Biography of David Kahneman, 2002 Winner of the Nobel Prize in Economics

Daniel Kahneman, the winner of the 2002 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, was born in Tel Aviv on March 5, 1934. Kahneman was raised in Paris, France and Palestine, and, after a life altering childhood encounter with a German S.S. soldier, decided to major in psychology at the Hebrew University in Jerusalem. After graduating with a Bachelor of Science in Psychology and a minor in Mathematics in 1954, he served in the Israeli Defense Forces for four years, before moving to Berkeley, California to earn a PhD. in Psychology from the University of California, Berkeley, which he completed in 1961. Since receiving his doctorate, Kahneman has made numerous important contributions both in the field of psychology and in economics. He does state, however, that he has never taken a single class on economics.

Daniel Kahneman won half of the 2002 Nobel Prize in Economics "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty." (The other half of the prize was won by Vernon L. Smith, who was awarded "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms.")

Specifically, Daniel Kahneman is most well known for his idea of Prospect Theory, which he developed alongside Amos Tversky in 1979. Prospect Theory shows that people value losses and gains differently. Rather than valuing only absolute utility, Prospect Theory suggests that people tend to avoid losses because they are hurt by loss more than they profit from gains. For example, take the scenario of a person receiving two unexpected letters in the mail. One letter says that the person just won one hundred dollars, while the other states that the person, for whatever reason, owes one hundred dollars. Expected Utility Theory states that the person would add up the gain and the loss, netting zero dollars, and end up with the exact same utility that they had before they received the unanticipated letters. However, Prospect Theory hypothesizes that while the person really is no better or worse off after reading the mail, the person will most likely feel worse off. Because losses have a larger impact than gains, according to Prospect Theory, the one hundred dollar loss would seem larger than the one hundred dollar gain, ultimately providing the recipient of the mail with a loss of utility, despite the fact that they actually have the exact same amount of money that they started out with. This is because people get utility and disutility not only from gains and losses of wealth alone, but from the actual process of gaining or losing as well. Graphically, this produces a curve, existing infinitely in the first and third quadrants, that is concave in positive outcomes and convex in negative outcomes.

Kahneman and Tversky argue that because people see gains differently than they see losses, people go through a decision making process that maximizes their total utility based on the probability of obtaining a desirable outcome in situations involving risk (potential loss). Prospect Theory evaluates situations using the formula:

U = w(p1)v(x1) + w(p2)v(x2) + ... w(pn)v(xn)

Where U is total expected utility, x1, x2, xn are the potential outcomes and p1, p2, pn, are the probabilities of each of those potential outcomes.

One important aspect of Prospect Theory is that gains and losses are irrelevant without a beginning reference point (in the above graph, the origin serves as the reference point). This idea has a few implications to economic thought. First, is the idea that people act according to their frame of reference. This means that people make decisions based not only on their possible results, but based on their current state and how those results might affect that state. For example, a person with a thousand dollars might receive less disutility from a loss of a dollar than a person with one hundred dollars, because their beginning reference points are different. Similarly, a multi-billionaire might not get as much marginal utility from finding a ten dollar bill as somebody who works for minimum wage would.

Overall, Kahneman's work in incorporating psychology economics to explain why people value gains and losses differently is quite revolutionary and highly deserving of the Nobel Prize in Economics. Currently, Daniel Kahneman is a fellow at Hebrew University in Jerusalem and a faculty member at Princeton University in New Jersey.

Bibliography

"Daniel Kahneman". Wikipedia. (Accessed May 7, 2007)

"Daniel Kahneman - Autobiography". Nobelprize.org. (Accessed May 7, 2007)

"Prospect Theory". Wikipedia. (Accessed May 7, 2007)

"The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2002". Nobelprize.org. (Accessed May 7, 2007)