Beyond the Economist: Dean Kreps Pays Tribute to Michael Spence
Issue date: 10/15/01 Section: Features
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Mike Spence was and is a phenomenon. He was captain of the Princeton hockey team, then a Rhodes Scholar. His Ph.D. thesis, written in the Harvard University Department of Economics, was good enough to merit a Nobel Prize thirty-odd years later, which is pretty good as Ph.D. theses go. He had a brilliant career as an economist, publishing a number of path-breaking papers. He was appointed the Dean of Arts and Sciences at Harvard University in 1984 (at age 40 or 41, I believe), and he moved from there to become Dean of the GSB in 1991, where he served for eight years, until his “retirement” in 1999. In “retirement,” he serves on a number of boards and is a Partner of Oak Hill Venture Partners, up on Sand Hill Road. He is also an avid and accomplished wind surfer; current students will not remember, but the way to tell that Mike was in the office was when his Ford Explorer (I think), with the wind-surfboard on the roof, was in the parking lot.
Since the Nobel Prize was about Spence the Economist, and not Spence the anything else, I’ll discuss his economic work. (This shouldn’t be necessary for the 2nd years, who saw all this last year in E200, remember? But since the editor wanted a rehash, perhaps one or two of you forgot.) The prize-winning work concerns equilibrium signaling. The story can be told in a lot of contexts, but perhaps the most accessible concerns the used car market. Used cars come in a variety of quality levels. Some are lemons, and others are excellent vehicles. The owner of the used car knows the quality level of his or her particular car; but potential buyers do not. Moreover, buyers can’t depend on reports from the owners; how often have you heard the seller of a used car say, “This car is a real lemon.”
So buyers will offer to pay an amount that balances the risks they take in buying a car of unknown quality. The owners of superior used cars, seeing this price, are somewhat likely to withdraw their cars; why sell a better than average car for an average price? But if at least some of the superior used cars don’t come onto the market, the average quality of cars on the market falls, so the price buyers are willing to pay falls, and so more owners of good used cars will withdraw their vehicles. Formalizing this idea---and noting that, in extreme cases, the market may settle out in a place where only the lemons are on the market, at a price appropriate for a lemon---is the contribution of George Akerlof, the first of the three winners of the Prize.
Spence’s work comes at this stage: Suppose the owner of a good used car, knowing that she has a good used car, offers the car for sale with a warranty. She will pay the costs of any repairs needed by the car for the next six months, for an additional $100. Suppose this warranty package is economical for owners of good used cars, but the potential liability for repairs on lemons is such that the owner of a lemon would be unwilling to sell his car with this warranty, even if he got a premium price for his car, where the alternative is selling without a warranty for the price of a lemon. Then this warranty is a credible signal that the car for sale is of high quality, and so it will generate a premium price. In Spencian terms, the warranty is a signal of the car’s quality. (Of course, with used cars, garages can often do a reasonable diagnosis of a particular car’s quality. So the story is more of a metaphor than an analysis of the used car market.)
Akerlof used the used-car metaphor to illustrate the general problem of asymmetric information, Spence used education as a signal of ability as his dominant metaphor in the study of market signals and, a few years later, Joe Stiglitz---the third member of the group of laureates---in collaboration with Michael Rothschild, used the insurance market and deductibles as their dominant metaphor in refining and extending Spence’s idea of signals. But the basic economic phenomena that these individuals explored have been applied to all sorts of markets and situations, including financial markets, marketing and advertising, HRM, and competitive strategies. The profession has been expecting a Nobel Prize on this subject for quite a while and, his protests notwithstanding, Spence is obvious as one of the laureates.
While a Dean, both at Harvard and at Stanford, Mike didn’t do a lot of “serious” economics. (He ran a real-life institution instead, which involves serious economics.) But after his “retirement,” he and Garth Saloner were instrumental in developing the e-commerce course; if you want a taste and can’t get into the course, Garth and he are just this month publishing a book out of the course, Creating and Capturing Value: Perspectives and Cases on Electronic Commerce (John Wiley, publishers).
Since the Nobel Prize was about Spence the Economist, and not Spence the anything else, I’ll discuss his economic work. (This shouldn’t be necessary for the 2nd years, who saw all this last year in E200, remember? But since the editor wanted a rehash, perhaps one or two of you forgot.) The prize-winning work concerns equilibrium signaling. The story can be told in a lot of contexts, but perhaps the most accessible concerns the used car market. Used cars come in a variety of quality levels. Some are lemons, and others are excellent vehicles. The owner of the used car knows the quality level of his or her particular car; but potential buyers do not. Moreover, buyers can’t depend on reports from the owners; how often have you heard the seller of a used car say, “This car is a real lemon.”
So buyers will offer to pay an amount that balances the risks they take in buying a car of unknown quality. The owners of superior used cars, seeing this price, are somewhat likely to withdraw their cars; why sell a better than average car for an average price? But if at least some of the superior used cars don’t come onto the market, the average quality of cars on the market falls, so the price buyers are willing to pay falls, and so more owners of good used cars will withdraw their vehicles. Formalizing this idea---and noting that, in extreme cases, the market may settle out in a place where only the lemons are on the market, at a price appropriate for a lemon---is the contribution of George Akerlof, the first of the three winners of the Prize.
Spence’s work comes at this stage: Suppose the owner of a good used car, knowing that she has a good used car, offers the car for sale with a warranty. She will pay the costs of any repairs needed by the car for the next six months, for an additional $100. Suppose this warranty package is economical for owners of good used cars, but the potential liability for repairs on lemons is such that the owner of a lemon would be unwilling to sell his car with this warranty, even if he got a premium price for his car, where the alternative is selling without a warranty for the price of a lemon. Then this warranty is a credible signal that the car for sale is of high quality, and so it will generate a premium price. In Spencian terms, the warranty is a signal of the car’s quality. (Of course, with used cars, garages can often do a reasonable diagnosis of a particular car’s quality. So the story is more of a metaphor than an analysis of the used car market.)
Akerlof used the used-car metaphor to illustrate the general problem of asymmetric information, Spence used education as a signal of ability as his dominant metaphor in the study of market signals and, a few years later, Joe Stiglitz---the third member of the group of laureates---in collaboration with Michael Rothschild, used the insurance market and deductibles as their dominant metaphor in refining and extending Spence’s idea of signals. But the basic economic phenomena that these individuals explored have been applied to all sorts of markets and situations, including financial markets, marketing and advertising, HRM, and competitive strategies. The profession has been expecting a Nobel Prize on this subject for quite a while and, his protests notwithstanding, Spence is obvious as one of the laureates.
While a Dean, both at Harvard and at Stanford, Mike didn’t do a lot of “serious” economics. (He ran a real-life institution instead, which involves serious economics.) But after his “retirement,” he and Garth Saloner were instrumental in developing the e-commerce course; if you want a taste and can’t get into the course, Garth and he are just this month publishing a book out of the course, Creating and Capturing Value: Perspectives and Cases on Electronic Commerce (John Wiley, publishers).