Information and the Change in the Paradigm in Economics Author(s): Joseph E. Stiglitz Source: The American Economic Review, Vol. 92, No. 3, (Jun., 2002), pp. 460-501 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/3083351 Accessed: 22/07/2008 15:44 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with the scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that promotes the discovery and use of these resources. For more information about JSTOR, please contact [email protected]. http://www.jstor.org Informationand the Change in the Paradigmin Economicst By JOSEPHE. STIGLITZ* The research for which George Akerlof, named after its Chairmanof the Board, Gary Michael Spence, and I are being recognized is has declined to but a shadow of its former part of a larger research programwhich today self. But even in its heyday, it was marredby embraces a great numberof researchersaround poverty, periods of high unemployment, and the world. In this article, I want to set the massive racial discrimination.Yet the economic particular work which was cited within this theories we were taught paid little attention to broaderagenda, and that agenda within the still poverty, said that all marketscleared-including broaderperspective of the history of economic the labormarket, so that unemploymentmust be thought. I hope to show that information eco- nothing more than a phantasm-and claimed nomics representsa fundamentalchange in the that the profit motive ensured that there could prevailing paradigmwithin economics. not be economic discrimination(Gary Becker, Informationeconomics has alreadyhad a pro- 1971). As a graduatestudent, I was determined found effect on how we think about economic to try to create models with assumptions-and policy and is likely to have an even greater conclusions-closer to those that accordedwith influence in the future. Many of the major pol- the world I saw, with all of its imperfections. icy debates over the past two decades have My first visits to the developing world in centered around the related issues of the effi- 1967, and a more extensive stay in Kenya in ciency of the market economy and the appro- 1969, made an indelible impression on me. priate relationshipbetween the market and the Models of perfect markets, as badly flawed as government. The argument of Adam Smith they might seem for Europeor America,seemed (1776) that free markets lead to efficient out- truly inappropriatefor these countries. While comes, "as if by an invisible hand,"has played many of the key assumptionsthat went into the a centralrole in these debates:It suggested that competitiveequilibrium model seemed not to fit we could, by and large, rely on marketswithout these economieswell, I was particularlystruck by government intervention (or, at most, with a the imperfectionsof information,the absence of limited role for government). The set of ideas markets, and the pervasiveness and persist- that I will present here undermined Smith's ence of seemingly dysfunctional institutions, theory and the view of the role of government such as sharecropping. I had seen cyclical that rested on it. They have suggested that the unemployment-sometimes quite large-and reason that the hand may be invisible is that it is the hardshipit brought as I grew up, but I had simply not there-or at least that if is there, it is not seen the massive unemployment that palsied. characterized African cities, unemployment When I began the study of economics some that could not be explained either by unions 41 years ago, I was struck by the incongruity or minimum wage laws (which, even when between the models that I was taught and the they existed, were regularly circumvented). world that I had seen growing up in Gary, Again, there was a massive discrepancy be- Indiana. Founded in 1906 by U.S. Steel, and tween the models we had been taught and what I saw. In contrast, the ideas and models I will dis- t This article is a revised version of the lectureJoseph E. cuss here have proved useful not only in ad- on Stiglitz delivered in Stockholm, Sweden December 8, dressing broad philosophical questions, such as 2001, when he received the Bank of Sweden Prize in Eco- the role of the but also in nomic Sciences in Memory of Alfred Nobel. The article is appropriate state, copyright ? The Nobel Foundation2001 and is published analyzingconcrete policy issues. For example, I here with the permission of the Nobel Foundation. believe that some of the huge mistakes which * Graduate School of Business, Uris Hall, Columbia have been made in policy in the last decade, in University, 3022 Broadway, New York, NY 10027. for instance the managementof the East Asian 460 VOL. 92 NO. 3 STIGLI7Z:INFORMATION ECONOMICS AND PARADIGMCHANGE 461 crisis or the transitionof the former communist want to trace out some of their origins. To a countries to the market, might have been large extent, these ideas evolved from attempts avoided had there been a better understanding to answer specific policy questions or to explain of issues-such as financial structure, bank- specific phenomena to which the standardthe- ruptcy,and corporategovernance-to which the ory provided an inadequate explanation. But new information economics has called atten- any discipline has a life of its own, a prevailing tion. And the so-called "Washington consen- paradigm, with assumptions and conventions. sus"' policies, which have predominatedin the Much of the work was motivatedby an attempt policy advice of the internationalfinancial in- to explore the limits of that paradigm-to see stitutions over the past quarter century, have how the standardmodels could embrace prob- been based on market fundamentalistpolicies lems of information imperfections (which which ignored the information-theoreticcon- turned out to be not very well). cerns; this explains, at least partly, their wide- For more than 100 years, formal modeling in spread failures. Information affects decision- economics had focused on models in which making in every context-not just inside firms information was assumed to be perfect. Of and households. More recently, as I discuss course, everyone recognized that information below, I have turned my attention to some as- was in fact imperfect, but the hope, following pects of what might be called the political econ- Marshall's dictum "Natura non facit saltum," omy of information: the role of information was that economies in which information was in political processes and collective decision- not too imperfect would look very much like making. There are asymmetries of information economies in which information was perfect. between those governing and those governed, One of the main results of our research was to and just as participants in markets strive to show that this was not true; that even a small overcome asymmetriesof information,we need amountof informationimperfection could have to look for ways by which the asymmetries of a profound effect on the nature of the informationin political processes can be limited equilibrium. and their consequences mitigated. The creators of the neoclassical model, the reigningeconomic paradigm of the twentiethcen- I. The HistoricalSetting tury, ignored the warningsof nineteenth-century and still earlier masters about how information I do not want here to review in detail the concernsmight alter their analyses-perhaps be- models that were constructedexploring the role cause they could not see how to embrace them of information;in recent years, there has been a in their seemingly precise models, perhaps be- number of survey articles and interpretivees- cause doing so would have led to uncomfortable says, even several books in this area.2 I do conclusions about the efficiency of markets.For want to highlight some of the dramaticimpacts instance, Smith, in anticipatinglater discussions that information economics has had on how of adverse selection, wrote that as firms raise economics is approachedtoday, how it has pro- interestrates, the best borrowersdrop out of the vided explanations for phenomena that were market.3If lenders knew perfectly the risks as- previously unexplained, how it has altered our sociated with each borrower,this would matter views about how the economy functions, and, little; each borrower would be charged an ap- perhaps most importantly,how it has led to a propriaterisk premium.It is because lenders do rethinking of the appropriaterole for govern- ment in our society. In describing the ideas, I 3 "If the legal rate ... was fixed so high ... the greaterpart of the money which was to be lent, would be lent to ' See John Williamson (1990) for a description and prodigals and profectors, who alone would be willing to Stiglitz (1999c) for a critique. give this higher interest.Sober who will for the 2 people, give Review articles include Stiglitz (1975b, 1985d, 1987a, use of money no more than a part of what they are likely to 1988b, 1992a, 2000d) and John G.