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Two Americans Get Nobel Economics Prize

Have you ever spent $4 on gasoline driving to a warehouse store to save $3 on paper towels? Or bought an expensive service contract for an appliance that would be cheap to replace and probably won't break anyway? The last time you rented a car at the airport, did you purchase insurance at $20 a day "to be on the safe side?" (That's an annual premium of $7,300 by the way.)

Designing experiments that can explain why people can make such irrational economic choices in a theoretically "rational" marketplace helped Princeton University cognitive psychologist Daniel Kahneman win a share of the 2002 Nobel economics prize.

The prize, announced on Wednesday, went to Kahneman, whose work examines just how irrational economic decision-making can be, along with experimental economist Vernon Smith, whose experiments tested fundamental precepts of economic theory.

Smith, a Kansas-born, ponytailed professor of economics and law at George Mason University in Virginia, was honored for his work in establishing controlled laboratory experiments as a vital tool for understanding how financial, labor and product markets work.

Kahneman, born in Tel Aviv in 1934, a U.S. and Israeli citizen and professor of public affairs at Princeton University, was honored for using insights gained from psychological research to challenge the traditional economic theory that self-interest and rational decision-making govern people's economic choices.

Smith told a press conference that he hadn't expected the Nobel Prize, but was very happy that his friends who had been predicting that outcome for 22 years had "finally got it right."

Kahneman, the first Israeli to win the Nobel economics prize, said he was "much honored" by the prize, but saddened that he could not share the honor with his friend and colleague Amos Tversky, with whom he developed his influential approach to the study of judgment and decision-making. Tversky died in 1996.

"The award is given largely for work that I did many years ago with my close friend and colleague, Amos Tversky, who died in 1996," Kahneman said. "The thought of his missing this day saddens me."

"For a long time, economics based its models on the idea that people act rationally," said Nicholas Barberis, associate professor of finance at the University of Chicago's Graduate School of Business. "It's a simple way to view the world, but Daniel Kahnemann has shown us ways in which people don't act rationally."

Kahneman -- in collaboration with the late Amos Tversky -- showed that people are incapable of fully analyzing complex decision situations when the future consequences are uncertain, relying on short cuts or rules of thumb instead.

The studies developed the idea of representativeness, in which people are too quick to see patterns in data that are actually random. For instance, an investor may conclude that a fund manager who beat a benchmark index two years in a row is systematically more competent than average investors, whereas the true statistical implication is much weaker.

The studies also developed the concept of availability biases.

"The idea is when people try to figure out how likely something is, they scan through their memory," said the University of Chicago's Barberis. "But recent and salient events are always more memorable. So if you have a friend who was recently mugged, you're more likely to believe that your city is dangerous, just because it's a salient event that stands out in your mind."

Such studies have led to a lively area of research known as behavioral finance which applies psychological insights in an attempt to understand the functioning of financial markets. And a new generation of economists is gradually joining two previously distinct research traditions in experimental economics and economic psychology in which Smith and Kahneman, respectively, were key figures.

Alongside his research, Kahneman co-teaches "Introduction to Psychology," better known as "Psych 101." at Princeton.

"He likes introducing students to the field," said Deborah Prentice, chair of Princeton's Department of Psychology.