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November 5, 2002

On Profit, Loss and the Mysteries of the Mind

By ERICA GOODE

"Kahnemanandtversky."

Everybody said it that way.

As if the Israeli psychologists Daniel Kahneman and Amos Tversky were a single person, and their work, which challenged long-held views of how people formed judgments and made choices, was the product of a single mind.

Last month, Dr. Kahneman, a professor at Princeton, was awarded the Nobel in economics science, sharing the prize with Vernon L. Smith of George Mason University. But Dr. Kahneman said the Nobel, which the committee does not award posthumously, belongs equally to Dr. Tversky, who died of cancer in 1996 at 59.

"I feel it is a joint prize," Dr. Kahneman, 68, said. "We were twinned for more than a decade."

In Jerusalem, where their collaboration began in 1969, the two were inseparable, strolling on the grounds of Hebrew University or sitting at a cafe or drinking instant coffee in their shared office at the Van Leer Jerusalem Institute and talking, always talking. Later, when Dr. Tversky was teaching at Stanford and Dr. Kahneman at the University of British Columbia, they would call each other several times a day.

Every word of their papers, now classics studied by every graduate student in psychology or economics, was debated until "a perfect consensus" was reached. To decide who would appear as first author, they flipped a coin.

Wiry, charismatic, fizzing with intelligence, Dr. Tversky was younger by a few years. Dr. Kahneman, as intellectually keen, was gentler, more intuitive, more awkward.

Together, the psychologists developed a new understanding of judgments and decisions made under conditions of risk or uncertainty.

Economists had long assumed that beliefs and decisions conformed to logical rules. They based their theories on an ideal world where people acted as "rational agents," exploiting any opportunity to increase their pleasure or benefit.

But Dr. Kahneman and Dr. Tversky demonstrated that in some cases people behaved illogically, their choices and judgments impossible to reconcile with a rational model. These departures from rationality, the psychologists showed, followed systematic patterns.

For example, the exact same choice presented or "framed" in different ways could elicit different decisions, a finding that traditional economic theory could not explain.

In an oft-cited experiment, the psychologists asked a group of subjects to imagine the outbreak of an unusual disease, expected to kill 600 people, and to choose between two public health programs to combat it.

Program A, the subjects were told, had a 100 percent chance of saving 200 lives. Program B had a one-third chance of saving 600 lives and a two-thirds probability of saving no lives.

Offered this choice, most of the subjects preferred certainty, selecting Program A.

But when the identical outcomes were framed in terms of lives lost, the subjects behaved differently. Informed that if Program A were adopted, 400 people would die, while Program B carried a one-third probability that no one would die and a two-thirds probability that 600 people would die, most subjects chose the less-certain alternative.

Over more than two decades, working together or with others, Dr. Kahneman and Dr. Tversky elaborated many situations in which such psychological "myopia" influenced people's behavior and offered formal theories to account for them.

They established, among other things, that losses loom larger than gains, that first impressions shape subsequent judgments, that vivid examples carry more weight in decision making than more abstract but more accurate information.

Anyone who read their work, illustrated, as one admirer put it, with "simple examples of irresistible force and clarity," was drawn to their conclusions.

Even economists, unused to looking to psychology for instruction, began to take notice, their attention attracted by two papers, one published in 1974 in Science, the other in 1979 in the economics journal Econometrica. Eventually, the psychologists' work provided the undergirding for behavioral economics, the approach developed by Dr. Richard Thaler.

In a recent conversation, Dr. Kahneman, who carries both American and Israeli citizenship, talked about what happens when psychology and economics meet.


Q. Did you set out to challenge the way economists were thinking?
A. We certainly didn't have in mind to influence economics.

In the first years, economists, and philosophers, too, were simply not interested in the trivial errors that we as psychologists were studying.

I have a clear memory of a party in Jerusalem around 1971, attended by a famous American philosopher. Someone introduced us and suggested that I had an interesting story to tell him about our research. He listened to me for about 30 seconds, then cut me off abruptly, saying, "I am not really interested in the psychology of stupidity."

Our work was completely ignored until our 1974 paper, which eventually had an impact on both economics and epistemology. Of course, we did not mind in the least because economists were not our intended audience anyway; we were talking to psychologists. It came as a pleasant surprise when others started to pay attention.
Q. Why is the rational model of human behavior so entrenched in economic theory?
A. There's a very good reason for why economics developed the way it did, and that is that in many situations, the assumption that people will exploit the opportunities available to them is very plausible, and it simplifies the analysis of how markets will behave.

You know, when you're thinking of two stalls next to each other selling apples at different prices, then you're assuming that the fellow who is selling them at too high a price is just not going to have customers.

So you get rationality at this level, and it buys a lot of predictive power by this assumption. When you are building a formal theory, you want to generalize that assumption, and then you end up making people completely rational.
Q. You and Amos Tversky are perhaps best known for prospect theory. Could you explain what this is based on?
A. When I teach it, I go back to 1738. In 1738, Daniel Bernoulli wrote the big essay that introduced utility theory. Utility really means pleasure more than anything else.

The question that Bernoulli put to himself was "How do people make risky decisions?" And he analyzed really quite a nice problem: a merchant thinking of sending a ship from Amsterdam to St. Petersburg at a time of year when there would be a 5 percent probability of the ship being lost.

Bernoulli evaluated the possible outcomes in terms of their utility. What he said is that the merchant thinks in terms of his states of wealth: how much he will have if the ship gets there, if the ship doesn't get there, if he buys insurance, if he doesn't buy insurance.

And now it turns out that Bernoulli made a mistake; in some sense it was a bewildering error to have made. For Bernoulli, the state of wealth is the total amount you've got, and you will have the same preference whether you start out owning a million dollars or a half million or two million. But the mistake is that no merchant would think that way, in terms of states of wealth. Like anybody else, he would think in terms of gains and losses.

That's really a very simple insight but it turns out to be the insight that made the big difference. Because, if that's not the way that people think, if people actually think in terms of gains and losses and not in terms of states of wealth, then all the mathematical analysis that has been done which assumed people do it that way is not true. It took us a long time to figure it out.
Q. What kinds of things does prospect theory explain?
A. I think the major phenomenon we observed is what we called "loss aversion." There is an asymmetry between gains and losses, and it really is very dramatic and very easy to see. In my classes, I say: "I'm going to toss a coin, and if it's tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?"

People want more than $20 before it is acceptable. And now I've been doing the same thing with executives or very rich people, asking about tossing a coin and losing $10,000 if it's tails. And they want $20,000 before they'll take the gamble.

So the function for gains and losses is sort of kinked. People really discriminate sharply between gaining and losing and they don't like losing.
Q. How did prospect theory influence economists?
A. Correcting Bernoulli's error was influential, because it was picked up by Richard Thaler, who started behavioral economics. We provided cover for behavioral economics, because the challenge to the rational model was taken seriously and presented in a way that readers of the work found compelling.

But it's not as if this has swept economics. It hasn't, and for very deep structural reasons, it's not going to. The rational model has a hold on economics, and it's going to stay that way. Behavioral economists fiddle with it, improving the assumptions and making them psychologically sensible. But it's not a completely different way of doing economic theory.
Q. One of the things you are studying now is well-being. Does this connect in any way to economics?
A. I would like to develop a measure of well-being that economists would take seriously, an alternative to the standard measure of quality of life.

We're attempting to measure it not by asking people, but by actually trying to measure the quality of their daily lives. For example, we are studying one day in the lives of 1,000 working women in Texas. We have people reconstruct the day in successive episodes, as recalled a day later, and we have a technique that recovers the emotions and the feelings. We know who they were with and what they were doing. They also tell us how satisfied they are with various aspects of their lives. We know a lot about these ladies.
Q. What are you finding out?
A. I'll give you a striking finding. Divorced women, compared to married women, are less satisfied with their lives, which is not surprising. But they're actually more cheerful, when you look at the average mood they're in in the course of the day. The other thing is the huge importance of friends. People are really happier with friends than they are with their families or their spouse or their child.

Q. Why would divorced women be more cheerful?
A. So far, I don't understand it, but that's what the data says.


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