Laurels for an Odd Couple

A psychologist and a traditionalist share this year's Nobel

Daniel Kahneman isn't an economist, and that may be one big reason why he received a share of the 2002 Nobel prize in economics. Kahneman, 68, is a cognitive psychologist, and that training has allowed him to see how people really behave--not in the ultra-rational manner that the textbooks say they should. According to Kahneman and the late Amos Tversky, his longtime collaborator, homo economicus is shortsighted, overconfident in his predictive skills, and irrationally prone to buying insurance on cheap home appliances. In short, a lot like your dumb brother-in-law. By showing how people are bad at assessing probabilities, the Nobel selection committee said, Kahneman "has seriously questioned the empirical validity of one of the fundamentals of traditional economic theory."

It's a sign of good health and humility for economics that the profession--or at least the Nobel selection committee--is willing to grant its highest award to an iconoclastic outsider. Last year the award went to another group of challengers--George A. Akerlof, A. Michael Spence, and Joseph E. Stiglitz--who studied how markets can falter when buyers and sellers don't have the same set of information.

Perhaps to strike a balance, Stockholm awarded the other half of the 2002 Nobel to a strong believer in free markets, 75-year-old Vernon L. Smith. Smith, an economist at George Mason University in Fairfax, Va., pioneered the use of experiments to test economic theory. He concluded from his experimental auctions that people do behave rationally in buying and selling situations, as standard theory would predict. Smith "was the first to actually see the operations of supply and demand in a laboratory environment," says Charles R. Plott of California Institute of Technology, who has built on Smith's work. Ironically, Smith is such a believer in the rationality of markets that he took on Kahneman and Tversky in a 1991 article in the Journal of Political Economy, accusing them of "ignoring contrary interpretations and evidence over extended periods of time."

In a field as murky as economics, it is quite possible that Kahneman and Smith are both right, even though the two hold disparate views of how people behave. Plott argues that Smith is right about the collective behavior of people in market situations. Says Plott: "If you then look in detail at how individuals decide, you get into a much more speculative area, and that's where [Kahneman] presides."

Both men's work has had practical consequences. The research of Smith, Plott, and others has contributed to the development of auctions for privatizing public utilities, airwaves, and other assets, as well as auctions for selling government bonds and trading electricity and natural gas. It's clear, though, that auctioneering science remains imperfect--as the failure of California's poorly designed electricity markets shows.

As for Kahneman's work, economists are building on his insights to develop market mechanisms that correct for people's characteristic mistakes, much the way that eyeglasses correct for myopia. One promising effort is intended to increase the low personal savings rate in the U.S., which could doom many people to a penurious retirement. Richard H. Thaler of the University of Chicago and Shlomo Benartzi of the University of California at Los Angeles have created a program called Save More Tomorrow in which people commit to having part of any future salary increase put straight into their savings accounts. Since the raise never shows up in employees' take-home pay, they don't miss it when it goes into savings--an idea that dovetails neatly with Kahneman's work.

Alan B. Krueger, a Princeton University colleague of Kahneman, recalls that when the two co-taught a class in the early 1990s, Kahneman, who was raised and educated mostly in Israel, bragged that he had never taken an economics class in his life. Yet Kahneman's work, says Krueger, is "the direction economics is going." Mr. Smith may not agree, but clearly sometimes it's good to be an outsider.

By Peter Coy in New York

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