The Nobel Memorial Prize for Daniel Kahneman
Author(s): Matthew Rabin
Source: The Scandinavian Journal of Economics, Vol. 105, No. 2 (Jun., 2003), pp. 157-180
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Scand. J. of Economics 105(2), 157-180, 2003
The Nobel MemorialPrize for DanielKahneman
Matthew Rabin*
University of California, Berkeley, CA 94720-3880, USA
[email protected]
I. Introduction
In an essay on his web page, Paul Krugman recommendsas his first rule of
researchto young economists that they "Listento the Gentiles.... Pay attention
to what intelligentpeople are saying, even if they do not have your customs or
speak your analyticallanguage."His own context for applyingthis principlewas
in understandingthat international-tradeeconomistsshould pay attentionto the
field of geography:"Geographersand regional scientistshave amassed a great
deal of evidence on the nature and importanceof localized externaleconomies,
and organizedthat evidenceintelligentlyif not rigorously."To urge an academic
disciplineto listen to its critics,and to embracethe insightsof another discipline
even when the languageand conceptualdifferencesbetweenthe disciplinesinvite
dismissal,is excellentadvice. It is rarelyfollowed. But it is even rarerfor critics
from one discipline to persistentlyand intelligentlyinsinuate themselves into
anotherdisciplineby making an effort to use a common languageand to minimize conceptual differences.Yet this is what two brilliantpsychologists, Daniel
Kahnemanand Amos Tversky,have done sincethe early 1970s.It is surelyone of
the biggestboons to the social sciencesin recentdecadesthat they have launched
this researchprogram so relevant for economics, doing so with an ability and
willingnessto addresseconomistsin economic languageand venues,and with an
emphasison the implicationsof their researchfor economic questions.In recognition of these contributions, Daniel Kahneman was awarded The Bank of
SwedenPrizein Economic Sciencein Memory of AlfredNobel in October2002.'
*I thank Jeff Holman for helpful comments, and Russell Sage, MacArthur, and National Science
Foundations for financial support. References to the research discussed in this article can be
found on Kahneman's web site, www.princeton.edu/~psych/PsychSite/fac_kahneman.html.
'As Kahnemanhimselfhas expressed,a shadow hangs over his awardof the Nobel MemorialPrizein
Economics:that Amos Tversky,Kahneman'scollaboratoron so much of his work, could not win the
awardwith him becauseof his prematuredeathin 1996.Few doubt that if Tverskywerestillalive,they
would have been awarded the prize jointly. As I review Kahneman's contributionsbelow, when
appropriate I shall refer to their joint work under both their names, and refer to Kahneman's
voluminousresearchby himselfand with other collaboratorsseparately.Also, for obvious reasons,I
emphasizein this essay Kahnemanand Tversky'scontributionand focus on economic theory. Their
researchis, in fact,muchbroader.Indeed,Kahnemanand Tverskyarealso the centralfiguresin another
line of social-scientificresearchthat started about three decades ago-the "cognitive"revolutionin
social psychology,which emphasizesthe role of cognition in people'ssocial beliefsand behaviors.
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158 M. Rabin
Daniel Kahneman's research presents a menu of important ways that
economics has traditionally misunderstood human behavior. He, Amos
Tversky, as well as another long-time collaborator, economist Richard
Thaler, have been useful gadflies, convincing economists (eventually) that
many of our assumptions are importantly misleading. But Kahneman and
these others have not just been a thorn in the side of economics; his research
provides the material to improve economics. A recent spate of research that
attempts to improve economic analysis by incorporating greater psychological realism into economic research has built fundamentally on his
findings. Even though we are only just beginning to incorporate many of
his insights, Daniel Kahneman has contributed as much as anybody else in
the last half century to improving our conception of human nature in
economic contexts.
In this essay, I review many of Kahneman's main contributions to economics. Although neither as distinct nor as exhaustive as the structure
implies, I do so by breaking them down into six categories. In Section II,
I discuss Kahneman and Tversky's research on heuristics and biases in
judgment under uncertainty. This research identifies the shortcuts in reasoning (heuristics) people use in making probability judgments, and identifies
broad classes of situations where such shortcuts lead to systematic errors
(biases).
Section III presents research by Kahneman and Tversky on how a person's status quo and other reference points strongly influence his tastes and
choices, with an emphasis on research demonstrating that people seem very
averse to even small losses relative to their reference points. I also discuss
Kahneman's closely related work with Jack Knetsch and Richard Thaler on
the "endowment effect." In Section IV, I discuss the implications for risky
choice of loss aversion and other factors that Kahneman and Tversky
(1979) incorporate into their notion of "prospect theory." This includes
their contribution to the literature on non-expected-utility that explores how
the "decision weights" people use to assess uncertain prospects are systematically different than actual probabilities, as assumed by expected-utility
theory. I also review the crucial role for risk attitudes played by what
Kahneman and Lovallo (1993) call "isolation errors," whereby people tend
to treat risky prospects separately rather than together.
In Section V, I review Kahneman, Knetsch and Thaler's research on
people's fairness judgments regarding economic behavior, identifying how
consumers react in judgments and in behavior to price increases and other
potentially unfair market behavior. In Section VI, I discuss Kahneman and
Tversky's research on framing effects and related phenomena that illustrates
the surprisingly strong ways in which the details of the phrasing or structure
of a choice problem can affect decisions. Some such framing effects raise
more fundamental questions about the very existence of stable, context-free
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The Nobel Memorial Prize for Daniel Kahneman 159
preferences.In Section VII, I discuss recent research by Kahneman exploring
the relationship between anticipated utility, recollected utility, and "true"
experienced utility, and more generally his perspective on the frequent difference between what people choose and what choices would bring them the
most experienced well-being.
Throughout the essay I identify some of the potential economic implications, pointed out by either Kahneman or subsequent researchers, of the
phenomena discussed. I conclude briefly in Section VIII.
II. Heuristics and Biases
Economics has traditionally assumed that, when making decisions under
uncertainty, people form subjective probabilistic assessments about the state
of the world derived correctly according to the laws of probability. Much of
Kahneman and Tversky's early research documents departures from rationality in judgment and decision-making under uncertainty. As Tversky and
Kahneman (1974) nicely frame their agenda,
"... people rely on a limited number of heuristic principles which reduce
the complex tasks of assessing probabilities and predicting values to
simpler judgmental operations. In general, these heuristics are quite
useful, but sometimes they lead to severe and systematic errors. The
subjective assessment of probability resembles the subjective assessment
of physical quantities such as distance or size. These judgments are all
based on data of limited validity, which are processed according to
heuristic rules. For example, the apparent distance of an object is determined in part by its clarity. The more sharply the object is seen, the closer
it appears to be. This rule has some validity, because in any given scene
the more distant objects are seen less sharply than nearer objects. However, the reliance on this rule leads to systematic errors in the estimation
of distance. Specifically, distances are often overestimated when visibility
is poor because the contours of objects are blurred. On the other hand,
distances are often underestimated when visibility is good because the
objects are seen sharply. Thus, the reliance on clarity as an indication of
distance leads to common biases. Such biases are also found in the
intuitive judgment of probability."
The analogy to visual perception in the above passage reflects Kahneman's
background: his earlier research was on visual perception, and the analogy
is one that appears as a repeated theme in his talks and writings. But it is
also a great metaphor for thinking about how economists should react to
research on judgmental biases. Perfect vision is not viewed by any scientific
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160 M. Rabin
discipline nor by traffic engineers as an axiom of human nature, and nobody
constructs a priori "methodological" reasons why systematic imperfections
in vision cannot exist, or must cancel out, or cannot be important in realworld situations, or are inconsistent with evolution. Optical imperfections
and illusions are a fact about human beings, and how and when they do and
don't matter should be studied as a matter of normal science. Likewise,
judgmental imperfections and illusions are a fact about human beings, and
how and when they do and don't matter should be studied as a matter of
normal science.
Kahneman and Tversky's research on judgmental biases is an especially
useful approach to bounded rationality for at least two reasons. First, they
stress not the existence of errors, but their predictable nature. We learn from
Kahneman and Tversky's research not merely that people aren't perfectly
rational, but rather how probability judgment departs from our standard
model. Second, despite emphasis on how people depart from the notion of
perfect rationality assumed by economists, the heuristics-and-biases paradigm very much acknowledges that people are intelligent and purposive in
their decision-making. In recent years, some economists have relaxed the
assumption of perfect rationality by investigating the opposite extreme of
complete agnosticism about how rational people are in novel situations. Just
as the assumption of perfect rationality does, this research provides useful
insights into boundary conditions. But for addressing certain important
economic questions, the most useful conception of "bounded rationality"
should embrace both the "bounded" and the "rationality"components. To
return to the vision analogy, the proposition that there exist widespread and
systematic visual illusions is wholly different than either the proposition that
everybody is blind or the proposition that there is no correlation between
what people think they see and what they actually see.
Probably the most important biases Kahneman and Tversky identified
are an array of related biases collected under the rubric of "the representativeness heuristic." If a man behaves more like a criminal (shifty eyes, etc.),
we think it is more likely he is a criminal. This is, of course, what Bayesian
updating tells us. Kahneman and Tversky and subsequent researchers
demonstrate, however, that people tend to over-use "representativeness"in
assessing probabilities. One implication of this is the tendency to under-use
base rates: If we see somebody who looks like a criminal, our assessment of
the probability that he is a criminal tends to under-use knowledge about the
percentage of people who are criminals. Similarly, if a certain medical test
always comes out positive among people with a rare disease, and only
occasionally among people without the disease, people tend to exaggerate
the likelihood of having the disease given a positive result. Given the rarity
of the disease, the total number of false positives may be far greater than the
number of true positives.
t
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The Nobel Memorial Prize for Daniel Kahneman 161
Tversky and Kahneman (1974) demonstrate base-rate neglect by showing
subjects various personality descriptions, then asking them to judge
the probability that each describes an engineer rather than a lawyer.
Some subjects were told that the description described a person chosen at
random from a group of 70 engineers and 30 lawyers; other subjects were
told a group of 30 engineers and 70 lawyers. It can be shown by Bayes' rule
that the odds that any particular description belongs to an engineer rather
than to a lawyer should be (0.7/0.3)2 5.44 times as high for people in the
first group as for those in the second group. Yet the two groups of subjects
produced virtually the same probability judgments, evaluating the probability overwhelmingly by the degree to which this description matched the
stereotype of a lawyer or engineer. The population proportions had a
statistically significant effect, but far smaller than the magnitude demanded
by Bayes' law.
An even more striking manifestation of base-rate neglect is the common
violation of the conjunction rule, a fundamental axiom of probability
theory: The probability that somebody belongs to both Categories A and
B is less than or equal to the probability that she belongs to Category B
alone. Kahneman and Tversky demonstrate what they call the conjunction
effect: When a description is representative of a person in Category A but
not of a person in Category B, people often judge it more likely that the
description matches somebody who falls into both Categories A and B than
into Category B alone. Tversky and Kahneman (1992, p. 297) illustrate this
effect by providing subjects with the following description:
"Linda is 31 years old, single, outspoken, and very bright. She majored in
philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear
demonstrations."
Subjects were then asked to rate the relative likelihood that eight different
statements about Linda were true. Two statements on the list were "Lindais a
bank teller" and "Linda is a bank teller and is active in the feminist movement." Over 85 percent of subjectsjudged it more likely that Linda was both
a bank teller and a feminist than that she was a bank teller. The description of
Linda made her seem like a feminist, so that being a bank teller and a feminist
seemed a more natural description, and thus more "representative"of Linda,
than simply being a bank teller. Or, to take a real-world (and Scandinavian)
example, subjects were asked to predict what would happen if Bjorn Borg
(then at the height of his dominance of professional tennis) reached the finals
of Wimbledon. Because good performance was more typical of Borg than
bad performance, subjects thought it more likely that Borg would lose the
first set but win the match than that he would lose the first set.
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162 M. Rabin
Tversky and Kahneman (1971) argue that another manifestation of the
representativenessheuristic is a bias they call "The Law of Small Numbers":
People exaggerate how often a small sample closely resembles the parent
population or underlying probability distribution that generates the sample.
We expect even small classes of students to contain very close to the typical
distribution of smart ones and personable ones. Likewise, we underestimate
how often a good financial analyst will be wrong a few times in a row, and
how often a clueless analyst will be right a few times in a row.
Belief in the Law of Small Numbers combines with the common lack of
belief in the Law of Large Numbers to lead people to expect close to the
same probability distribution of types in small groups as they do in large
groups. For example, Kahneman and Tversky (1982) asked undergraduates
how frequently more than 60 percent of babies born on a given day will be
boys in each of two hospitals, one where about 15 babies are born each day,
and the other where 45 babies are born each day. Equal numbers (22
percent) of subjects thought such days would be more frequent in the big
hospital as thought it would be more frequent in the smaller hospital, when
in fact it would be far more common in the small hospital (more than 15
percent of the time) than in the large hospital (less than 7 percent of the
time). Subjects did not see the relevance of the number of child births per
day, and presumably both exaggerated how often even a sample of 15 births
will closely resemble the 50-50 split distribution of sex one can expect for
large numbers of births, and underestimated how likely this was to be true
among 45 babies born.
The Law of Small Numbers leads to a range of errors that are likely to be
important for economics. For instance, when the underlying probability
distribution generating observed sequences is uncertain, it leads people to
over-infer the probability distribution from short sequences. This may be an
important explanation for many economic phenomena. Because we exaggerate how likely it is that a bad financial analyst making three predictions will
be wrong at least once, we exaggerate the likelihood that an analyst is good
if she is right three times in a row. Hence people will come to believe in
much more variation in skill than in fact exists; somebody who makes
successful investments three years in a row may be labeled a financial
genius, when in reality she was just lucky.
The tendency to over-infer from short sequences, in turn, leads to misperception of regression to the mean. Because we read too much into
patterns that deviate from the norm, we don't anticipate that further observations will look less deviant. As teachers, we exaggerate the extent to which
one good or bad performance on a test is a sign of good or bad aptitude, so
we don't expect exceptional performances to be followed by unexceptional
performances as often as they are. This can give rise to spurious explanations for observed regression. If a student performs well on a mid-term but
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The Nobel Memorial Prize for Daniel Kahneman 163
poorly on the final, teachers are prone to over-infer that the student has
slacked off. Such misperceptions can lead to all sorts of errors in the design
of incentives, and hence can influence organizational design.2
Besides representativeness, Kahneman and Tversky identified and provided evidence for other heuristic biases. A pervasive fact about human
judgment is that we tend to disproportionately weight salient, memorable,or
vivid evidence even when we have better sources of information. In Tversky
and Kahneman's (1973) formulation, "a person is said to employ the
availability heuristic whenever he estimates frequency or probability by the
ease with which instances or associations could be brought to mind." For
instance, our assessment of the danger of a given city (such as Walnut
Creek, CA) is likely to be too influenced by whether we personally know
somebody who has been assaulted, even if we are familiar with much more
relevant general statistics. Likewise, dramatic stories by people we know
about difficulties with a brand of car are likely to be overly influential even
if we are familiar, via Consumer Reports, with general statistics of the
reliability of different brands. In both of these cases and in many others,
the more salient information should have virtually no influence on our
beliefs in the face of much more pertinent statistical information. The
over-use of salient information is likely to be tremendously important
in many economic settings. It may, for instance, be fruitful to study its
implications in the context of the social-learning and social-contagion
models that are (rightfully) becoming important in economics.
Besides the biases that Kahneman and Tversky have themselves identified
and provided evidence for, research on other biases (e.g., the hindsight bias)
that are likely to be quite important for economics has benefited from the
more general research program to which they centrally contributed.3
Research on cognitive biases has been slow to penetrate economics, partly
because it is difficult to fold into standard economic models. But such
research has now begun-most notably, in the area of behavioral
finance-and is likely to provide insight in many domains where economic
actors make inferences subject to judgmental bias.
2Tversky and Kahneman (1974) themselves provide a colorful example of this. Flight-training
instructors observed that when they praised pilots for smooth landings, performance usually
deteriorated on the next landing; but when they criticized pilots for poor landings, performance
improved the next time. But randomperformance will lead to "deterioration"following a good
landing and "improvement" following a poor landing. These flight instructors developed a
wrong theory of incentives based on erroneous statistical reasoning.
3For a good introduction to the overall research program on heuristics and biases spawned by
Kahneman and Tversky, see the early edited collection, Kahneman, Slovic and Tversky (1982),
that served as a sort of early bible of the program, and the recent collection, Gilovich, Griffin
and Kahneman (2002), that presents much of the research since and takes stock of the progress.
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164 M. Rabin
III. Reference-basedPreferences and Loss Aversion
Humans are typically more sensitive to how an outcome contrasts with
reference levels than to the absolute level of the outcome itself. Kahneman
and Tversky (1979) stress that the salience of changes from reference points
is a basic aspect of human nature:
"An essential feature of the present theory is that the carriers of value are
changes in wealth or welfare, rather than final states. This assumption is
compatible with basic principles of perception and judgment. Our perceptual apparatus is attuned to the evaluation of changes or differences
rather than to the evaluation of absolute magnitudes. When we respond
to attributes such as brightness, loudness, or temperature, the past and
present context of experience defines an adaptation level, or reference
point, and stimuli are perceived in relation to this reference point (Helson
(1964)). Thus, an object at a given temperature may be experienced as hot
or cold to the touch depending on the temperature to which one has
adapted. The same principle applies to non-sensory attributes such as
health, prestige, and wealth. The same level of wealth, for example, may
imply abject poverty for one person and great riches for anotherdepending on their current assets."
The attentiveness to contrasts and changes is fundamental to human perception and cognition. In the context of utility theory, understanding that
people often feel the effects of changes and contrasts more intensely than
absolute levels suggests that instead of assuming utility at time t, ut, depends
solely on present consumption, ct, it may also depend on a "referencelevel,"
rt, determined by factors such as past consumption or expectations of future
consumption. Hence, instead of positing a utility function at time t of the
form ut(ct), utility should be written in a more general form, ut(rt,ct). While
the role of reference levels in decision-making is often inconsistent with fully
rational behavior, Tversky and Kahneman (1991) and others have shown
that many reference-level effects can be captured within the framework of
utility theory.
Kahneman and Tversky identified two pervasive ways in which reference
levels influence preferences and choice. First, people are loss averse: In a
wide variety of domains, people are more averse to losses relative to their
reference level than they are attracted to same-sized gains. Tversky and
Kahneman (1991) suggest that in most domains where sizes of losses and
gains can be measured, people value moderate losses roughly twice as much
as equal-sized gains. Second, people exhibit diminishing sensitivity: The
marginal change in perceived well-being is greater for changes that are close
to one's reference level than for changes that are further away. Kahneman
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The Nobel Memorial Prize for Daniel Kahneman 165
and Tversky (1979) argue that diminishing sensitivity reflects a more fundamental feature of human cognition and motivation:
"Many sensory and perceptual dimensions share the property that the
psychological response is a concave function of the magnitude of physical
change. For example, it is easier to discriminate between a change of 3
and a change of 6 in room temperature, than it is to discriminate between
a change of 13 and a change of 16. We propose that this principle applies
in particular to the evaluation of monetary changes. Thus, the difference
between a gain of 100 and a gain of 200 appears to be greater than the
difference between a gain of 1,100 and a gain of 1,200. Similarly, the
difference between a loss of 100 and a loss of 200 appears greater than
the difference between a loss of 1,100 and a loss of 1,200, unless the larger
loss is intolerable. Thus, we hypothesize that the value function for changes
of wealth is normally concave above the reference point... and often
convex below it.... That is, the marginal value of both gains and losses
generally decreases with their magnitude."
There is no doubt that the influence of the status quo and other reference
points on behavior will make itself manifest once researchers acquire the
models and the disposition to investigate it.
Kahneman and Tversky (1979) first introduced the concepts of loss
aversion and diminishing sensitivity in the context of risk preferences; I
discuss this in the next section. Another important consequence of
loss aversion (broadly defined) emphasized in the literature is the striking
endowmenteffect identified by Thaler (1980, 1985), and subsequently fleshed
out by Kahneman, Knetsch and Thaler (1990). Once a person comes to
possess a good, she immediately values it more than before she possessed it.
An experiment in the latter paper nicely illustrates this phenomenon. A
decorated mug (worth about $5) was placed in front of one-third of a
group of students. Prices at which the subjects were willing to sell their
mugs were elicited in a way that made it optimal for subjects to be truthful.
Other subjects were asked to give the minimal amount of money that they
would prefer to receiving that mug. (Careful subsequent experiments have
indicated that erroneous "strategic bargaining considerations" by subjects
do not explain the findings.) These two groups face exactly the same choice,
but differ in their reference level-for sellers, losing the mug is a loss, while
for "choosers"no loss is involved. The average selling price was about $7.00,
and the average exchange value for choosers was about $3.50. The difference in these amounts reflects an instantaneous effect of owning an object
on the valuation of that object. Such an endowment effect is usefully
conceptualized as a case of loss aversion. Individuals treat the endowed
mugs as part of their reference levels, and consider subsequently not having
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166 M. Rabin
a mug to be a loss, whereas individuals without mugs consider not having a
mug as remaining at their reference point.
The general notion that a person's sense of well-being is heavily influenced by past consumption, past experiences, expectations, and other reference points, is a major fact about human beings, and is gradually being
incorporated into economic modeling. Indeed, the endowment effect is
qualitatively similar to models of habit persistence developed by economists
such as Ryder and Heal (1973). While such models of habit formation
have gradually taken hold in economics, such research has yet to fully
recognize the nature of the situations and the scale of the effects identified
by Kahneman and others, and has not embraced the qualitative difference
in how people react to losses vs. gains. More than the general idea that
decisions and experienced well-being can depend on past consumption and
other reference points, this research shows that reference points ubiquitously influence decision-making-with potentially important economic
consequences.
A striking example was identified by Genesove and Mayer (2001), who
study the market for downtown Boston condominiums sold between 1990
and 1997 by sellers who originally purchased the houses after 1982. Because
there were major changes in the housing market due to booms and recessions, they were able to study the selling behavior as a function of the prices
at which houses were bought disentangled from the intrinsic value of the
houses, which in turn let them study the role of loss aversion in price-setting.
Regardless of whether Person A bought a house at a 10 percent higher price
than Person B because she happened to buy at a time when the housing
market averaged 10 percent higher prices, the new buyers will likely value
the house equally. Hence, otherwise identical sellers who happened to have
paid different prices for their houses should, if they do not feel loss aversion,
have identical selling strategies.4
Genesove and Mayer provide very strong evidence that loss aversion
matters a lot in the housing market, showing that the effect of the nonvalue-based purchase price on the initial asking price of sellers is dramatic:
Sellers who are selling their condominiums for a loss (in nominal terms)
relative to their buying price ask a significantly higher price than those
selling equally-valued homes without a loss. To use their illustrativeexample,
an occupant-owner whose house has declined in value by 20 percent since
purchase will initially ask for a price about 10 percent higher than an
occupant-owner selling a house of equal value who bought the house at a
price equaling its current value. Moreover, the excess pricing in eventual
sale price was similar in scale to the excess initial asking price; the initial
4By controlling for the outstanding loan compared to the value of the house, they show that
liquidity constraints cannot explain the correlation between selling and buying prices.
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The Nobel Memorial Prize for Daniel Kahneman 167
asking price by sellers is not simply quickly-abandoned wishful thinking.
Rather, sellers persisted in asking for higher prices than their non-loser
counterparts, and typically sold at a higher price, though they often sold
more slowly or not at all.
In the context of risky choice discussed in the next section, Odean (1998)
explores a very similar manifestation of prospect theory in investment
behavior: Investors in the stock market are reluctant to sell stocks at prices
lower than the prices at which they bought them, while much more willing
to sell stocks that gained since bought. He is able to clearly eliminate some
potential alternative explanations (e.g., tax incentives would push investors
in the opposite direction). Interestingly, the most promising alternative
explanation is the false regression-to-the-mean beliefs discussed in the previous section: Investors may have an exaggerated belief that losing stocks
are "due" for a rebound, and gaining stocks are due for losses.
Such examples barely scratch the surface of how reference dependence
and loss aversion affect economic behavior. As reviewed below, Thaler
(1980) and Kahneman, Knetsch and Thaler (1986) demonstrate that loss
aversion plays a very strong role in people's notion of fairness, and many
examples of framing effects revolve around loss aversion. Loss aversion is
implicated in the strong resistance to cuts in (nominal) wages, for instance,
and such attitudes are clearly economically important. The salience of losses
relative to the status quo is a big fact about human judgment, preferences,
and behavior, with pervasive implications for economics.
IV. Choice under Uncertainty
One of the earliest and most profound influences of Kahneman's research
on economics is in the domain of risk preferences. One of the most important and widely cited papers in economics of recent decades is Kahneman
and Tversky's (1979) "Prospect Theory: An Analysis of Decisions Under
Risk." This paper raised two central aspects of choice under uncertainty: (1)
The role of loss aversion and diminishing sensitivity in the valuation of
monetary gains and losses, and (2) How people do not weight risky prospects as a linear function of the probabilities of different outcomes. A third
component was more tacit in this and subsequent research on choice under
uncertainty, but just as central: (3) That people form their attitudes towards
different risky prospects in isolation rather than by assessing the aggregate
effects of their choices.
It was in the context of preferences over risky financial prospects that loss
aversion was first introduced. That the displeasure from a monetary loss is
greater than the pleasure from a same-sized gain is also implied by a
concave utility-of-wealth function, which economists typically use as the
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168 M. Rabin
explanation for risk aversion. What distinguishes loss aversion from conventional risk aversion is that the value function abruptly changes slope at
the reference level, so that people are significantly "risk averse" for even
small amounts of money. People dislike losing $10 more than they like
gaining $11, and hence prefer their status quo to a 50/50 bet of losing $10
or gaining $11. While such "first-order"risk aversion is widely observed,
the standard concave-utility function implies that people are close to riskneutral for small stakes. A "kink" in the utility function (illustrated in
Figure 1) is required to get such an attitude towards risk.
In the context of risk preferences over monetary outcomes, diminishing
sensitivity has a provocative implication: While people are likely to be
risk-averse over gains, they are often risk-loving over losses. For instance,
Kahneman and Tversky (1979) found that 70 percent of subjects report that
they would prefer a 3/4 probability of losing nothing and 1/4 probability of
losing $6,000 to a 1/2 probability of losing nothing and 1/4 probability each
of losing $4,000 or $2,000. The preferred lottery here is a mean-preserving
spread of the less-preferredlottery; hence, the responses of 70 percent of the
subjects are inconsistent with the standard concave utility-for-wealth
assumption. More generally, there is evidence that people often have riskseeking preferences over negative outcomes. Letting c be the wealth level
and r the reference wealth level, Kahneman and Tversky (1979) illustrate the
value function for gains and losses in Figure 1 that incorporates both loss
aversion and diminishing sensitivity.
The risk-loving behavior in losses is a weaker factor in risky choice than
loss aversion itself, and is probably also more tenuous and context-specific
than the risk aversion over gains. But it seems to be real, and has been
identified in a number of economic contexts.
A
U(r,c)
<
/
c=r
Losses
Gains
>
c-r
V
Fig. 1
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The Nobel Memorial Prize for Daniel Kahneman 169
Besides this value function, the second main element of Kahneman and
Tversky (1979)'s multi-faceted prospect theory is the fact that people do not
evaluate uncertain prospects in the linear-in-probabilities way conventionally assumed by economists. (This is similar in broad terms to the results
from other researchers in non-expected utility, such as the large volume of
research building from the "Allais paradox.") Kahneman and Tversky argue
that people maximize with respect to a monotonic non-linear function of
probabilities with the following properties: People ignore very low probability events, but among events they don't ignore, low probabilities are
overweighted, moderate and high probabilities are underweighted, and the
latter effect is more pronounced than the former. Kahneman and Tversky
have emphasized more than other researchers the interaction of decision
weights with the differential attitudes towards gains and losses. In particular, Tversky and Kahneman (1992) conclude that decision weights
and the value function combine to imply "a distinctive fourfold pattern of
risk attitudes: risk aversion for gains and risk seeking for losses of high
probability; risk seeking for gains and risk aversion for losses of low
probability."
The third important element in risky choice is something whose centrality
to understanding risk attitudes researchershave only begun to fully appreciate: That people assess risky prospects in isolation, rather than by aggregating them. Kahneman and Lovallo (1993) brought this issue into finer
focus, labeling them "isolation errors." The degree of risk aversion shown
over small-scale risks is wholly inconsistent with the degree of risk aversion
over large-scale risk. It is now recognized that the economists' model of risk
attitudes over money deriving from diminishing marginal utility of wealth
within the expected-utility framework cannot plausibly explain risk attitudes
over modest-scale risk aversion, since anything besides virtual risk-neutrality
over modest stakes implies that the marginal utility of wealth must be
plummeting at such a quick rate to make us absurdly (and counterfactually)
risk-averseover large stakes. Hence, the theory predicts virtual risk-neutrality
in all but very large-scale risks. Loss aversion, by contrast, can reconcile
behaviorally realistic degrees of aversion to small- and large-scale risks
by allowing (without invoking also-implausible wealth effects) different
curvature in the value function close to versus far away from the reference
level of wealth.
But loss aversion itself is not a sufficient explanation for such modestscale risk if we do not add an extra component. If people hate losses, but
tally their losses only in the long run, netting out all the small losses they
experience with all the small gains, then they would once more be de facto
risk neutral-since over time most of us face a sufficiently large number of
modest risks with positive expected value that if we accepted all such risks
we would come out ahead in the long run. Isolation errors are essential for
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170 M. Rabin
explaining the behavioral implications of loss aversion: People are averse to
even small risks because they evaluate losses one gamble at a time.
As an illustration of isolation errors, consider an experiment by Tversky
and Kahneman (1986). They asked subjects to "Imagine that you face the
following pair of concurrent decisions. First examine both decisions, then
indicate the options you prefer."Putting it in slightly simpler form than they
did, the choices were:
Choose between:
A: $240 for sure
B: (0.25 + $1,000, 0.75 $0)
Choose between:
C: -$750 for sure
D: (0.75-$1,000, 0.25 $0)
Eighty-four percent of subjects chose A over B and 87 percent chose D over
C-in accordance with the principles of diminishing sensitivity. But, combining subjects' choices for both decisions, 73 percent chose the combination AD, 11 percent chose AC, 14 percent chose BD, and 3 percent chose
BC. The problem with these choices is that AD is in fact a 75 percent chance
of losing $760 and a 25 percent chance of no change, while BC is a 75
percent chance of losing $750 and 25 percent of no change. BC is clearly
better than AD (and, in a group of 86 other subjects asked to choose
directly between the two, all chose BC). The fact that most people made
the choice AD when asked to choose separately clearly indicates that they
did not integrate the decisions-despite the use of the word "concurrent"in
the instructions, and the request to first examine both decisions. Indeed, in
groups of other subjects asked to make just one of the A vs. B or C vs. D
choices in isolation, 85 percent chose A over B and 86 percent chose D
over C, virtually the same as those choosing for both choices, suggesting
virtually none of the subjects in the first experiment were integrating the two
decisions.
This example is a form of framing effects of the sort I discuss later: two
different ways of eliciting a preference between AD and BC lotteries generated different choices. But isolation errors are central for understanding
risky preferences because they are central for explaining risk aversion over
modest stakes. They help explain a lot of important phenomena that
expected utility theory either has avoided trying to explain, or explained
incorrectly. In the first category is the pervasiveness of de facto small-scale
insurance policies. Millions of people buy extended warranties on consumer
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The Nobel Memorial Prize for Daniel Kahneman 171
products costing $50 to $500, and buy insurance against having to pay for
telephone repairs, where these warranties are nowhere near actuarially fair.
Consumers who decline these warranties are virtually assured of being
wealthier in the long run than those who buy them. In the second category
is the famous equity-premium puzzle-that (risky) stocks earn persistently
higher returns than lower-risk bonds, where the degree of risk aversion
needed to explain the lower demand for stocks is recognized to be implausibly high. Benartzi and Thaler (1995), under the rubric of "myopic loss
aversion," use a very simple and plausible calibration of the prospect-theory
value function to argue that the equity-premium puzzle can be explained
by investors' aversion to short-term financial losses. Investors are overattentive to short-term losses, even when they do not spend their investments in the short term and should recognize that in the long run the losses
will be outweighed by gains. Economists have been puzzled by this for
years, and have been constructing more and more exotic models to explain
it, but I think it will soon be recognized as manifest that myopic loss
aversion is a major part of the explanation.
V. Fairness
Many economists have over the years discussed the existence of and economic implications of preferences that depart from pure self-interest, as
narrowly defined. But much of the credit for introducing the empirical
study of the economic implications of fairness judgments into economics
can be given to Kahneman, Knetsch and Thaler (1986). Their interest was
positive, not normative: Instead of studying normative standards of what
we as policy-makers (or philosophers) might consider fair allocations or
appropriate social-welfare functions, they study with surveys what a typical
economic actor might assess as fair or unfair behavior. For instance, they
asked subjects to assess the fairness of reducing the wages of current
employees vs. hiring new employees at lower wages after normal turnover
in response to market unemployment. They found that respondents are
likely to consider lowering wages to current workers unfair, while they
consider using market conditions to set new wages acceptable. Respondents
also considered it unfair to raise the price of peanut butter already in stock
in response to a rise in the wholesale price of peanut butter (much as people
protest when gas stations immediately raise prices on petrol in stock in
response to an increase in wholesale petrol prices). Kahneman, Knetsch
and Thaler identify some more general principles with their surveys: People
generally find it acceptable for firms to raise prices or lower wages in
response to concurrent shifts in their costs, but not in response to demand
shifts or to shortages.
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172 M. Rabin
Of course, such consumer attitudes need not necessarily translate directly
into market behavior different than those predicted by standard fairnessfree preferences. But the authors discuss (and researchers are beginning to
investigate) hypotheses about how market actors concerned for fairness
respond differently than the canonical models predict. Consumers may
refuse paying prices that they feel reflect exploitation of market power; the
resulting shift in demand would change how profit-maximizing firms will set
prices. And both community-based local stores and large corporations with
public-relations departments have an interest in some situations of not
maximizing their profits myopically if it will hurt them in the long run. In
labor markets, strong aversion to wage cuts for existing employees has
obvious implications for downward wage stickiness.
While there remain many debates about how important fairness considerations are in different economic settings, the proposition that departures
from self-interest deserve systematic study by economists, controversial 15
years ago, is now widely accepted: Virtually every researcher to examine
behavior in experimental settings has concluded that preferences depart
from pure self-interest in non-trivial ways. The ultimatum game, first introduced by Guth and Tietz (1982), and replicated by Kahneman, Knetsch and
Thaler (1986), demonstrates that people turn down lopsided offers, and
dozens of replications over the years have confirmed this. It has been
experimentally verified that people contribute to public goods more than
can be explained by pure self-interest, and that many subjects free to
allocate money between themselves and others as they choose do not grab
everything for themselves.
In addition to investigating attitudes towards fairness in market settings,
Kahneman, Knetsch and Thaler provide what to my knowledge is the first
experimental demonstration of punishment behavior that cannot be interpreted as deriving from a subject's distributional preferences over outcomes,
but rather due to retaliation based on moral indignation about unfair
behavior. In one of their experiments, they (truthfully) informed subjects
that their allocation decision would affect each of two other anonymous
subjects-one who had in a previous experiment behaved unfairly, and one
who had behaved fairly. Subjects were then given the choice between
allocating $6 each to themselves and to the unfair partner, with $0 to the
fair partner, or $5 each to themselves and the fair party, with $0 to the unfair
party. Three-fourths of the subjects chose the $5 allocation, sacrificing $1 to
(anonymously) punish the misbehaving party. This is a simple, elegant experiment that demonstrated subjects' motives more cleanly than many of the
subsequent experiments in the burgeoning literature on "social preferences."
Kahneman, Knetsch and Thaler's (1986) work is also unique in how it
elegantly combines controlled, "context-free" financial-stakes experiments
with surveys that elicit people's fairness judgments about realistic market
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The Nobel Memorial Prize for Daniel Kahneman 173
scenarios. In moving from abstract, context-free allocation problems to
everyday economic fairness judgments, fairness norms become both more
complicated, and more economically significant, than those emphasized by
experimental researchers. As elsewhere, reference levels and loss aversion
play a huge role in the domain of fairness: Firms have more of an obligation
not to hurt workers or customers relative to reference transactions than they
have to improve the terms of trade. Kahneman, Knetsch and Thaler also
argue that reference dependence causes people's general perceptions of fair
behavior to adjust dramatically over time, arguing that, "Terms of exchange
that are initially seen as unfair may in time acquire the status of a reference
transaction. Thus, the gap between the behavior that people consider fair
and the behavior that they expect in the marketplace tends to be rather
small." In markets, for instance, people may eventually come to believe that
the prevailing market price is fair. But they note that because adjustments of
fairness judgments are not immediate, fairness considerations may help
explain the sort of medium-run stickiness in both prices and wages studied
by macroeconomists.
VI. Framing Effects
Probably the most striking and problematic departures from rationality
emphasized in Kahneman and Tversky's early research are what they call
framing effects: two logically equivalent statements of a problem lead
decision-makers to choose different options. Examples of framing effects
typically involve differing frames whose logical equivalence is neither totally
transparent nor terribly obscure. They argue and demonstrate that this
"failure of invariance is both pervasive and robust." More interestingly,
the ways in which decisions are influenced is typically predictable by the
features emphasized by the different frames, most notably related to the
principles of loss aversion and diminishing sensitivity outlined above.
Because losses resonate with people more than gains, a frame that highlights
the losses associated with a choice makes that choice less attractive. Similarly, a frame that exploits diminishing sensitivity by making losses appear
small relative to the scales involved makes that choice more attractive.
Tversky and Kahneman (1986) give the following example, illustrating
these principles in a public-health context. A total of 152 subjects were
asked the following hypothetical question:
"Imagine that the U.S. is preparing for the outbreak of an unusual Asian
disease, which is expected to kill 600 people. Two alternative programs to
combat the disease have been proposed. Assume that the exact scientific
estimates of the consequences of the programs are as follows:
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174 M. Rabin
If Program A is adopted, 200 people will be saved.
If Program B is adopted, there is a one-third probability that 600 people
will be saved and a two-thirds probability that no people will be saved."
Seventy-two percent of subjects said that they preferred Program A over B.
But they also asked another 155 subjects the same question with the two
programs framed thusly:
"If Program C is adopted, 400 people will die.
If Program D is adopted, there is a one-third probability that nobody will
die and a two-thirds probability that 600 people will die."
In this second group, 78 percent preferred Program D. Clearly, A and C are
precisely the same choices, as are B and D. The large shift in responses is
predictable based on the principle of diminishing sensitivity embedded in
prospect theory: Framing the choice in terms of numbers of lives saved
clearly evokes "risk aversion" in gains-better to save 200 lives for sure than
an uncertain number of lives averaging 200. Framing the choice in terms of
number of victims dying evokes "risk-loving"attitudes in losses-the chance
of preventing any deaths is very attractive.
These and other questions they asked are hypothetical. But they also
asked experienced physicians questions about cancer treatments, and
found similar effects, suggesting that similar patterns might play out in the
real world. Moreover, similar framing effects were found in choices over
lotteries with small monetary stakes.
While framing effects are more difficult to reconcile with and embed
within standard economic analysis than most of Kahneman's other research
topics, their reality and economic importance is manifest. Tversky and
Kahneman (1986) discuss several real-world examples from other researchers. Thaler (1980) studies the effect of labeling a difference between two
prices as a surcharge or a discount; because losing a discount is merely
losing a potential gain, while paying a surcharge is a loss, people are less
averse to forgoing a discount than to accepting a surcharge.Thus, credit-card
issuers in the past lobbied for labeling price differencesbetween cash and card
purchases as cash discounts rather than credit surcharges. Such framing can
also help explain why price cuts in response to periods of low demand often
take the form of sales rather than cuts in regular prices, since consumers will
be less bothered by subsequent price increases if they are framed as merely
canceling discounts rather than outright price increases.
Although I did not discuss the relevant examples above, a broad theme of
Kahneman, Knetsch and Thaler's (1986) study of fairness judgments concern such framing effects. Indeed, several of their examples concern what is
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The Nobel Memorial Prize for Daniel Kahneman 175
probably the most economically important framing effect-money illusion.
Inflation generates "framing"that allows, for instance, cuts in real wages to
appear as gains rather than losses. They provide survey evidence that people
are much more attentive to nominal rather than real changes in wages and
prices in assessing the fairness of firm behavior. For instance, a nominal
wage increase of 5 percent in a period of 12 percent inflation offends
people's sense of fairness less than a 7 percent decrease in a time of no
inflation. More generally, people react more to decreases in real wages when
they are also nominal decreases, and react negatively to nominal price
increases even if they represent no increase in real prices. Shafir, Diamond
and Tversky (1997) explore the psychology of money illusion further, and
researchers such as Akerlof, Dickens and Perry (1996) have argued that
such money illusion implies that (a little) inflation can be good for the
economy, lowering unemployment and raising growth, because it allows
firms to peacefully cut real wages when necessary without lowering nominal
wages. While economically significant framing effects are much more pervasive than money illusion, if the research on framing effects were only to
provide a framework for systematically thinking about money illusion, its
contribution would be enormous.
Many examples of framing effects can be viewed as comparable to the
sort of heuristics and biases discussed in Section 2: People are boundedly
rational, and the presentation of a choice may draw our attention to
different aspects of a problem, leading us to make mistakes in pursuing
our true, underlying preferences. But sometimes framing effects cut more
deeply to economists' model of choice, suggesting that more than confusing
people in pursuit of stable underlying preferences, the "frames"may in fact
partially determinea person's preferences. In recent years, many researchers
have explored this more radical perspective that elicitation procedures
indeed "construct" preferences-and that framing effects and other elicitation effects are indications of a deeper mistake economists are making when
assuming that even seemingly consistent patterns of choice are revealing
preferences. Kahneman, Ritov and Schkade (1998), for instance, argue that
asking people to use dollar value to rate harm in public issues is extremely
problematic from many perspectives. Basically, people use dollar levels,
devoid of a meaningful comparison level, to express their attitude towards
polluters. Both governmental agencies and the courts have been using
surveys of citizens to gather evidence about how people value such nonmarket goods as environmental pollution or protection of endangered species. It is now widely accepted that methods of "contingent valuation" used
by courts and governmental agencies to elicit such preferences are flawed.
Indeed, when people make evaluations in terms of dollars, they often don't
treat these in terms of foregone consumption, etc., but rather as an arbitrary
number scale. Contingent valuations of various disasters can also be heavily
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176 M. Rabin
distorted because people form implicit comparisons that bias their answers.
Combining these two points, if separate groups are asked, for instance, to
state willingness to pay to avoid decimating a local dolphin population or to
prevent one of the frequent famines in a small African country, neither
group will really treat the dollar amounts in terms of the alternative uses the
money could be put to, but will try to grapple with some judgment about
whether this deserves a lot or a little money. In so doing, the first group may
be prone to compare decimating the dolphin population to other environmental disasters, and give a high dollar amount; the second group may be
prone to compare this humanitarian disaster to other (larger) humanitarian
disasters, and give a low dollar amount. Because these dollar amounts are so
arbitrary on an absolute scale, these evaluations may be driven much more
by the reference group chosen than by any absolute judgment.
VII. Decision Utility, Experienced Utility and Hedonics
The research on heuristics and biases discussed above indicates that people
misjudge the probabilistic consequences of their decisions. But a spate of
recent research suggests that, even when they correctly perceive the physical
consequences of choices they make, people may systematically misperceive
the hedonic consequences of those choices. As Kahneman (1994) argues,
"... it may be rash to assume as a general rule that people will later enjoy
what they want now. The relation between preferences and hedonic
consequences is better studied than postulated. These considerations
suggest an explicit distinction between two notions of utility. The experienced utility of an outcome is the measure of the hedonic experience of
that outcome.... The decision utility of an outcome, as in modern usage,
is the weight assigned to that outcome in a decision."
Kahneman (2001) summarizes and provides a conceptual framework for
understanding these utility-misprediction errors. Two biases are especially
noteworthy. First, in forecasting future utility, people tend to use the
"transitionrule: predictions of a person's initial reaction to a new situation,
which may be quite accurate in itself, is incorrectly used as a proxy to
forecast the long-term effects of that situation." The most important error
resulting from this is the tendency to under-appreciate the hedonic effects of
adaptation, and thus exaggerate changes in utility caused by small and big
changes in their lives. This under-appreciation of adaptation affects choices.
Many researchers have concluded, for instance, that this misprediction is
implicated in the endowment effect: People evaluate selling a mug by extrapolating their sensible prediction of the immediate sensation of losing a mug
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The Nobel Memorial Prize for Daniel Kahneman 177
too far into the future, when in fact they will soon adjust. And as with mugs,
so with limbs: People exaggerate the badness of paraplegia or other very bad
life events. Kahneman (2001) reports a student's study providing evidence
that a source of this misprediction is in fact the transition rule: Surveys
asking respondents to rate how bad somebody is likely to feel immediately
after losing limbs found little difference between those who knew a paraplegic
and those who didn't. But those surveyed who knew a paraplegic predicted
significantly greater happiness for somebody a year after losing limbs. This
suggests that less-informed intuitive predictions of the hedonic consequences
of negative life events tend to exaggerate their persistence.Comparable results
have been found for good life events, such as winning the lottery;people think
that the positive sensation of winning will last longer than it will.
One major way people predict their utility from future experiences is, of
course, by recollecting utility from comparable past experiences. It is reasonable to suppose that people's predictions about their utility from familiar
experiences will be fairly accurate. But the second noteworthy way that
people mispredict future utility actually comes from a biased evaluation of
past episodes. In particular, even when people might well recollect the
momentary hedonic sensations from past experiences, they might be bad
at "adding up" these hedonic sensations from extended episodes.
Kahneman and others have conducted a series of experiments comparing
the periodic hedonic reports by subjects of their well-being at each point in
time to their gestalt recollection of the overall episodes. Kahneman (1994)
offers the following succinct summary of his findings on how retrospective
evaluations of episodes compare to their experienced well-being:
"The results of these studies support two empirical generalizations. (1)
'The Peak and End Rule': global evaluations are predicted with high
accuracy by a weighted combination of the most extreme affect recorded
during the episode and of the affect recorded during the terminal
moments of the episode. Here again, as in the context of decision utility,
the evaluation of particular moments appears to be used as a proxy for
the evaluation of a more extended period of time. (2) Duration Neglect.
The retrospective evaluation of overall or total pain (or pleasure) is not
independently affected by the duration of the episode. In the colonoscopy
study, for example, the duration of the procedure varied from 4 to 69
minutes in a sample of 101 patients. Surprisingly, these variations of
duration had no significant effect on retrospective evaluations. The ratings of both patients and attending physicians were dominated by the
intensity of pain at its worst, and by the intensity of discomfort during the
last few minutes of the procedure. Duration neglect is not immutable, of
course.... In general, however, affective peaks and endings are more
salient than duration in the cognitive representation of events."
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178 M. Rabin
To make normative statements about these patterns, Kahneman argues that
the proper evaluation of a person's well-being over extended episodes is
simply to add up her moment-by-moment well-being, giving equal weight to
each moment. Under this criterion, both empirical generalizations about
how people evaluate episodes identify cognitive mistakes. But results of
some of his experiments indicate that people's retroactive evaluation of
episodes even violates the weaker normative criterion of "temporal monotonicity": The premise that adding moments of pain to an otherwise
unchanged experience decreases overall well-being, and that adding
moments of pleasure increases overall well-being.
Recognizing this possibility that there are potential flaws in how people
go about managing their flows of utility, Kahneman and others have
launched research that may help move economics towards a more realistic
approach to welfare analysis. It will let us continue applying revealedpreference theory in the many domains where doing so gets things right,
but also allow us to engage in careful and systematic scientific inquiry into
when and how there is a separation between people's choices and what
brings them satisfaction. More generally, in some of his ongoing research
projects, and as an editor and contributor to a recent volume, Kahneman,
Diener and Schwarz (1999), that lays out the existing findings and an overall
agenda for such research, Kahneman is a leader in the exciting new focus in
social sciences on the direct empirical study of what makes people happy.
VIII. Conclusion
I have necessarily only been able to give a cursory sense of the range and
content of Kahneman's relevant research in this essay. Kahneman's award
of the Nobel Memorial Prize recognizes the enormous contributions he has
made. The recent explosion of research in "behavioral economics" that
integrates psychological insights into economic analysis also reflects the
importance of his research: While there are some psychological topics
important for economics to which Kahneman has not been a central contributor, anybody surveying this recent research will notice how often those
of us trying to improve the psychological realism of economics have used
Kahneman's empirical findings and conceptual frameworks as our starting
point. The agenda he (along with collaborators Amos Tversky, Richard
Thaler and others) has been pursuing for decades has come to fruition.5
5For an excellent, up-to-date introduction to both his own research and much of the research
Kahneman has spawned, see Kahneman and Tversky's edited volume, Choices, Values, and
Frames.
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The Nobel Memorial Prize for Daniel Kahneman 179
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