• July 30, 2014

Nobel in Economics Goes to 2 Americans Who Brought Markets Into the Lab

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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