Chronicle of Higher Education - web daily - October 9, 2002
Nobel in Economics Goes to 2 Americans Who Brought Markets Into the Lab By DAVID GLENN
Two Americans have been awarded this year's Nobel in economic science for separate work that brought experimental methods to bear on economic behavior. Daniel Kahneman, of Princeton University, and Vernon L. Smith, of George Mason University, have pioneered new uses of empirical data to test the assumptions of formal models employed in neoclassical economics.
Mr. Kahneman is regarded as a founder of behavioral economics. He has used the tools of cognitive psychology to call into question neoclassical models' presumption that people or companies always make economic decisions on a rational basis. Mr. Smith, a leader of the field known as experimental economics, has developed ways to subject theoretical models of economic problems to laboratory simulations informally known as "wind tunnels" (in homage to the labs in which new aircraft designs are tested).
The economics prize, which is formally known as the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, was not one of the five awards created by the will of the Swedish inventor in 1895. The economics prize was established in his honor in 1968 by the Bank of Sweden. The two economists will share a prize of $1.08-million, and will travel to Sweden in December to receive the award.
Mr. Kahneman, who was born in Tel Aviv in 1934, is best known for his explorations of why people make consistent errors in reaching some decisions under conditions of uncertainty. His best-known insights derive from "prospect theory," which explores decision making in gambling scenarios. Contrary to the assumptions of neoclassical economics, which hold that economic actors will "maximize their utility" in a strictly rational way, Mr. Kahneman has found that people are systematically more averse to losses than attracted to gains.
He has further found that decision makers carry an implicit "reference point" for their gains and losses. If they feel they are below that reference point ("in the realm of loss"), they tend to accept much greater gambling risks, even when such risks are irrational -- "going for broke," in order to return to their reference point. Mr. Kahneman's 1979 article "Prospect Theory: An Analysis of Decisions Under Risk" (written with Amos Tversky, who died in 1996) is the most-cited article in the history of the journal Econometrica.
In one recent experiment, he and his colleagues gave mugs to half the students in a classroom. The students were told that the mugs were theirs to keep -- but, if they wished, they could trade in the mugs for a small amount of cash, up to $10, at the end of the class. Those students' behavior suggested that they valued their mugs at $7.12, on average.
The other students in the class were told to look at their neighbors' mugs. At the end of the class, they would be able either to collect a mug just like that or a small amount of cash, up to $10. In effect, the offer was identical to that made to the first group of students. But students in the second group behaved as if they valued the mugs at only $3.50. If the students' decision making were rational, according to the standard tenets of economics, there would have been no such discrepancy.
Mr. Kahneman attributes the phenomenon to "status quo bias." The students who were actually presented with mugs at the beginning of class found it emotionally difficult to give them up, and hence demanded more cash for them.
Mr. Smith, who was born in Wichita, Kan., in 1927, studied economics at Harvard University, where he was inspired by his teacher Edward H. Chamberlin's efforts to simulate market behavior by assigning his students to act as buyers and sellers in classroom experiments.
Mr. Smith expanded Mr. Chamberlin's methods in a 1962 article that assigned students to simulate a double oral auction, in which both prices offered to buy and sell are being shouted at the same time, mimicking the structure of real-world commodity markets. His early work found that auction behavior does in fact match the predictions generated by traditional economic theory: Prices converge around an equilibrium, even when buyers and sellers have no information about each other's "reservation prices."
In later empirical work, however, Mr. Smith and his colleagues discovered that the specific rules of real-world auction markets can have effects that had eluded formal economic theory. For example, if buyers are allowed to change their bids only every two minutes, instead of continuously, the market will converge toward its equilibrium much more slowly.
More recently, Mr. Smith has developed "wind tunnel" experiments that have tested competing mechanisms for assigning airport landing slots and competing models of deregulated energy markets.
The text of the Nobel announcement is available on the Nobel Foundation's World Wide Web site.
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<http://www.nobel.se/economics/laureates/2002/press.html>
Press Release: The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 2002
9 October 2002
The Royal Swedish Academy of Sciences has decided that the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, 2002, will be shared between
Daniel Kahneman Princeton University, USA
"for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty"
and
Vernon L. Smith George Mason University, USA
"for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms".
Psychological and experimental economics
Traditionally, much of economic research has relied on the assumption of a "homo ¦conomicus" motivated by self-interest and capable of rational decision-making. Economics has also been widely considered a non-experimental science, relying on observation of real-world economies rather than controlled laboratory experiments. Nowadays, however, a growing body of research is devoted to modifying and testing basic economic assumptions; moreover, economic research relies increasingly on data collected in the lab rather than in the field. This research has its roots in two distinct, but currently converging, areas: the analysis of human judgment and decision-making by cognitive psychologists, and the empirical testing of predictions from economic theory by experimental economists. This year's laureates are the pioneers in these two research areas.
Daniel Kahneman has integrated insights from psychology into economics, thereby laying the foundation for a new field of research. Kahneman's main findings concern decision-making under uncertainty, where he has demonstrated how human decisions may systematically depart from those predicted by standard economic theory. Together with Amos Tversky (deceased in 1996), he has formulated prospect theory as an alternative, that better accounts for observed behavior. Kahneman has also discovered how human judgment may take heuristic shortcuts that systematically depart from basic principles of probability. His work has inspired a new generation of researchers in economics and finance to enrich economic theory using insights from cognitive psychology into intrinsic human motivation.
Vernon Smith has laid the foundation for the field of experimental economics. He has developed an array of experimental methods, setting standards for what constitutes a reliable laboratory experiment in economics. In his own experimental work, he has demonstrated the importance of alternative market institutions, e.g., how the revenue expected by a seller depends on the choice of auction method. Smith has also spearheaded "wind-tunnel tests", where trials of new, alternative market designs - e.g., when deregulating electricity markets - are carried out in the lab before being implemented in practice. His work has been instrumental in establishing experiments as an essential tool in empirical economic analysis.
Read more about this year's prize:
* Information for the Public * Advanced Information (pdf) * Links and further reading
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Daniel Kahneman, born 1934 (68 years) in Tel Aviv, Israel (US and Israeli citizen). PhD from University of California at Berkeley in 1961. Since 1993, Eugene Higgins Professor of Psychology and Professor of Public Affairs at Princeton University, NJ, USA. www.princeton.edu/~psych/PsychSite/fac_kahneman.html
Vernon L. Smith, born 1927 (75 years) in Wichita, KS, USA (US citizen). PhD from Harvard University in 1955. Since 2001, Professor of Economics and Law at George Mason University, VA, USA. www.gmu.edu/departments/economics/facultybios/smith.html
The Prize amount: SEK 10 million, will be shared equally among the Laureates
Contact persons: Katarina Werner, Information assistant, phone +46 8 673 95 29, katarina at kva.se and Eva Krutmeijer, Head of information, phone +46 8 673 95 95, +46 709 84 66 38, evak at kva.se