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Michael Lewis’s book, The Undoing Project: A Friendship That Changed Our Minds, published in 2016, is a nice introduction to behavioural economics for the non-technical reader.
Daniel Kahneman (1934), who won the Nobel Prize for Economics in 2002, and Amos Tversky (1937 – 1996) are the founders of behavioural economics: their work persuaded the young Richard Thaler, who received the Nobel Prize in 2017, to adopt the same line of research. Behavioural economics applies psychology to the study of economic decisions. Robert Shiller, whose work on behavioural finance was awarded the Nobel in 2013, hails from the same school of thought. The two earlier “behavioural” winners shared the Prize with “orthodox” economists – Kahneman with Vernon Smith, Shiller with Eugene Fama and Lars Peter Hansen – as if the Swedish Academy of Science wanted to balance the two alternative points of view. On the contrary Thaler was the only winner, signalling a clearer message from the Academy about the value attributed to behavioural economics.
Lewis has written a fine book on the intellectual adventures of Kahneman and Tversky, examining their early studies, the prevailing views on rationality in economics prior to their research, their innovative contributions, their friendship, and what came after behavioural economics.
Training and Education
Daniel and Amos graduated in Psychology from the Hebrew University of Jerusalem and completed PhD programmes at the Universities of Berkeley and Michigan, respectively. As Lewis recalls, at the start of their academic careers they worked in different fields. Daniel was interested in perception, optical illusions, how our senses interpret reality and how they can fool us. Amos, on the other hand, was a psychologist come mathematician. In the 1960s, he was working with some American scholars on the ‘Foundations of Measurement’, a series of theoretical volumes containing a succession of axioms and theorems. The collaboration between Amos and Daniel began as a result of their dissatisfaction with the ways in which the dominant economic theory handled decision-making in conditions of risk.
Economic Rationality Before Kahneman And Tversky
Economics has traditionally viewed individuals as rational beings; people can decide what they want and order possible alternatives based on a logical approach, for example according to the transitivity of preferences: if alternative A is preferred to B, and B to C, then A must be preferred to C. When have to take a risky decision, such as placing a wager, individuals can calculate its expected value: this is the sum of the possible outcomes of the bet, in other words of the winnings and losses, multiplied by the probabilities. Assuming that U(x)=x, if I’m offered a wager that involves tossing a coin in the air and I’m told if it’s heads you win €100 and if it’s tails you lose €50, the expected utility is 100 x 0.50 + (– 50) x 0.50 = 50 – 25 = 25. This axiomatic approach was codified in 1944 by John von Neumann and Oskar Morgenstern in the classic work Game Theory and Economic Behaviour.