George Akerlof’s 1970 paper, “The Market for Lemons”, is a foundation stone of information economics. The first in our series on seminal economic ideas
[W]hen, in the late 1960s, George Akerlof wrote “The Market for Lemons”, which did just that, and later won its author a Nobel prize, the paper was rejected by three leading journals. At the time, Mr Akerlof was an assistant professor at the University of California, Berkeley; he had only completed his PhD, at MIT, in 1966. Perhaps as a result, the American Economic Review thought his paper’s insights trivial. The Review of Economic Studies agreed. The Journal of Political Economy had almost the opposite concern: it could not stomach the paper’s implications. Mr Akerlof, now an emeritus professor at Berkeley and married to Janet Yellen, the chairman of the Federal Reserve, recalls the editor’s complaint: “If this is correct, economics would be different.” . . .
Before Mr Akerlof and the other pioneers of information economics came along, the discipline assumed that in competitive markets, prices reflect marginal costs: charge above cost, and a competitor will undercut you. But in a world of information asymmetry, “good behaviour is driven by earning a surplus over what one could get elsewhere,” according to Mr Stiglitz. The wage must be higher than what a worker can get in another job, for them to want to avoid the sack; and firms must find it painful to lose customers when their product is shoddy, if they are to invest in quality. In markets with imperfect information, price cannot equal marginal cost.