Faculty News

The School’s third Nobel laureate is recognized for his “signaling theory,” which helped to define the role of information in markets.

BY KATHLEEN O'TOOLE

PHOTOGRAPH BY MATTHEW THAYER

NOBEL PRIZES IN ECONOMICS go to people who create order out of the apparent chaos of markets, but their ideas often are regarded as kooky at first. The GSB’s first Nobel Prize winner, William Sharpe, devised an asset-pricing model that became the standard for pricing securities and made him a Nobel laureate in 1990. But Sharpe can still remember the pangs of self-doubt he felt in 1964 as “months went by and no one said anything” about his freshly published idea.

That silence may have been preferable to the initial fate of the School’s newest Nobel laureate, former dean A. Michael Spence. His 1972 doctoral thesis, for which he garnered a Nobel in December, initially was misread by some and regarded as a foolish put-down of a solid economic principle.

“The first reaction at the University of Chicago to what I wrote was, ‘Here is a guy who says education doesn’t add to a person’s productivity!’” Spence recalled last October, shortly after the Swedish Royal Academy awakened him at his Hawaiian vacation home to tell him he would share the 2001 prize. Spence is now one of 17 living Nobel laureates on the Stanford faculty and the third GSB laureate, following Sharpe in 1990 and Myron Scholes in 1997. He shares the current prize with George Akerlof, a professor at the University of California, Berkeley, and Joseph Stiglitz, a former Stanford colleague now at Columbia. Independently but collectively, the Swedish academy said, the three created the field of information economics.

Spence, of course, never doubted that a solid education enhances one’s productivity and a nation’s economic growth. He has been dean of two venerable educational institutions—Harvard’s College of Arts and Sciences and Stanford’s Graduate School of Business. His profession long ago figured out he hadn’t committed heresy, for he was awarded the prestigious John Bates Clark Medal in 1983. Now an emeritus faculty member, he still teaches and conducts research at the GSB while also serving on company boards and managing technology investments for a venture capital firm.

What he wrote about education in 1972 was that a college degree had more private economic value to the individual who receives it than economic value to society from the individual’s added productivity. From society’s standpoint then, the market doesn’t work as efficiently as it should. The larger ideas in his thesis were not just about education and job markets, but about how people behave in markets where buyers and sellers don’t have access to the same information and therefore have difficulty agreeing on a price.

At a School celebration for him in October, Spence thanked mentors, colleagues, and students who had exchanged ideas with him over the years and spoke of “the joy of discovery that motivates us.” Economics is a team effort, the former Princeton hockey team captain said, describing his own contribution, known as “signaling theory,” simply as “moving the ball [perhaps he should have said puck] down the field.”

It was Akerlof who started the ball rolling by analyzing why people were reluctant to buy and sell used cars without a dealer middleman. Used cars come in a variety of quality levels, he said, and just like the job seekers whom Spence was thinking about, some turn out to be lemons. The owner of each car knows its quality, but potential buyers do not. Buyers can’t depend on reports from the owners. As Professor David Kreps put it to GSB students, “How often have you heard the seller of a used car say, ‘This is a real lemon’?”

Given the unknowns, Akerlof theorized, buyers offer less than the seller of a quality car believes it is worth. Seeing this price, at least some sellers of superior cars will avoid the market, so the average quality falls.

Spence’s work suggested one way a seller of a superior car could solve the problem—by finding a signal to convey his private information. Knowing the car was sound, the owner could offer a warranty to cover the cost of repairs. Owners of lemons would find it too costly to offer the warranty; therefore, the warranty offer becomes a credible signal that the car is worth a premium price.

Stiglitz contributed ideas on how market players could force others to reveal private information. An insurance company, for instance, could offer different deductibles. Those who were worse risks would reveal that by seeking a smaller deductible.

Over the years, scholars and managers have applied the threesome’s ideas on information asymmetries to a wide variety of markets. A major implication has been that the “invisible hand” of the market cannot always be relied upon to get prices right. “It gives government a big role in information supply,” Spence’s early mentor, Kenneth Arrow, a Stanford economist and early Nobel laureate, told the Los Angeles Times.

Spence began working on theories to explain labor markets as a result of faculty seminars he attended as a graduate student at Harvard but also because he heard a lot about job seekers from his then wife, who was a placement officer at Radcliffe. In the late ’60s and early ’70s, men and women with similar educational degrees did not have similar outcomes in the labor market, and his original thesis gives an information signaling explanation.

“The idea of signaling is pretty simple,” he says now, “but there is a complicated part about the equilibrium,” by which he means the patterns of job applicant behavior and employer wage offers that persist because the signals appear to produce confirming feedback. If applicants and employers view men and women as in different labor pools, he argued then, they will send and receive signals that tend to regenerate sex-segregated employment patterns in a kind of self-fulfilling prophecy. The problem also could apply to race or other observable characteristics that people cannot change about themselves.

When he became a dean, Spence says now, his earlier work “definitely affected my thinking about admissions programs. Both at Harvard and here, we viewed affirmative action as the need to conduct a talent hunt, because this [signaling theory] tells you that there are talented people who will not apply on their own. I cannot prove it, but I don’t have any doubt that in the first 20 years after World War II, the equilibrium for men and women was dramatically different, and then it changed rapidly, providing different returns to education.”

The theories also help explain why the recent Internet bubble burst. Spence puts it this way:

“The definition of an equilibrium in a signaling world is that the signals that will survive are those that are consistent with experience. They close the feedback loop. When the Internet came along, it was clear to many people that it would have a major impact on the economy, but we were in dataless, uncharted territory. When the first data trickled in, it disconfirmed some of the expectations, and the stock prices came crashing down.”

Spence believes the Internet will have lasting effects on the economy because “it crushes certain kinds of transaction costs and creates markets where there weren’t any.” These are concepts he and GSB Professor Garth Saloner explain in their recent book, Creating and Capturing Value: Perspective and Cases on Electronic Commerce.

That said, Spence takes a breath and continues, “The question is, does it go deeper than that? I want to do a lot more thinking about that.”