Daniel Kahneman and his works in Economics

The following points highlight the top two economic ideas of Daniel Kahneman. The economic ideas are: 1. Decision Making Under Risk and Uncertainty 2. Functioning of Markets and Experimental Economics.

Economic Idea # 1. Decision Making Under Risk and Uncertainty:

A behavioural scientist by training and temperament, Daniel Kahneman of Princeton University in New Jersey (U.S) brought to economic research quite a different bag of tools and insights from those of the technical economist.

As a social psychologist Kahneman has integrated insights from psychology into economics, “especially concerning human judgement and decision-making under uncertainty” said the Royal Swedish Academy of Sciences in its citation.

He was so impressed by the complete lack of connection between the statistical information and the compelling experience of insight that he coined a term for it: “the illusion of validity”. It was the first cognitive illusion he discovered. Kahneman is the great entrepreneur of controlled laboratory experiments, and for this methodological interest alone the economics profession owes him an immense debt.

A simple example of the discussion of the anomalous experimental results of decision-making under uncertainty can be found in D.Kahneman and A.Tversky’s work when they argue that there are biases in the perception of probability distributions.

Moreover, experimental psychologists like D.Kahneman, P.Slovic and A.Tversky do not accept that events, which are driven by stochastic processes, are stochastic by nature. Kahneman’s experiments in probability theory showed a shortsightedness in interpreting data that could explain large fluctuations on financial markets and other phenomena that elude existing models.

His assignment involved two tasks:

(i) There were personality dimension that mattered more in some combat jobs than in others,

(ii) To develop interviewing guidelines that would identify those dimensions.

D.Kahneman made a discussion about predictions and observations. Observation in the experimental psychological literature often reveals that laboratory experiments or clinical studies are more realistic than actual surveys.

He invented a statistical technique for the analysis of multi-attribute heteroscedastic data, which used to produce a complex description of the psychological requirements of the various units. By being able to control the environment, clinics avoid the pitfall of actual market observations.

Clinics can provide useful information about how the participants, say consumers, in a stipulated store react to change in the commodity price, product packaging, displays, price of competing products and other factors affecting the demand for a firm’s product.

Participants in the experiment can be selected so as to closely represent the socio-economic characteristics of the market of interest. In contrast to the conventional surveys, the clinical studies undertake the continuous monitoring of the psychological variables such as the attitudes, expectations and intentions of the participants.

The clinical method mimics the essential features of the real world situation. However, the sample of participants must necessarily be small because this procedure is expensive. Also, the results are questionable because participants are aware but they are in an artificial situation.

Unlike clinical experiments, which are conducted under strict laboratory conditions, market surveys can be conducted on a large scale to ensure the validity of the results and participants are not aware that they are part of an experiment. Nevertheless, clinical experiments are supplemented with market surveys.

He had devised personality profiles for a criterion measure, and now he needed to propose predictive interview. He developed a structured interview schedule with a set of questions about various aspects of civilian life which the interviewers were to use to generate ratings about different aspect of personality.

Economic Idea # 2. Functioning of Markets and Experimental Economics:

Vernon L. Smith of George Mason University in Virginia (U.S) laid the foundations for the field of experimental economics, demonstrating the importance of alternative institutions. Smith “established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms”.

The Royal Swedish Academy singled our Mr. Smith’s use of “wind tunnel tests”, where trials of new, alternative market designs are carried out in the lab before being implemented. That could be useful, for example, in deciding on deregulating electricity markets and the privatization of public monopolies. Vernon Smith shows how the “home made leverage theorem” is vulnerable to default risk.

In game theory, not all games are zero sum. Also negative-sum games are possible in which both parties loose. A two-person, non-zero sum game where the payoffs are negative is given by the “prisoner’s dilemma”. It has been found that the best strategy for playing the prisoner’s dilemma is a “tit for tat” behaviour, which can be summed by “do to your opponent what he has just done to you”.

That is, as long as your opponent cooperates, you cooperate. If he betrays you, the next time you betray him back. If he cooperates again, the next time you cooperate also. As viewed by Vernon Smith, controlled experiments with human participants have shown that such a tit-for-tat behaviour leads people to cooperate and reach a better outcome than with any other form of behaviour.

Experimental economics or the probing of human behaviour through laboratory experiments has recently gained popularity in analysing complex situations (such as game theory), where useful or practical and theoretical conclusions have been hard to obtain.

The experiments are conducted with volunteers, often college students, who are provided money to buy and sell a fictitious commodity with in a simple specified institutional framework. The participants are allowed to keep some of the money that they earn by acting in an economically rational way. For example, in a recent time Vernon Smith handed out several thousand dollars of his own money to a group of students participating in a stimulated stock market study, which provided very interesting results. One is that stock market or speculative “bubbles” occur regularly with in the experimental framework.

Traders seem to be carried away in a raising market and continue to bid stock prices up for past the expected dividend and price/earnings ratio of the stock-inevitably lead to an eventual crash. Smith’s experiments showed that imposing limits on price declines only postpones the crash and makes it deeper when it comes. Only the availability of futures trading seemed to reduce the size and duration of speculative bubbles.

These experimental results could have important practical implications in devising regulations to make stock market less volatile in the real world. Despite the very simple setting in which these experiments were conducted, their outcome closely mimics the actual stock market crash of 1987.