Nobel Prize-Winning Economic Theories You Should Know About
January 16 2013| Filed Under » Financial Theory
The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded 44 times to 71 Laureates who have researched and tested dozens of ground-breaking ideas. Here are five prize-winning economic theories that you'll want to be familiar with. These are ideas you're likely to hear about in news stories because they apply to major aspects of our everyday lives.
1. Management of Common Pool Resources In 2009, Indiana University political science professor Elinor Ostrom became the first woman to win the prize. She received it "for her analysis of economic governance, especially the commons." Ostrom's research showed how groups work together to manage common resources such as water supplies, fish and lobster stocks, and pastures through collective property rights. She showed that ecologist Garrett Hardin's prevailing theory of the "tragedy of the commons" is not the only possible outcome, or even the most likely outcome, when people share a common resource.
Hardin's theory says that common resources should be owned by the government or divided into privately owned lots to prevent the resources from becoming depleted through overuse. He said that each individual user will try to obtain maximum personal benefit from the resource to the detriment of later users. Ostrom showed that common pool resources can be effectively managed collectively, without government or private control, as long as those using the resource are physically close to it and have a relationship with each other. Because outsiders and government agencies don't understand local conditions or norms, and lack relationships with the community, they may manage common resources poorly. By contrast, insiders who are given a say in resource management will self-police to ensure that all participants follow the community's rules.
Learn more about Ostom's prize-winning research in her 1990 book, "Governing the Commons: The Evolution of Institutions for Collective Action," and in her 1999 Science journal article, "Revisiting the Commons: Local Lessons, Global Challenges."
2. Behavioral Economics The 2002 prize went to psychologist Daniel Kahneman, "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty." Kahneman showed that people do not always act out of rational self-interest, as the economic theory of expected utility maximization would predict. This concept is crucial to the field of study known as behavioral finance. Kahneman conducted his research with Amos Tversky, but Tversky was not eligible to receive the prize because he died in 1996 and the prize is not awarded posthumously.
Kahneman and Tversky identified common cognitive biases that cause people to use faulty reasoning to make irrational decisions. These biases include the anchoring effect, the planning fallacy and the illusion of control. Their article, "Prospect Theory: An Analysis of Decision Under Risk," is one of the most frequently cited in economics journals. Their award-winning prospect theory shows how people really make decisions in uncertain situations. We tend to use irrational guidelines such as perceived fairness and loss aversion, which are based on emotions, attitudes and memories, not logic. For example, Kahneman and Tversky observed that we will expend more effort to save a few dollars on a small purchase than to save the same amount on a large purchase.
Kahneman and Tversky also showed that people tend to use general rules, such as representativeness, to make judgments that contradict the laws of probability. For example, when given a description of a woman who is concerned about discrimination and asked if she is more likely to be a bank teller or a bank teller who is a feminist activist, people tend to assume she is the latter even though probability laws tell us she is much more likely to be the former.
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3. Asymmetric Information In 2001, George A. Akerlof, A. Michael Spence and Joseph E. Stiglitz won the prize "for their analyses of markets with asymmetric information." The trio showed that economic models predicated on perfect information are often misguided because, in reality, one party to a transaction often has superior information, a phenomenon known as "information asymmetry."
An understanding of information asymmetry has improved our understanding of how various types of markets really work and the importance of corporate transparency. Akerlof showed how information asymmetries in the used car market, where sellers know more than buyers about the quality of their vehicles, can create a market with numerous lemons (a concept known as "adverse selection"). A key publication related to this prize is Akerlof's 1970 journal article, "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism."
Spence's research focused on signaling, or how better-informed market participants can transmit information to lesser-informed participants. For example, he showed how job applicants can use educational attainment as a signal to prospective employers about their likely productivity and how corporations can signal their profitability to investors by issuing dividends.
Stiglitz showed how insurance companies can learn which customers present a greater risk of incurring high expenses (a process he called "screening") by offering different combinations of deductibles and premiums.
Today, these concepts are so widespread that we take them for granted, but when they were first developed, they were groundbreaking.
4. Game Theory The academy awarded the 1994 prize to John C. Harsanyi, John F. Nash Jr. and Reinhard Selten "for their pioneering analysis of equilibria in the theory of non-cooperative games." The theory of non-cooperative games is a branch of the analysis of strategic interaction commonly known as "game theory." Non-cooperative games are those in which participants make non-binding agreements. Each participant bases his or her decisions on how he or she expects other participants to behave, without knowing how they will actually behave.
One of Nash's major contributions was the Nash Equilibrium, a method for predicting the outcome of non-cooperative games based on equilibrium. Nash's 1950 doctoral dissertation, "Non-Cooperative Games," details his theory. The Nash Equilibrium expanded upon earlier research on two-player, zero-sum games. Selten applied Nash's findings to dynamic strategic interactions, and Harsanyi applied them to scenarios with incomplete information to help develop the field of information economics. Their contributions are widely used in economics, such as in the analysis of oligopoly and the theory of industrial organization, and have inspired new fields of research.
5. Public Choice Theory James M. Buchanan Jr. received the prize in 1986 "for his development of the contractual and constitutional bases for the theory of economic and political decision-making." Buchanan's major contributions to public choice theory bring together insights from political science and economics to explain how public-sector actors (e.g., politicians and bureaucrats) make decisions. He showed that, contrary to the conventional wisdom that public-sector actors act in the public's best interest (as "public servants"), politicians and bureaucrats tend to act in their own self-interest, just like private-sector actors (e.g., consumers and entrepreneurs). He described his theory as "politics without romance."
Using Buchanan's insights regarding the political process, human nature and free markets, we can better understand the incentives that motivate political actors and better predict the results of political decision-making. We can then design fixed rules that are more likely to lead to desirable outcomes. For example, instead of allowing deficit spending, which political leaders are motivated to engage in because each program the government funds earns politicians support from a group of voters, we can impose a constitutional restraint on government spending, which benefits the general public by limiting the tax burden.
Buchanan lays out his award-winning theory in a book he coauthored with Gordon Tullock in 1962, "The Calculus of Consent: Logical Foundations of Constitutional Democracy."
Honorable Mention: Black-Scholes Theorem Robert Merton and Myron Scholes won the 1997 Nobel Prize in economics for the Black-Scholes theorem, a key concept in modern financial theory that is commonly used for valuing European options and employee stock options. Though the formula is complicated, investors can use an online options calculator to get its results by inputting an option's strike price, the underlying stock's price, the option's time to expiration, its volatility and the market's risk-free interest rate. Fisher Black also contributed to the theorem, but could not receive the prize because he passed away in 1995.
The Bottom Line Each of the dozens of winners of the Nobel memorial prize in economics has made outstanding contributions to the field, and the other award-winning theories are worth getting to know, too. A working knowledge of the theories described here, however, will help you to establish yourself as someone who is in touch with the economic concepts that are essential to our lives today.
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Amy Fontinelle is a financial journalist and editor for a variety of websites, public policy organizations, and book publishers. She has written hundreds of published articles and blog posts on topics including budgeting, credit management, real estate and investing. Her articles have been featured on the homepage of Yahoo! and on Yahoo! Finance, Forbes.com, SFGate.com and numerous local news websites.
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