Bridging economics and psychology

This image released 09 October 2002 by Princeton University shows Daniel Kahneman. It was announced earlier 09 October that Kahneman, a professor of Psychology, has been awarded the 2002 Nobel Prize in economic sciences. AFP PHOTO/ PRINCETON UNIVERSITY

TWO Americans have won this year’s Nobel prize for Economics for trying to explain idiosyncrasies in people’s ways of making decisions, research that has helped incorporate insights from psychology into the discipline of economics. Daniel Kahneman, a Professor of Psychology and Public Affairs at Princeton University, and Vernon L. Smith, a Professor of Economics and Law at George Mason University in Fairfax, Va, shared the prize, which is worth approximately $1.07 million before taxes. Their work shed light on strategies for explaining everything from stock market bubbles to regulating utilities and countless other economic activities. In many cases, the winners tried to explain apparent paradoxes. For example, Prof. Kahneman made the economically puzzling discovery that most of his subjects would make a 20-minute trip to buy a calculator for $10 instead of $15, but would not make the same trip to buy a jacket for $120 instead of $125 and save the same amount, $5. Though the two winners will now inevitably be grouped together, they approached their field from very different backgrounds. “Kahneman’s a psychologist - he’s interested in how your brain works, how you make decisions,” said Professor Alvin E. Roth, an economist at Harvard who specializes in experimental methods. “Smith is an economist. He’s interested in how markets work.” With different goals came different approaches, and sometimes conflicting conclusions. Prof. Smith originally set out to demonstrate how well economic theory worked in the laboratory, according to Professor Richard H. Thaler, an economist at the University of Chicago who studies behavioral patterns. By contrast, Prof. Kahneman, and his longtime collaborator Amos Tversky, who died in 1996, “were more interested in the ways that economic theory mispredicted,” he said. Both winners of the award - the Nobel Memorial Prize in Economic Science - tested the limits of the standard economic theory of choice in predicting the actions of real people. The theory assumes that individuals make decisions systematically, based on their preferences and available information, in a way that changes little over time or in different contexts. By the late 1970’s, Prof. Kahneman, an Israeli citizen, and Mr. Tversky had begun to perform experiments with human subjects that suggested seemingly irrational wrinkles in behavior. In a 1981 article, they reported the results of a study in which 152 students were given hypothetical choices for trying to save 600 people from a disease. Using one strategy, exactly 200 people could be saved for certain.

Using another, there would be a one-third chance everyone would live, and a two-thirds chance no one would be saved.

Seventy-two percent of the subjects, preferring the less risky strategy, chose the first option. But when the researchers presented 155 other students with the same choice worded differently - either 400 people would die for sure or there would be a one-third chance that no one would die - only 22 percent chose the first option. The difference, Prof. Kahneman and Mr. Tversky explained, stemmed from the presentation of the options as sure gains or sure losses. People in their experiments generally shunned risk when gains, like lives saved, were in question - they wanted to lock in the gains with certainty. Yet people preferred risk when the alternative was a certain loss, even if taking the risk implied the chance of an even greater loss. Prof. Smith’s work formalized laboratory techniques for studying economic decision making, with a focus on trading and bargaining. In the early 1960’s, he was among the first economists to make experimental data a cornerstone of academic output. His studies included people playing games of cooperation and trust and simulating different types of markets in a laboratory setting. The choices of the two men for the prize left few academic economists completely surprised. Both Prof. Roth and Prof. Thaler said they had an inkling of the Nobel Committee’s leanings last year, after attending a meeting on behavioral and experimental economics at a Swedish symposium celebrating the 100th anniversary of the Nobel Prizes. And Prof. Kahneman was among the favorites in a betting pool for economists, according to Siva Anantham, a Harvard graduate student who administers the pool. Behavioral economics and experimental methods have become hot topics for graduate students in some of the nation’s top economics departments. Universities in the United States, Europe, Israel and Japan have opened centers dedicated to behavioral and experimental economics in the last few years. Though this year’s prize was the first to reward such work, the Nobel Committee has long shown an interest in the nexus of economics and psychology. Maurice Allais, who won the prize in 1988, demonstrated how economic theory broke down when used to predict people’s choices between different sets of lotteries. And human beings’ limited capacity to digest information needed to make complex decisions was a prime concern of Herbert A. Simon, an American who won the prize in 1978. Many economists’ laboratory experiments use ideas about competitive interactions pioneered by game theorists such as John Forbes Nash Jr., who shared the Nobel in 1994, as points of reference. But behavioral economists often concentrate on cases where people’s actions depart from the systematic, rational strategies Prof. Nash and his counterparts envisioned.