Nobel Prize Insights

Daniel Kahneman has won this year’s Nobel Prize for economics for showing that human beings are irrational. Readers will ask, isn’t that too obvious to merit an award?

Answer: an economist is one who observes that something works in practices and then finds a way of proving it in theory. That may sound like a con game, but isn’t. A successful theory predicts not only obvious but also unsuspected consequences, and so can greatly improve policy-making.

Paradoxically, Kahneman shares the Nobel prize this year with Vernon Smith, who proved the opposite: that people do indeed exhibit the rational behaviour assumed in classical economics. He pioneered controlled experiments to test human behaviour. He gave groups of people actual cash which was theirs to keep, and then tested how  respond to various market incentives and disincentives. These experiments showed that people typically respond rationally to market incentives.

How do we reconcile the findings of Smith and Kahneman? First, irrational decisions by individuals often go in opposite direction and cancel out, so the behaviour of an entire market can be fairly rational even if that of several individuals is not. Second and more important, irrationality is most pronounced in certain circumstances: for  instance when people have to calculate odds or are driven by fear or euphoria.

People are poor at calculating odds. Consider a toss of the coin, with winners getting Rs 1,100 and losers paying Rs 1000. The odds favour all who join the game, yet most people will avoid it as a risky gamble. Why? Partly because they are poor at calculating odds. Partly also because they attach a higher value to a loss of Rs 1000 than a gain of Rs 1100. They feel that the loss is real, whereas the gain is an unearned bonus which they could do without.

Yet the same people will happily wager small sums at very unfavourable odds by buying lottery tickets. The reason: lottery tickets are cheap, so people are willing to pay a sum they will not miss for the excitement involved.

Mortals tend to think that existing trends will continue indefinitely, and have difficulty in accepting the historical truth that economies and stock markets go up and down in cycles. Euphoria induces herd behaviour in booms and crashes.

What are the lessons for policy? We should take into account the fact that people’s decisions can be driven by euphoria and fear, can be poor at weighing losses against gains, and poor at visualising the future in cycles.

Consider telecom policy. The world over, some governments have invited bids for licences, while others they have gone for revenue-sharing with operators. India originally auctioned licences, attracting euphoric, irrationally high bids. The winners, on sober consideration, refused to regaining their sanity, refused to implement their licences. Something similar looks like happening after the auction for third generation telecom licences in Europe. High bids are desirable, but not if they are so high that winners back out. When uncertainties are high, as in telecom, unsustainably high bidding is likely. A better way of ensuring adequate telecom investment is to have  revenue sharing, a model which India has now adopted.

The willingness of people to invest in lotteries leads me to suggest a scheme for checking the evasion of sales tax by consumers in collusion with shop-keepers. Let state governments launch a lottery in which all sales tax bills are treated as lottery tickets. Let there be a winner every month, to promote popular awareness. I believe many small consumers will start demanding  bills instead of avoiding them, seeing a chance to win a lottery. This could greatly improve sales tax collection.

The asymmetry of people’s attitudes to losses and gains has implication for reforms. The right strategy is to start with reforms that produce some gain while inflicting relatively little pain. This will produce a constituency in favour of reforms, and the tougher reforms can be pursued at a later date. Now, the tougher reforms may well be better for economic growth. But since losses weigh more heavily on people’s minds than gains, it is best to start with reforms that impose minimal pains even if the gains are modest.

But the most important lesson of all from the new Nobel Laureates is Vernon Smith’s demonstration that, in controlled experiments, people do indeed exhibit the market behaviour predicted by classical economics. Adam Smith theorised that, in competitive markets, businessmen seeking their self-interest will, as if led by an invisible hand, end up with prices and production that promote the public good, even though that is not their intention. This insight ran counter to common intuition, and was decried by sceptics as a crazy theory. Vernon Smith’s experiments show that this is in fact the way the world works in practice.

Socialists and other sceptics will, I suspect, not be convinced even by experimental proof. This puts them in the same league as the Flat Earth Society.

What do you think?