should behave” (Akerlof 2005: 8, original emphasis). People are then supposed to maximize utility functions with new arguments (beside the traditional ones), positive (identity of their social category) as well as negative (the gap between the corresponding ideal behaviour). With this seemingly technical extension, Akerlof is able to give account of a host of hitherto unexplained facts, and as diverse as the efficiency of management by objectives compared to the use of monetary incentives (Akerlof and Kranton 2005b), or the prevalence of self-destructive behaviour among dominated groups (Akerlof and Kranton 2000). It gives credit to active and preventive social policies, at variance with the prevalent neo-liberal political philosophy. An economic agent caring about his or her own quality is likely to be a more fragile machinery than the same one only concerned by prices and quantities.

The macroeconomic negative consequences of norms

The immediate consequence of the third step is that now the way people should behave becomes an essential part of the explanation of how people do behave - Akerlof is probably the economist in the world who makes the greatest use of the normative conditional “should”.

When going from microeconomics to macroeconomics, he strongly rehabilitates, first, Keynes’s economics, exactly for those reasons why new classical economists despise it - that is, the use of psychological factors, including “animal spirits” (Akerlof and Shiller 2009); and second, Keynesian economics, because the norms followed by economic agents - on consumption, savings, investment, wages, prices, and nominal values - can be shown to destroy the five neutralities upon which the new mainstream orthodoxy is built (life cycle, Modigliani-Miller theorem, Ricardian equivalence, rational expectations, and natural rate of unemployment) (Akerlof 2007). Sometimes this might look like new wine in old bottles: unemployment is due to downward rigidity of wages, which restore a possible macroeconomic role for monetary policy. However, those old bottles are now illuminated by their affiliation to the new paradigm of behavioural macroeconomics (Akerlof 2002). A market economy with quality is also much more complex a machinery than a market economy without it.

Methodological Prescriptions

It should be clear by now that Akerlof would not have reached these results - more precisely these kinds of results - had he not experienced a new style of economic research, characterized by a paradoxical set of features: a sharp discontinuity with Friedman’s methodology of positive economics, and a strong continuity with the usual practice of mainstream economists.

The discontinuity with mainstream practices

Back to realism! The objective is no longer to make sense only of some quantitative facts with a parsimonious model, but rather of some (often) obvious facts, including qualitative ones, with a plausible microeconomic model. Therefore it is essential to study specific markets or behaviours instead of looking for the highest generality. It becomes relevant to use (careful) case studies, where individuals are asked for the reasons of their decisions: they should no longer be systematically banned by scientists suspecting deceptive answers because of asymmetric information.

Farewell to imperialism! The relationships between economics and the other social sciences is now more balanced, with the former trying to give its own account of facts collected by the latter due to their traditional expertise in case studies and their absence of scorn toward fine-grained descriptions, especially in fields implying normative behaviours. Sometimes the economist may even proceed to a direct theoretical import from anthropology (Mauss) or social psychology (social identity theory).

The continuity

There is at least one thing in the practice of mainstream economists that Akerlof does not even think of criticizing: doing economic theory amounts to building a formal model - with individuals maximizing their utility, and coordinated through market or game equilibria. Of course it is not standard utility, but that may point to the Achille’s heel of Akerlof’s influence. The heart of his message about economic agents is that their rationality is not only of a calculative type, but also of an interpretative one: “social category”, for instance, is clearly not an argument of the same logical type as consumption or leisure. It was shrewd to insert identity inside utility and to keep on maximizing. Nevertheless it has a cost as high as its benefit: the equilibrium techniques belong to the standard tool kit, whereas we would have expected, as well as the usual economic variables, the emergence of some semantic concepts such as meaning. That should be the task of Akerlof’s followers, including a richer view of institutions, strangely lacking in his framework. A consistent economic theory with quality is too complex a task to be mastered in one life, be it as innovative as the intellectual life of Akerlof.

Olivier Favereau

George Akerlof (b. 1940)

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