Joseph E. Stiglitz and his Works in Economics

The following points highlight the top four economic ideas of Joseph E. Stiglitz. The economic ideas are: 1. The Economics of Screening 2. Traditional Vs. Behavioural Theories of the Firm 3. Asymmetric Information 4. The Principal-Agent Problem.

Economic Idea # 1. The Economics of Screening:

Professor Joseph Stiglitz stressed the importance of the availability and transmission of information about alternative opportunities in making the education system as a more effective vehicle for income redistribution. In his paper on “Information and Economic Analysis”, Stiglitz surveyed widely all the current works in the area of the economics of information and screening in education, labour and insurance markets.

He laid the foundation for constructing an “economics” of information-production and dissemination of information. He analysed two kinds of information. “One is associated with ‘research and development’ and the other with ‘screening'”. These two kinds of information are viewed as “polar cases”; while other kinds of information are thought of a mixture of the two.

J.E. Stiglitz defined screening as simply “the process of discrimination, of distinguishing among “things” which, in the absence of screening, would, for economic purposes, be treated the same, even though it may be known that they differ in perhaps some important ways”.

Stiglitz discussed screening device with examples and examined the screening mechanisms by examination and self-selection, motivations for screening in monopoly and competitive market choices associated with differential information, screening costs and imperfect information on both sides of the market.

Most of the analysis focused on imperfections of information on one side of the market. But Stiglitz focused on imperfections on both sides, e.g., in education market including examination system, insurance market, labour market and capital market. Screening was examined in a variety of contexts in these markets and the analysis has been extended to welfare economics also.

Spence in his insightful work (1973,1974) focused on what has been referred to as self-selection mechanism and also on signals. Akerlof’s seminal paper on the market for lemons and the literature on the economics of discrimination by Arrow, Phelps and Stiglitz and Spence work are noted as the two important antecedents of the Theory of Screening.

The development of the theory of imperfect information and non-convexity of technology altered the conventional fundamental analysis of markets. The seminal contributions questioned the assumptions of perfect competition, convexity of technology and the concept of equilibrium.

Economic Idea # 2. Traditional Vs. Behavioural Theories of the Firm:

The traditional theory of the firm (the neoclassical theory) assumes a single owner entrepreneur. There is no separation between ownership and management. The owner-entrepreneur takes all the decisions. The entrepreneur is further more assumed to have unlimited information, unlimited time at his disposal and unlimited ability to compare all the possible alternative actions and choose the one that maximizes his profit. There is no time, information or other constraints in pursuing the single goal of profit maximization.

Clearly the neoclassical (marginalist) assumptions are unrealistic, considering the complexity of modern enterprises. In the modern business world the firm is a complex organization, characterized by the divorce of ownership and management. This gives discretion to the managers to pursue goals other than profit maximisation.

Information is not unlimited. It acquisition involves expenses. Further-more it is often distorted as it passes through the various hierarchical levels of administration. As recognized by the behavioural theories firms have no perfect knowledge of their costs, revenues and their environment and they operate in a world of uncertainty. Entrepreneurs attitudes towards risk plays an important role in actual decision-making.

Information activity is problematic in the behavioural theories. That is, a search is made whenever a problem is identified. Information flow is not costless, as the conventional theory of the firm assumed. Furthermore a search is not made on marginalistic rules, as the neoclassical theory postulated. Nobel economists have recognized that information is not costless, but they have treated information search as a resource absorbing activity. Information affects expectations and hence demands and goals of management.

Economic Idea # 3. Asymmetric Information:

A very widespread economic situation is that of the relation between a principal and principal agent relation. The interactions between the two are almost universal in the economy and are significant almost in all transactions.

The problem acquires interest only when there is uncertainty at some point, and in particular, when the information available to the two participants is unequal. In technical language, there is asymmetric information between the two sides.

Asymmetric information is a situation where one party in an economic relationship (e.g., an agent) has more information than another (e.g., the principal). The inherent dangers for the principal in these relationships are that the agent knows more about the situation than the principal and also the agent may well not act in the principals best interests and may be able to get away with it because of the principal’s imperfect knowledge.

The main problem is where the agent’s action is not directly observable by the principal and where in addition the outcome is affected but not completely determined by the agent’s action. Technically the outcome is a random variable whose distribution depends on the action taken.

More generally, there may be many agents for a single principal. Each takes an action and the output of the system is a random function of all the actions. The principal cannot observe the actions themselves but may make some observations of the output and possible others (hidden action type). Also the agent makes an observation and bases his action on that observation and the principal does not know whether or not it is the most appropriate (hidden-information type). These are two types of principal-agent problems: hidden action and hidden information, respectively.

Economic Idea # 4. The Principal-Agent Problem:

The principal-agent theory can be interpreted both normatively and descriptively. It can also be interpreted as an attempt to guide principal-agent problems in the real world and acts as a foundation for social engineering.

It can be interpreted as an attempt to explain observed phenomena in the empirical economic world, particularly exchange relations which are observed but not explained by more standard economic theory. For example the case of a physician-patient relation. Here, the patient is the principal and the physician is the agent. The physician has a superior knowledge and the patient cannot check to see if the actions of physician are as diligent as they could be.

How can principals tackle the Problem?

There are two types of solutions:

1. The principals must have some way of monitoring the performance of their agents and

2. There must be incentives for agents to behave in the principal’s interests.

In economics, the issue of the divorce between the ownership and control of a company is known as the principal-agent problem. The principal-agent problem refers to a situation where people (principals), as a result of lack of knowledge cannot ensure that their best interests are served by their agents.

One of the features of a complex modern economy is that people (principals) have to employ others (agents) to carry out their wishes. The point is that these agents have specialist knowledge and can save the principal, a great deal of time and effort. It is merely an extension of the benefits of the specialization and division of labour.