A Nobel That Bridges Economics and Psychology

By DANIEL ALTMANOCT. 10, 2002

Correction Appended

Two Americans have won this year's Nobel award in 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, who is also a citizen of Israel, 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, Professor 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 -- saving the same $5. ''It took me several years,'' Professor Smith said at a news conference yesterday, ''to realize that the textbooks were wrong, and the people in my class were correct.''

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 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. Professor Smith originally set out to demonstrate how well economic theory worked in the laboratory, according to Richard H. Thaler, an economist at the University of Chicago who studies behavioral patterns. By contrast, Professor 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, Professor Kahneman and Mr. Tversky had begun to perform experiments with human subjects that suggested seemingly irrational wrinkles in behavior.

In a 1981 article, they reported 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, Professor 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.

Professor 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 his 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 Professor Roth and Professor 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 Professor 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. ''Many of the best and the brightest young graduate students are interested in these issues, and they're getting good jobs,'' Professor Thaler said. Universities in the United States, Europe, Israel and Japan have opened centers dedicated to behavioral and experimental economics in the last few years.

David I. Laibson at Harvard credited the rapidly rising interest in the subject to the strength of its science. ''The field is based primarily on work that reflects real people's choices,'' he said. ''In that sense, the findings have an inherent validity.''

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 in 1978.

Many economists' laboratory experiments use ideas about competitive interactions pioneered by game theorists like 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 Professor Nash and his counterparts envisioned.

At his news conference at Princeton yesterday, Professor Kahneman expressed regret that the recognition of the value of behavioral economics did not come quickly enough for Mr. Tversky to share in the recognition. The prize committee cited him in its news release, but Nobel prizes are not awarded posthumously. This award is the second time in recent years that a deceased researcher in economics has been mentioned by the committee. Fischer Black, one of the architects of a popular model for pricing options, received recognition when Robert C. Merton and Myron S. Scholes, with whom he collaborated, won the prize in 1997.

Unlike the five other Nobel Prizes, the award in economics was not set up by the will of Alfred Nobel, the Swedish inventor of dynamite who died in 1896. It has been awarded by the Royal Swedish Academy of Sciences, with sponsorship from the Bank of Sweden, only since 1968.