QUERETARO, Mexico, Oct. 9 (UPI) -- "Irrational exuberance" said Alan Greenspan, the chairman of the U.S. Federal Reserve in December 1996 about investors' willingness to bid up the price of shares. "Animal sprits" said John Maynard Keynes, the second most famous of all economists, when he accounted for the swings up or indeed down of the stock market. Yet the science of economics has traditionally done little to accommodate the irrational behavior of men or markets.
In traditional economic theory Homo economics, economic man, is rational. The new winners of the Nobel Prize for economics have addressed this problem, bringing some irrationality to the dismal science's view of mankind.
The two winners of the 2002 Nobel prize for economics awarded by the Royal Swedish Academy of Sciences are Daniel Kahneman and Vernon Smith, both professors at American universities. Kahneman was recognized by the academy as an economist who has drawn lessons from psychology in order to bring fresh insights into human judgment and decision-making. Smith, meanwhile, was an experimental economist who had found ways of testing economic models "in the laboratory."
Kahneman, of Princeton University, was born in Tel Aviv, Israel and is 68 years old. The academy commended him "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty."
Smith, a 75 year-old American, now with George Mason University in Fairfax, Virginia, and an adjunct scholar at the libertarian Cato Institute, was commended "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms."
Perhaps Kahneman's most central contribution to economic literature was his development, in association with the late Amos Tversky of Stanford University, of what was termed "prospect theory." The theory was derived from experiments in which people chose between pairs of gambles. What Kahneman and Tversky found is that people are "loss averse." They would rather not lose $100 than win $100.
This, to most of us, may sound entirely rational. But Kahneman and Tversky found further examples of this asymmetric decision-making, which show that people are generally not rational in their economic choices. People are unable to analyze complex decisions with uncertain consequences. They therefore rely on rules of thumb.
Kahneman's work, the Swedish academy said, has spawned efforts by many more economists to bring psychological insights into economic theory.
Smith, meanwhile, brought the "laboratory" to economic theory, testing theoretical predictions in experiments. One of the tests he and colleagues conducted was on different methods of conducting auctions. Smith's team found that a typical English raise-the-bid auction would tend to generate the same price for a seller as a so-called second-price auction, in which the bidder who offers the highest price in an auction of sealed bids actually pays the second highest price. In this case the "laboratory" experiment came up with the same answer as economic theory. But the experiment tended to disprove economic theory on the supposed equivalence of a Dutch auction --- in which the seller starts with a high price that he gradually lowers until a buyer is found --- and a first price auction in which the winning bidder is obliged to pay the price he himself offered in his sealed bid. Smith's tests found that the Dutch auction gained a lower price for the seller.
Smith moved on from this to evaluation mechanisms for privatization and public procurement of goods in what he termed a "wind tunnel." He has been involved in the design of energy markets in Australia and New Zealand.
The achievements of Kahneman and Smith are therefore to have broadened economics, drawing into the science the less rational workings of the human mind and of markets. To do the opposite, and bring reason to the human mind and markets, is likely to prove beyond the scope even of future Nobel prize-winners.
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