The Nobel Prize

Daniel Kahneman (b. 1934)

Daniel Kahneman was born in Tel Aviv (now in Israel) in 1934 while his mother was visiting family there. His parents were Lithuanian Jews who had emigrated to France in the early 1920s and Kahneman spent his childhood in Paris. Following the German invasion the family fled to Vichy France, though not before Kahneman’s father had been interned for a time in the notorious Drancy transit camp. After the war, Kahneman moved to Palestine with his mother and sister. His father had died of diabetes a short time before the Allied invasion of Normandy (Nobel Foundation, 2004).

Kahneman’s decision to become a psychologist rested on his youthful interest in questions about faith, human existence and morality. Interestingly, the vocational guidance he received before university suggested that he should study psychology, but economics came a close second. He was awarded a BA in psychology and mathematics at the Hebrew University, Jerusalem in 1954 and a PhD in psychology from the University of California, Berkeley in 1961.

Kahneman was a visiting scientist in the Department of Psychology at the University of Michigan in 1965–66 and Lecturer in Psychology at Harvard University in 1966–67. He worked at the Applied Psychological Research Unit at Cambridge University in 1968–69. Between 1970 and 1978 he returned to Jerusalem and was first associate professor and then professor at the Hebrew University. In 1978 Kahneman was appointed Professor of Psychology at the University of British Columbia, a post held until 1986. Between 1984 and 1986 he was also an associate fellow of the Canadian Institute for Advanced Research. From 1986 until 1994 Kahneman was Professor of Psychology at the University of California, Berkeley. In 1991–92 he was also a Russell Sage Foundation Visiting Scholar. Kahneman is presently Eugene Higgins Professor of Psychology and Professor of Public Affairs, Woodrow Wilson School; both posts are at Princeton University and have been held since 1993. He is also a fellow at the Center for Rationality at the Hebrew University, a post held since 2000.

Kahneman’s awards and distinctions – of which there are more than 20 on his CV at the time of writing – include the award of the Warren Medal by the Society of Experimental Psychologists and the Hilgard Award for Lifetime Contributions to General Psychology, both in 1995. In 2002 he received a Career Achievement Award from the Society of Medical Decision Making and, jointly with Amos Tversky, the Grawemeyer Prize in Psychology. In the same year he was awarded the Nobel Memorial Prize in Economics ‘for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty’ (Nobel Foundation, 2004).

Kahneman’s work has focused on aspects of bounded rationality. It has contributed to a deeper and more satisfactory understanding of decision making by economic agents. Kahneman has demonstrated the limitations of the economist’s traditional attachment to rational behaviour and offered an alternative model – prospect theory – in its stead. Much of Kahneman’s writing was done with Amos Tversky. At a press conference in Princeton to mark the announcement of the Nobel Memorial award, Kahneman acknowledged his debt in saying:

The work for which I’m honoured today is work I did collaboratively with a close friend and a very famous psychologist, Amos Tversky, who died in 1996. Certainly we would have gotten this together, and that’s one of the things that this means to me today. There is that shadow over the joy I feel.

In a highly influential paper in Science, Tversky and Kahneman (1974) identified a number of valuable heuristics commonly used by individuals to simplify complex tasks of judgement. Their insight was to show that these heuristics, although often leading to reasonable answers, also result in systematic and therefore predictable errors or biases. For economics, this means that assumed rationality is not otiose, rather it is limited in consistent ways: hence the notion of bounded rationality. The baby need not be thrown out with the bath water (see Kahneman, 2003).

Tversky and Kahneman considered three heuristics: representativeness, availability, and adjustment and anchoring, and explored a range of problems associated with each. For a fuller review than is given here, see Tversky and Kahneman (1974) and Rabin (2003) (see also Kahneman and Tversky, 1973; 2000 and Kahneman et al., 1982; 2002).

Representativeness involves judgements based on probabilities derived from the resemblance of objects, events or processes to one another: ‘For example, when A is highly representative of B, the probability that A originates from B is judged to be high. On the other hand, if A is not similar to B, the probability that A originates from B is judged to be low’ (Tversky and Kahneman, 1974, p. 1124). The problem is that representativeness does not encompass several criteria that are important for making probability judgements. One such criterion is identified by Tversky and Kahneman as ‘insensitivity to predictability’. This suggests that agents may make inaccurate numerical predictions on the basis of information inappropriate to the purpose of prediction. As an illustration, Tversky and Kahneman suggest that the image of a firm one receives may be suggestive of a predicted profit outcome: a high profit may be representative of a favourable image, a low profit representative of a poor image. But, if there is no information available that has a direct and necessary bearing on profit, there is no basis for different predictions: Tversky and Kahneman suggest that a uniform outcome – such as average profit – should be predicted for all firms.

A second source of bias associated with the representativeness heuristic reflects people’s insensitivity to the importance of sample size in making judgements. For example, Tversky and Kahneman (1974) found that subjects assigned the same probability of obtaining an average height of greater than 6 feet to samples of 1000, 100 and 10 men. Rabin (2003) suggests that the tendency to overinfer on the basis of short sequences may provide insights into many economic phenomena. He argues that because we exaggerate the likelihood that, for example, a bad financial analyst will make one poor prediction in three forecasts, we also tend to incorrectly estimate the skill of an analyst who makes three accurate forecasts: ‘people … come to believe in much more variation in skill than in fact exists; somebody who makes successful investments three years in a row may be labelled a financial genius, when in reality she was just lucky’ (ibid., p. 162).

When people assess the probability of an outcome or the size of a class with given properties by the ease with which concomitant events or classes can be recalled to mind, they are using a judgemental heuristic that Tversky and Kahneman call ‘availability’. As with representativeness, this is a potentially useful means of estimation but because it is influenced by factors beyond probability or the frequency with which a class occurs, it too can lead to predictable biases. Among several examples, perhaps the most evident are those arising from the ‘retrievability of instances’. Tversky and Kahneman use this phrase to describe judgements in which more striking evidence is accorded disproportionate weight. For example, one might explain the moral panic over asylum seekers in the UK in 2003 by reference to the disproportionate and sensationalist media coverage of this matter, and the marginalisation in the public mind of, by any objective account, more serious economic and social issues such as drug use.

A third heuristic – adjustment and anchoring – is used when people form estimates on the basis of an initial value to which some adjustment is made to produce a final value. Tversky and Kahneman point out that because, typically, adjustments are insufficient, estimates are biased towards starting values. They call this tendency ‘anchoring’. An example of the kinds of bias that can arise from anchoring concerns misperception of the significance of conjunctive and disjunctive events. Tversky and Kahneman take planning as an instance of a conjunctive process. In the development of a new product a series of events must happen but ‘even when each of these events is very likely, the overall probability of success can be quite low if the number of events is large’. The result is that estimates of the probability of conjunctive events and that the product will therefore succeed tend to be unjustifiably optimistic. On the other hand, risk evaluation in the context of disjunctive events can lead to the underestimation of risk. Tversky and Kahneman take the example of a nuclear reactor as a complex system dependent on many essential components. The probability that any one component will fail may be low but reactor catastrophe is more likely the greater the number of components involved. Anchoring shifts perceptions onto the likelihood of failure in disjunctive components and therefore the probability of failure tends to be underestimated. Tversky and Kahneman draw the general implication that the direction of anchoring bias may be inferred from the structure of the event: ‘the chain-like structure of conjunctions leads to overestimation, the funnel-like structure of disjunction leads to underestimation’.

In Kahneman’s view, the importance of the Science paper on heuristics was that it engaged the interest of scholars in other disciplines such as economics and philosophy. He also thinks that the paper became so influential not simply because it offered a means to critique the rational-agent model but also because of the way it was written. Directly citing in the text the single question and answer method he and Tversky used to explore human judgement made for a more compelling message than would have a drier more discursive approach. Kahneman also acknowledges that he and Tversky found their wider audience in a rather fortunate way. They did not set out to develop an explicit critique of the rational-agent model. Their purpose was simply to present the evidence they had uncovered on judgement under uncertainty, others then used this as a means to reflect on the shortcomings inherent in rationality (see Nobel Foundation, 2004).

In what was to become a widely cited paper in Econometrica, Kahneman and Tversky (1979) offered what they called ‘prospect theory’ as an alternative to standard utility theory. Prospect theory provides more satisfactory accounts of the observed behaviour of economic agents. Whereas utility theory emphasises satisfaction based on levels of current consumption, prospect theory suggests that agents use references to, for example, past consumption to determine gains and losses in utility. It is the changes in consumption (or wealth) from given reference points that are the ‘carriers of utility’. Prospect theory indicates that agents are loss averse and that losses tend to be weighted twice as heavily as gains of the same size. According to Kahneman (Nobel Foundation, 2004), ‘Loss aversion is manifest in the extraordinary reluctance to accept risk that is observed when people are offered a gamble in which they might lose $20, unless they are offered more than $40 if they win’. Kahneman considers loss aversion to be his and Tversky’s most useful contribution to the study of decision making.

An interesting aside: why prospect theory? Kahneman relates that he and Tversky agreed on the name because it was ‘meaningless’. They supposed that the distinctiveness of the label would be its most valuable characteristic should the theory gain ground (Nobel Foundation, 2004).

An important dimension of loss aversion was identified by an economist, Richard Thaler (Thaler, 1980). This – the endowment effect – suggests that people become more attached to an item of wealth once they own it. Thaler illustrated the endowment effect using the example of the owner of a bottle of vintage wine who would refuse to sell it for $200 but would not pay $100 to replace it if it was smashed (cited in Nobel Foundation, 2004). The point being that ownership of the bottle increases its perceived value. Once the good is lost, its value premium disappears. Jointly with Thaler and another economist, Jack Knetsch, Kahneman published the results of experiments with real goods that confirmed the endowment effect and its roots in loss aversion (Kahneman et al., 1990). As Kahneman and others have pointed out, loss aversion working through the endowment effect can have important implications in economics: for example, in explaining the sluggishness of property markets when prices are low: owners are reluctant to sell when the market value does not match their own endowmentinflated valuation of their property (Rabin, 2003; and see Genesove and Mayer, 2001).

In continued collaboration with Tversky, Kahneman published work that demonstrated how the structure of equivalent sets of questions about a given problem could influence the choice of solution; this phenomenon is known as framing. Tversky and Kahneman (1986a) asked 152 subjects to choose between two public health programmes as responses to a hypothetical epidemic that is expected to kill 600 people. The first programme saves 200 lives. The second programme gives a one-third probability that 600 people will be saved and a two-thirds probability that no one will be saved. Seventy-two per cent of subjects preferred the first programme (see also Kahneman and Tversky, 1984).

A different group of 155 subjects was presented with an identical problem but framed in a different way: if the first programme is adopted, 400 people will die; if the second programme is adopted, there is a one-third probability that no one will die and a two-thirds probability that 600 people will die. In this case, 78 per cent of subjects preferred the second programme. In Kahneman’s view, the potency of framing demonstrates a boundary to both cognitive power and, by implication the rational-agent model. Rationality requires a consistent or, in Tversky and Kahneman’s phrase, an ‘invariant’ response to sets of questions such as those summarised above.

Kahneman has also published research that explores the perception of fairness in economic transactions (Kahneman et al., 1986b). Rabin (2003) suggests that this work illustrates the most important application of framing in economics: it explains aspects of money illusion. Rabin offers a simple example by way of illustration:

[A] nominal wage increase of 5 per cent in a period of 12 per cent inflation offends people’s sense of fairness less than a 7 per cent decrease in a time of no inflation. More generally, people react more to decreases in real wages when they are also nominal decreases, and react negatively to nominal price increases even if they represent no increase in real prices. (Rabin, 2003, p. 175)

Another aspect of Kahneman’s work explores the practice of ‘contingent valuation’. For example, in the questions around the provision of public goods, ‘the translation of attitudes into dollars involves the almost arbitrary choice of a scale factor, leading some people to state very different values of their willingness to pay, for no good reason’ (Nobel Foundation, 2004; and see Kahneman and Knetch, 1992; Kahneman et al., 1999).

Kahneman’s current research focuses on the study of ‘experienced’ utility – a Benthamite conception of utility (see, for example, Kahneman, 1994; Kahneman et al., 1997). Kahneman argues that because agents are not rational, they have no innate capacity for utility maximisation. Whether or not utility is maximised thus becomes a question open to empirical resolution; this has led Kahneman to explore new approaches to the measurement of well-being and welfare.

Main Published Works
(1973), ‘On the Psychology of Prediction’ (with A. Tversky), Psychological Review, 80 (4), pp. 237–51. (1974) ‘Judgment Under Uncertainty: Heuristics and Biases’ (with A. Tversky), Science, 185, pp. 1124–31.
(1979), ‘Prospect Theory: An Analysis of Decisions Under Risk’ (with A. Tversky), Econometrica, 47, March, pp. 263–91.
(1982), Judgment Under Uncertainty: Heuristics and Biases (ed. with P. Slovic and A. Tversky), Cambridge: Cambridge University Press.
(1984), ‘Choices, Values and Frames’ (with A. Tversky), American Psychologist, 39 (4), pp. 341– 50.
(1986a), ‘Rational Choice and the Framing of Decisions’ (with A. Tversky), Journal of Business, 59, October, S251–S278.
(1986b), ‘Fairness as a Constraint on Profit Seeking: Entitlements in the Market’ (with J. Knetsch and R. Thaler), American Economic Review, 76, September, pp. 728–41.
(1990), ‘Experimental Tests of the Endowment Effect and the Coase Theorem’ (with J. Knetsch and R. Thaler), Journal of Political Economy, 98, December, pp. 1325–48.
(1991), ‘The Endowment Effect, Loss Aversion and Status Quo Bias’ (with J. Knetsch and R. Thaler), Journal of Economic Perspectives, 5, Winter, pp. 193–206.
(1992), ‘Valuing Public Goods: The Purchase of Moral Satisfaction’ (with J. Knetsch), Journal of Environmental Economics and Management, 22, January, pp. 57–70.
(1994), ‘New Challenges to the Rationality Assumption’, Journal of Institutional and Theoretical Economics, 150, March, pp. 18–36.
(1997), ‘Back to Bentham? Explorations of Experienced Utility’ (with P.P. Walker and R. Sarin), Quarterly Journal of Economics, 112, May, pp. 375–405.
(1999), ‘Economic Preferences or Attitude Expressions? An Analysis of Dollar Responses to Public Issues’ (with I. Ritov and D. Schkade), Journal of Risk and Uncertainty, 19, August, pp. 220–42.
(2000), Choices, Values and Frames (ed. with A. Tversky), Cambridge: Cambridge University Press and New York: Russell Sage Foundation.
(2002), Heuristics and Biases: The Psychology of Intuitive Judgment (ed. with T. Gilovich and D. Griffin), Cambridge: Cambridge University Press.
(2003), ‘Maps of Bounded Rationality: Psychology for Behavioural Economics’, American Economic Review, 93, December, pp. 1449–75.

Secondary Literature
Genosove, D. and D. Mayer (2001), ‘Loss Aversion and Seller Behaviour: Evidence from the Housing Market’, Quarterly Journal of Economics, 116, November, pp. 1233–60.
Rabin, M. (2003), ‘The Nobel Memorial Prize for Daniel Kahneman’, Scandinavian Journal of Economics, 105 (2), pp. 157–80. Thaler, R. (1980), ‘Towards a Positive Theory of Consumer Choice’, Journal of Economic Behaviour and Organization, 1, March, pp. 39–60.
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