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Two Americans To Share Nobel Prize In Economics

Washington Post
Page A03
Steven Pearlstein
October 10, 2002
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George Mason's Smith, Princeton Professor Win

The Nobel prize for economics yesterday went to two Americans, including a recently recruited professor at George Mason University, for work that has brought psychology and laboratory experimentation to the forefront of economics.

Vernon L. Smith, 75, a professor of economics and law at George Mason, will share this year's $1 million prize with Daniel Kahneman, 68, a psychologist at Princeton University who is the second non-economist to win the award.

Smith was cited for pioneering work in using carefully controlled laboratory experiments to test and ultimately tweak some of the basic theories on which standard economics is based. Among his most important findings is that some markets can work more efficiently if buyers and sellers have less rather than more information about each other's strategies and preferences, perfecting the game theory work done by an earlier Nobel winner, John F. Nash, who was the subject of the recent movie "A Beautiful Mind."

"What we found is that people don't have to know anything but their own needs and circumstances for markets to work efficiently," Smith explained yesterday.

Using techniques he developed, Smith and other experimental economists have used laboratory experiments to help design markets used to allocate landing slots at airports, sell spectrum to telecommunications firms, create a system for trading pollution rights and match law clerks and medical residents with judges and hospitals.

"Vernon took what had been a field science and transformed it into a laboratory science," said Charles R. Plott, another experimental economist at the California Institute of Technology.

Smith's prize was also a major coup for George Mason, at one time a suburban satellite of the University of Virginia system that has recently embarked on a campaign to pull itself up into the ranks of prestigious research universities by attracting academic stars, often late in their careers.

Last year, GMU lured Smith and six of his colleagues -- essentially, Smith's entire "Economic Science Laboratory" -- from the University of Arizona to the Fairfax County campus, where they joined an earlier recruit, James M. Buchanan Jr., who also received a Nobel prize in 1986 for his work on the theory of public choice.

The presence of Smith and Buchanan gives a conservative cast to the GMU economics department. Work by both has tended to support the notion that markets, while not perfect, are better at allocating resources and solving problems than various forms of government regulation.

By contrast, Kahneman and the growing band of behavioral economists have focused attention on the imperfections and failures of markets caused by consumers who behave irrationally rather than in the utility-maximizing fashion assumed by standard economic theory.

Kahneman and the late Amos Tversky, both Israeli-born psychologists, are best known for their own set of laboratory experiments, which showed that people care twice as much about avoiding losses as they do about making gains. Their "prospect theory" helped explained why people hold on too long to losing stocks in their portfolio or pay way too much to insure themselves against small losses.

Prospect theory also showed how downright silly people tend to be when dealing with odds and probabilities. In one famous experiment, Kahneman and Tversky told people about a woman named Linda who was a radical activist in college. Then they asked which was more probable: (a) that Linda is now a bank teller or (b) Linda is a feminist bank teller. The vast majority went with the feminist bank teller, which is clearly wrong: Even if there is only a 1-in-1,000 chance that Linda is anti-feminist, the probability of (a) will always be greater than (b).

Other Kahneman experiments revealed that people put a much higher value on something they already own than they would pay for the same thing if was offered for sale. And Kahneman found that notions of fairness affect economic decisions: Consumers will accept the idea of 2 percent discount for paying cash but get up in arms when asked to pay a 2 percent surcharge for credit card purchases, even though the policies essentially amount to same thing.

"Danny has a fantastic intuition about human behavior," said Richard H. Thaler, an economist at the University of Chicago who has collaborated frequently with Kahneman. "He also has an uncanny skill to boil a problem down to its essence and run an experiment that makes it look so simple."

While Kahneman was hardly the first person to note that economic actors are not always rational, he was among the first to show that the ways in which they are irrational can be predicted and quantified in ways that economists can now incorporate into more refined economic models.

Kahneman doesn't like using the term "irrational" because of the implication that people are stupid.

And while tendencies such as risk aversion may cause people to systematically overpay and misinvest, the 2002 Nobel laureate noted they may also explain why human beings still walk the earth while species known to have been much more prone to taking risks are now extinct.

Unlike the other awards in physics, chemistry, literature and peace, which were established by the will of Swedish industrialist Alfred Nobel in 1901, the economics prize was established in 1968 by the Bank of Sweden in Nobel's memory.

© 2002 The Washington Post Company