How Two Israeli Psychologists Changed
Economics
In March 1979 two Israeli psychologists
published an article entitled “Prospect Theory: An Analysis of Decision under
Risk” in Econometrica, one of the
most prestigious economics journals. That widely cited article established the
underpinnings of what became to be known as behavioral economics. Bestselling
author Michael Lewis lovingly tells the story of the decades long friendship
and intellectual collaboration between Daniel Kahneman and Amos Tversky.
Kahneman would go on to win the Noble Prize in economics in 2002 for their
joint work; Tversky being ineligible because he died prematurely in 1996 of
cancer.
Lewis is at his best when he discusses
their distinct personalities. Kahneman is an introvert and a pessimist. Tversky,
on the other hand, is an extrovert and optimist, yet they work together. They
also go to war together in 1967 and 1973 to defend the Israeli state. In fact
it is their experience in Israeli society in both peace and war enable them to
see the world more clearly. They did not live as all too many American
academics in cloistered cocoons. They are of the world and see the world as it
is and not as theory says it should be.
What Khaneman and Tversky do is to
convincingly demonstrate that human beings do not always act as rational
economic agents as economic theory would suggest and that individual errors do
not necessarily cancel out. They suggest that all too many times individuals
underestimate uncertainty by using short form rules of thumb, heuristics in their
words. Kahneman would later write a bestseller entitled “Thinking, Fast and
Slow” based on this premise. In contrast people sometimes overweight low probability
events. It is for this reason the same person might by an insurance policy and
a lottery ticket on the same day by over-estimating the likelihood of both
winning the lottery and their house burning down. Remember the expected value
of both the lottery ticket and the insurance policy is negative.
Lewis opens his book by discussing how
Daryl Morey, the general manager of the Houston Rockets basketball team uses
the principles of behavioral economics in selecting players. This is an obvious
follow on from his bestselling book “Moneyball” on the role of data in
baseball. Only after writing that book did Lewis realize that what he was
really writing about was the work of Khaneman and Tversky making it the genesis
of this book. Lewis goes on to discuss, in a very real and personal way, the
role of behavioral economics in medicine and government. I know I haven’t done
justice to the emotional interplay between Tversky and Khaneman and their
families that makes the book more than a history of their work. I will leave
that to the reader. “The Undoing Project:….” is well worth the read and I
highly recommend it.
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