The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2002
Daniel Kahneman, Vernon L. Smith
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Traditionally, economic theory has relied on the assumption of a "homo œconomicus", whose behavior is governed by self-interest and who is capable of rational decision-making. Economics has also been regarded as a non-experimental science, where researchers – as in astronomy or meteorology – have had to rely exclusively on field data, that is, direct observations of the real world. During the last two decades, however, these views have undergone a transformation. Controlled laboratory experiments have emerged as a vital component of economic research and, in certain instances, experimental results have shown that basic postulates in economic theory should be modified. This process has been generated by researchers in two areas: cognitive psychologists who have studied human judgment and decision-making, and experimental economists who have tested economic models in the laboratory. This year’s prize is awarded to the innovators in these two fields: Daniel Kahneman and Vernon Smith.
In controlled experiments, Smith and his
colleagues were able to test several theoretical predictions. For
example, they found – as foreseen by theory – that a
seller can expect the same revenue in English and second-price
auctions. Meanwhile, they were able to refute the theoretical
prediction of equivalence between the Dutch and the first-price
auction. Their experiments also demonstrated that the English and
second-price auctions produced the highest average selling price,
followed by the first-price auction and, lastly, the Dutch
auction.
Smith also initiated the use of laboratory experiments as a "wind
tunnel", where proposed auction mechanisms for privatization and
public procurement can be tested in advance. Since these
mechanisms are frequently complex and it is difficult to assess
their performance solely on the basis of theoretical
considerations, the experimental method becomes particularly
useful. In similar experiments, Smith has evaluated different
mechanisms for allocating airport time slots using
computer-assisted markets. He has also evaluated various means of
organizing energy markets in Australia and New Zealand, where the
results have influenced actual market design.
The values at stake on real-world markets are often of a wholly
different magnitude than the rewards which can be offered in an
experimental setup. In particular, while emphasizing the
importance of monetary incentives in experiments, Smith has
developed methods where such incentives are not only sufficiently
strong, but also designed to enhance the probability that the
results would be applicable in real market situations. A major
problem is that subjects’ own (and unobserved) preferences
can affect their behavior in an experiment. Consequently, a
subject who is assigned the role of buyer, with a given demand
function for a good, will not simply behave in accordance with
this demand curve. Smith introduced a technique, known as the
induced-value method, which solves this problem and
provides the subject with incentives to behave as the
experimenter intended. Through this and other contributions, as
well as a series of practical recommendations for appropriate
procedures in the laboratory, Smith has set methodological
standards for what constitutes a good experiment in economic
research.
Psychology and economics
Economic research often assumes that people are motivated
primarily by material incentives and make decisions in a rational
way. They are assumed to assess the state of the economy and the
effects of their behavior by processing available information
according to standard statistical principles. This approach has
been formulated axiomatically in so-called expected-utility
theory, which is the predominant economic theory for decisions
under uncertainty.
The prevailing view in psychology in general, and cognitive
psychology in particular, is to regard a human being as a system
that codes and interprets available information in a conscious
manner, but where other, less conscious factors also govern
decisions in an interactive process. Such elements include
perception, mental models for interpreting specific situations,
emotions, attitudes and memories of earlier decisions and their
consequences.
In extensive research on human behavior based on surveys and
experiments, Daniel Kahneman and other psychologists have called
into question the assumption of economic rationality in some
decision situations. Real-world decision-makers frequently appear
not to evaluate uncertain events according to the laws of
probability; nor do they seem to make decisions according to the
theory of expected-utility maximization.
In a series of studies, Kahneman – in collaboration with
the late Amos Tversky – has shown that people are incapable
of fully analyzing complex decision situations when the future
consequences are uncertain. Under such circumstances, they rely
instead on heuristic shortcuts or rules of thumb. A fundamental
bias is nicely illustrated in Kahneman and Tversky’s own
experimental data on the way individuals judge random events.
Most experimental subjects assign the same probabilities in small
and large samples, without taking into account that uncertainty
about (the variance of) the mean declines drastically with sample
size. People thus seem to adhere to a law of small
numbers, without due consideration of the law of large
numbers in probability theory. In a well-known experiment,
subjects regarded it as equally likely that, on a given day, more
than 60 percent of the births would be boys in a small hospital
(with few births) as well as in a large hospital (where many
children were born).
Similarly, an investor who recognizes that a fund manager beats
the index two years in a row may conclude that the manager is
systematically more competent than the average investor, whereas
the true statistical implication is much weaker. Such
shortsightedness in interpreting data might well help clarify
various phenomena on financial markets that are difficult to
explain with prevailing models – such as the ostensibly
unmotivated large fluctuations to which stock markets are often
exposed. In financial economics, a lively research area,
behavioral finance, has evolved which applies insights
from psychology in an attempt to understand the functioning of
financial markets.
Another rule of thumb is representativeness. Kahneman and
Tversky carried out an experiment in which subjects were asked to
categorize individuals as a "salesman" or a "member of
parliament" on the basis of given descriptions. When a randomly
chosen individual was portrayed as interested in politics and
participating in debates, most subjects thought he was a member
of parliament, regardless of the fact that the relatively higher
share of salespersons in the population increases the likelihood
that he was a salesman. Even after subjects were informed that
the proportions of members of parliament and salespersons in the
population had been altered substantially, it did not seem to
matter for the results.
Kahneman has thus demonstrated that in situations with
uncertainty, human judgment often exploits rules of thumb
which systematically contradict fundamental propositions in
probability theory. His most influential contribution, however,
concerns decision-making under uncertainty. A striking
finding is that individuals are much more sensitive to the way an
outcome deviates from a reference level (often the
status quo) than to the absolute outcome. When faced with
a sequence of decisions under risk, individuals thus appear to
base each decision on its gains and losses in isolation rather
than on the consequences of a decision for their wealth as a
whole. Moreover, most individuals seem to be more averse to
losses, relative to a reference level, than partial to gains of
the same size. These and other results contradict predictions
from the traditional theory of expected-utility
maximization.
Not satisfied with having criticized standard theories of
decision-making under uncertainty, Kahneman and Tversky also
developed an alternative, known as prospect theory,
intended to provide explanations for empirical observations.
Prospect theory and its extensions can be used to better explain
behavioral patterns which appear to be anomalies from the
perspective of traditional theory: the propensity to sign up for
costly small-scale insurance for appliances; willingness to drive
many miles for a few dollars’ discount on a minor purchase,
but reluctance to do so in order to save the same amount on a
more expensive good; or resistance to lowering consumption in
response to bad news about lifetime income.
Two merging research
areas
Modern research at the border line between economics and
psychology has shown that concepts such as bounded rationality,
restricted self-interest and limited self-control are important
factors behind a range of economic phenomena. In particular,
insights from psychology have had a strong impact on contemporary
developments in financial economics. Why, then, has it taken such
a long time for these ideas to gain recognition in economic
research? One explanation is that experimental methods have only
recently permeated economics. As a result of experimental
research on the relation between price formation and market
institutions, a growing number of economists have begun to regard
experimental methods as indispensable research tools. Today, a
new generation of economists is the catalyst in a gradual
amalgamation of two previously distinct research traditions in
experimental economics and economic psychology. Daniel Kahneman
and Vernon Smith, the key figures within these traditions, have
contributed to an exciting renewal of economic research.
Links and further reading
| The Laureates | |
| Daniel
Kahneman Department of Psychology Princeton University Princeton, NJ 08544 USA www.princeton.edu/~psych/PsychSite/fac_kahneman.html |
US and Israeli
citizen. Born 1934 (68 years) in Tel Aviv, Israel. PhD from
University of California at Berkeley in 1961. Has held
professorships at Hebrew University, Israel, University of
British Columbia, Canada and UC Berkeley. Since 1993, Eugene
Higgins Professor of Psychology, and Professor of Public
Affairs at Princeton University, NJ, USA. |
| Vernon L.
Smith Interdisciplinary Center for Economic Science George Mason University 4400 University Drive Fairfax, VA 22030-4444 USA www.gmu.edu/departments/economics/facultybios/smith.html |
US citizen. Born 1927 (75 years) in Wichita, KS, USA. PhD from Harvard University in 1955. Professorships at Purdue University, University of Massachusetts and University of Arizona. Since 2001 Professor of Economics and Law, George Mason University, VA, USA. |
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