Daniel Kahneman was one of the founders of behavioural economics in the 1970s. His new book shows that he remains an indispensable thinkerby Emmanuel Roman / November 16, 2011 / Leave a comment
Taming the beasts: The Bulls and Bears in the Market (1879) by William Holbrook Beard
Thinking Fast and Slow
by Daniel Kahneman (Allen Lane, £25)
For a long time, economists have tried to deal with the problem of decision-making. Daniel Kahneman, in his new book Thinking Fast and Slow, argues that, until he and his colleague Amos Tversky started behavioural economics in the 1970s, economists had been misguided. And for better or for worse, he is mostly right.
Think of a person offered the following gamble. Flip a coin; tails wins £50 and heads, just as likely as tails, wins nothing. The “expected value” of the gamble—a central concept in microeconomic theory—is one half of £50 plus one half of zero, or £25. Being willing to pay £1 to play this game strikes most of us as sensible, but paying £49 seems foolish. Deciding how much to pay, why and when illustrates many of the problems surrounding decision theory.
This is not a new problem. In his 1670 work, Les Pensées, Blaise Pascal came up with the original framework for computing expected value on the basis of probabilities. Economic theory was built on that premise. People with different attitudes to risk act differently, but they are rational and maximise their own “utility” or the satisfaction they expect to get. The simplicity and symmetry of this framework allowed economists to build many models to deal with policy issues ranging from economic growth to the optimal allocation of resources.
However, something was missing, as shown in one of Kahneman’s examples. Suppose one flips the coin, but the player will either lose £100, or win £150. There is the same 50-50 probability and the expected value remains £25. But when faced with threat of a loss, people in real life react very differently and will modify their calculation of the expected value of the gamble. This is called “loss aversion” and many studies show one needs at least a £200 win to balance the fear of losing £100.
In the 1970s, Kahneman and Tversky published a series of papers that changed what economists believed about decision theory. The most famous is “Judgment under Uncertainty: Heuristics and Biases,” published in Science in 1974, and now taught in most economics doctoral programs. For his work in this area, Kahneman received the Nobel Prize in economics in 2002.
Discussing bias, Kahneman uses the following example:…