SI G NALI N G I N RETR OSPECT A N D T HE I NF OR- MATI ONAL STR UCT URE OF MARKETS Prize Lecture, Dece mber 8, 2001 by A. M IC HAEL S PE NCE 1 Sta nford Busi ness Sc hool, Sta nford U niversity, 518 Me morial Way, Sta nford, C A 94305-5015, US A. INTRODUCTION W he n I was a graduate stude nt i n eco no mics at Harvard, I had t he privilege of serving as rapporteur for a faculty se minar in the then-ne w Kennedy Sc hool of Gover n me nt. A mo ng ot her disti nguis hed sc holars, it i ncluded all of my thesis advisers, Kenneth Arro w, Tho mas Schelling, and Richard Zeck- ha user. I n t he c o urse of t hat se mi nar t here were disc ussi o ns of statistical dis- cri mi natio n a nd ma ny ot her subjects t hat relate to t he i nco mplete ness of i n- for mation in markets. One of my advisers ca me in one day with the strong suggestion that I read a paper he had just read called “ The Market for Le mons” by George Akerlof. 2 I al ways di d w hat my a dvisers tol d me to do a n d he nce follo we d u p i m me diately. It was q uite electrifyi ng. T here we all fo u n d a wo n derf ully clear a n d pla usible a nalysis of t he perfor ma nce c haracteristics of a market with inco mplete and asy m metrically located infor mation. That, co mbi ned wit h my puzzle me nt about several aspects of t he discussio n of t he consequences of inco mplete infor mation in job markets, pretty much lau nc hed me o n a searc h for t hi ngs t hat I ca me to call sig nals, t hat would carry i nfor matio n persiste ntly i n eq uilibri u m fro m sellers to b uyers, or more ge nerally fro m t hose wit h more to t hose wit h less i nfor matio n. 3 T h e iss u e, of course, was t hat sig nals are not terribly co mplicated t hi ngs i n ga mes w here t he parties have t he sa me i nce ntives, i.e. w here t here is a co m mo nly u nder- 1 T his paper is based o n a lecture delivered by t he aut hor i n Stock hol m o n t he occasio n of t he 1 0 0 t h a n niversary of t he fo u n di ng of t he Nobel Prize. I wo ul d like to t ha nk my fello w reci pie nts of t he Nobel Prize i n Eco no mics t his year, Professor George Akerlof a n d Professor Jose p h Stiglitz, for t heir work a nd t heir i nspiratio n, a nd my t hesis advisers, Professors Ke n net h Arro w, T ho mas Schelling and Richard Zeckhauser whose ideas and guidance got me launched on the study of market structure (particularly i nfor matio nal structure) a nd perfor ma nce. My colleagues Profes- sors Ed ward Lazear a nd Mark Wolfso n gave me a great deal of co nstructive i nput. I also o we a great debt to Professors Ja mes Rosse a nd Bruce O we n, wit h w ho m I lear ned a nd taug ht i ndustrial organization and applied microecono mic theory at Stanford. It was a great group of young p e o pl e a n d a w o n d erf ul ti m e t o b e i n t h at p art of t h e fi el d. 2 George Akerlof, “ The Market for Le mons: Qualitative Uncertainty and the Market Mechanis m, Q uarterly Jo ur nal of Eco no mics . 3 I believe is was R o bert Jervis w h o i ntr o d uce d t he ter ms “i n dices” a n d “sig nals.” I n dices are attri- b utes over w hic h o ne has no co ntrol, like ge n der, race, etc. T hi nk of t he m as u nalterable attri- b utes of so met hi ng, not necessarily a perso n. Sig nals are t hi ngs o ne does t hat are visible a n d t hat are i n part desig ne d to co m m u nicate. I n a se nse t hey are alterable attrib utes. I t ho ug ht it was a us ef ul s et of disti n cti o ns a n d t er mi n ol o gy a n d I still d o. 4 0 7 stood desire to co m municate accurate infor mation to each other. Even in t hat case (so meti mes called t he pure coordi natio n case) ho wever, t here are pote ntial proble ms of c hoosi ng a mo ng eq uilibria as ill ustrate d i n Sc helli ng’s brillia nt a nalysis of t he use of f ocal p oi nts a n d c o ntext ual i nf or mati o n t o s olve co m munication/coordination proble ms when the parties have been de- prive d of t he a bility t o c o m m u nicate directly. 4 I n markets w here t he iss ue is of- te n u ndetectable or i mperfectly detectable quality differe ntials, t he alig n- me nt of i nce ntives is ty pically i m perfect a n d t he i nce ntive of t he hig h- q uality pro d uct o w ners to disti ng uis h t he mselves a n d t he i nce ntive of t he lo w-q uality o w n ers t o i mit at e t h e si g n al s o as t o o bs c ur e t h e disti n cti o n is f airly cl e ar. Of co urse t here is more to it, as o ne nee ds to k no w s uc h t hi ngs as w ho is i n t he market persiste ntly a n d he nce w ho has a n i nce ntive to establis h a re p utatio n t hroug h repeated plays of t he ga me. I a m goi ng to devote a good portio n of t his lect ure to t hese iss ues, i n a se nse to revisit sig nali ng, a n d t he n t ur n to so me ot her aspects of t he i nfor matio nal structure of markets t hat are raised by t h e p ar a m et er s hifts c a us e d by t h e pr olif er ati o n of t h e i nt er n et as a c o m- mu nicatio n mediu m i n t he past fe w years. 5 I was aske d rece ntly by a so me w hat i ncre d ulo us q uestio ner (act ually a jo ur- nalist) whether it was true that you could be a warded the Nobel Prize in Eco no mics for si m ply notici ng t hat t here are markets i n w hic h certai n parti- cipants don’t kno w certain things that others in the market do kno w. I t ho ug ht it was pretty f u n ny. It was as if t his ha d so me ho w bee n a closely g uar d- e d secret u p u ntil a b o ut 1970, at least i n ec o n o mics. I clearly ca n n ot s peak f or t hose w ho make t he decisio ns about t he Nobel Prize, but I suspect t hat t he correct a ns wer to t hat q uestio n is no. W hat di d blosso m at t hat ti me was a se- rious atte mpt by many talented econo mists to capture in applied microeco- no mic t heory a w hole variety of aspects of market structure a nd perfor ma nce. T hat work pro d uce d a partial mel di ng of t heory, i n d ustrial orga nizatio n, la- bor eco no mics, fi na nce a nd ot her fields. A n i mporta nt early part of t hat ef- fort was t he atte mpt to capture i nfor m atio n al as pects of market str uct ure to study the ways in which markets adapt, and the consequences of infor ma- tio nal gaps for market perfor ma nce.