The question of who gets the Nobel Prize, why and when, has been the subject of some interesting controversies over the years. As a young man I remember reading a novel called The Prize by Irving Wallace which went into the various issues surrounding this perhaps most prestigious laurel. I think the book was made into a film, starring Paul Newman.
It is very difficult for the Nobel Prize people to avoid criticism, of course. They have only so many prizes to give and the aspirants are many. It's the same thing with the Academy Awards. My favourite film is nearly always ignored and, if not, it certainly doesn't get as many awards as it deserves.
It happened in the past and will no doubt happen again. Generally, though, the laurel goes to the deserving, otherwise the institution concerned loses credibility. The Nobel Prize retained its prestige because, while not all the deserving get it, at least those who do merit it. This year's Nobel Prize in economics is certainly no exception.
The big title is "The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 2002" and it went to Daniel Kahneman and Vernon Smith.
Back at Tal-Qroqq, we folks who studied the social sciences used to feel a little fuzzy when debating with students in science or the law.
We never seemed to be so decisive and clear. The others seemed to talk black on white while we wallowed in grey. Their answers were clear-cut while ours were full of "ifs and buts".
That is why they used to dominate il-Kunsill. One understood this in so far as the white coats were concerned, but with lawyers, well, one would have thought they had a lot of grey in their subjects.
What we social science fudges had not realised then was that, while the scientists were buttressed by experiment, the lawyers always took one side or the other (defendant or plaintiff) and therefore saw things clearly while we were seekers after truth, as uncertain as Socrates.
It was when we learned of Vernon Smith's work that we started holding up our heads. All of a sudden we had experiment on our side too.
Smith, currently of George Mason University, in the United States, was one of the pioneers who introduced experiments into economics. An economist makes predictions based on theory and what Smith contributed was a body of knowledge as to how one goes about empirically testing these predictions.
Let us take a simple example. According to the theory, as the price of a service increases, less is demanded. Is this true in the real world?
A number of experiments were made to test this, including one involving the provision of medical services on a university campus. It started off with free medical services in the main student building, then free services five minutes' walk away, then one had to pay a dollar, then two, etc.
As the price (or inconvenience) increased, demand fell off. The initial very small fee cuts off a lot of the initial demand, including the frivolous.
In practice, a lot of practitioners get to know of Vernon Smith's work because of his studies on auction methods and his so-called "wind-tunnel" experiments. Take a government wanting to sell third-generation telecommunications licences. It wants to know which form of auction to use - there are four basic types - and also have a trial run in the laboratory, to see how the bidding is likely to develop. Smith's work in this area was not only fascinating but of great practical significance.
I first learned of Daniel Kahneman while studying at the University of British Columbia in Vancouver because, after Hebrew University, he held a professorship there and the professors used to refer to his work.
Kahneman did a lot of important work with Amos Tversky but the latter died in 1996 and the only way someone can get a Nobel Prize posthumously is if one died after being announced a winner but before the ceremony (which, if you think about it, is not so far-fetched!).
Kahneman's work is of fundamental importance and, indeed, he and his colleagues started a new area of economics and finance. I had occasion, some time ago, to write about behavioural finance here and the way it is changing investment management by injecting psychology into economic science.
The building blocks of the theoretical world of economics is Homo Economicus who acts exclusively in self-interest, is rational, calculating, etc. Kahneman and Tversky challenged precisely this assumption.
They found, for example, that decision makers often made use of heuristic shortcuts, that they decide on the basis of what, from experience and hearsay, they have found out (or think they have found out) for themselves, in other words, that they often decided by using rules of thumb rather than logic. This sometimes led decision makers to take decisions which went against the odds.
For example, if you ask someone: in Malta, is one more likely to die of Aids, suicide or homicide? The person is likely to answer according to how many cases of each cause he or she can recall.
If you ask: do you think there are more policemen than nurses, the answer is again likely to depend on how many of each a person regularly meets. In such cases there are recall biases.
Another bias has to do with representativeness. Take a share which has done very well during the last three years and one other share that has done poorly. If you ask an investor to guess the next three years' performance, he or she is likely to expect the good performer to perform better than the bad.
This is not borne out by statistical studies of the market since past poor performers usually do better than past good performers. The investor, therefore, is looking at what he or she is seeing (which is history), developing a mental rule of thumb, and applying it, without, for example, giving any weight to the commonly-observed behaviour of reversion towards the mean (i.e. that things tend towards the average).
Representativeness bias also comes in when we judge things and people by using stereotypes.
In the same way, Kahneman found that people do not distinguish sufficiently between small and large samples and assume, for example, that what happens to their family is going to happen to the country as a whole (but, often, not vice-versa).
People, in order to cope with the complexity of the world around them, have to simplify and this simplification leads to decision biases, and errors. People also deal with uncertainty in a way which contrasts with what mathematical probability suggests. Homo Economicus is not the Calculator-Man which classical economists assumed.
Kahneman and Tversky, in order to provide an explanation rather than just "criticise" investors' behaviour, came out with prospect theory. Their work in this area sheds light on various aspects of behaviour, for example, why consumers often penny-pinch on small purchase but show largesse when buying expensive goods. Especially interesting is their work on loss aversion where they show that the impact of a loss is about two and a half times greater than a gain of the same magnitude.
The Royal Swedish Academy of Sciences, in granting the Nobel Prizes in economics to Kahneman and Smith have recognised two individuals - three, considering Tversky - who have developed finance into a new direction and laid the foundation for experimental economics.