All too human
This year's Nobel prizes put man back at centre stage
BID farewell to the cold-hearted humans that, since Adam Smith's day, economists have used as their models. He (it is always a he) is particularly unlovable: selfish in the extreme, able to do sums in his head and an insufferable know-all. Now meet the new, sensitive homo economicus: he (she?) is more laid-back, relying on intuition and rules of thumb to make decisions, often without perfect knowledge.
This year's Nobel prize celebrates the ideas of Daniel Kahneman of Princeton University, who has built a career by reminding economists that their idealised subjects are all too human. The other winner, Vernon Smith of George Mason University in Virginia, has shown by experiments that, despite people's flaws, the perfect-world theories of university anoraks can work in the real world.
The awards, which combine the different work of two researchers at the crossroads of economics and psychology, mark a refreshing change for the Royal Swedish Academy of Sciences, which selects the winners. In recent years it seemed that most of the dismal science's giants had been spoken for, as the battle for most big economic ideas had already been won. Increasingly, the prize has gone to more abstract enthusiasms: game theory, statistics and monetary wizardry. Alfred Nobel's heirs even wanted to strip the economics prize of the family name, since so many winners did not share their anti-globalisation views.
How welcome then that Mr Kahneman, along with a colleague, Amos Tversky, who died in 1996, has made such an impact on the profession. Mr Kahneman is not even a traditional economist, but a psychologist. Yet his analysis of how humans make decisions when confronted by uncertainty and risk has created a new branch of economics. As a reward, their early work is cited in nearly every paper now written in the burgeoning fields of “behavioural” economics and finance.
Through experiments, they revealed that people look mostly to the information that surrounds them to understand how the world works, rather than having the unlimited knowledge hitherto assumed by ivory-tower economists. They also proved that people have a hard time working out the probability of future events. Another revelation is that answers to survey questions depend greatly on how they are phrased. If all this seems obvious, that just means you have not been trained as an economist.
Knowing that people get risks wrong has broad implications for public policy. For example, people tend to overestimate the probability of a nuclear-power disaster, and to underestimate the risks of being in a car accident.
Before Messrs Kahneman and Tversky came along, economists thought of human decisions in terms of expected utility: that is, the sum of the gains or wealth they think they will get from each possible future scenario, multiplied by its probability of occurring. But if people irrationally give greater weight to some scenarios than to others, their decisions will differ from the classical calculation. Observing this led Messrs Kahneman and Tversky to “prospect theory”, their greatest insight.
The best recent example of a failure to calculate risk is the stockmarket bubble. Insights from psychology show how people value the comfort of herds and are far more frightened of losses than inspired by potential gains. These weaknesses, say economists such as Robert Shiller, whose improbable bestseller, “Irrational Exuberance” (Princeton, 2000), foresaw the bursting of America's share-price bubble, can lead them to pay more for shares than any rational investor would.
Time for good behaviour
Do these findings mean that classical economics is useless? Economics is by no means a “hard” science. Most economists observe the world's economies from afar, and try to formulate theories to explain them. The laboratory experiments of physics and chemistry, or even psychology, seem inapplicable to market behaviour. How, after all, do you create a market in a test tube?
And yet. Although Mr Kahneman's experiments pointed out people's flawed assessments of many risks, Mr Smith's laboratory work proves that, in many market environments such as auctions, humans often behave exactly as rational economics would suggest. This may be because risks in most parts of market economies are not always as intractable as in Mr Kahneman's tests. Mr Smith's contributions have affected the design of large public auctions, for example for telecoms bandwidth, and have influenced policies of deregulation. A key insight was that laboratory volunteers needed enough incentives, specifically money, to behave as they would in the real world, and not just to try to please a kindly professor looking over their shoulder.
Known as the father of experimental economics, Mr Smith is hardly a household name. Yet, that may suit him just fine, since his experiments confirm that people entirely ignorant of economic laws (and indeed, of economists) often behave, even when there are few buyers and sellers, just as classical theory would predict. Another Smith (Adam) had a name for it: the Invisible Hand.