From THE NEW YORK TIMES:

November 5, 2002

On Profit, Loss and the Mysteries of the Mind

By ERICA GOODE

“Kahnemanandtversky.”

    Everybody said it that way.

    As if the Israeli psychologists Daniel Kahneman and Amos Tversky were a single person, and their work, which challenged long-held views of how people formed judgments and made choices, was the product of a single mind.

    Last month, Dr. Kahneman, a professor at Princeton, was awarded the Nobel in economics science, sharing the prize with Vernon L. Smith of George Mason University. But Dr. Kahneman said the Nobel, which the committee does not award posthumously, belongs equally to Dr. Tversky, who died of cancer
in 1996 at 59.

    “I feel it is a joint prize,” Dr. Kahneman, 68, said. “We were twinned for more
than a decade.”

    In Jerusalem,
where their collaboration began in 1969, the two were inseparable, strolling
on the grounds of Hebrew University or sitting at a cafe or drinking instant
coffee in their shared office at the Van Leer Jerusalem Institute and talking,
always talking. Later, when Dr. Tversky was teaching at Stanford and Dr.
Kahneman at the University of British Columbia, they would call each other
several times a day.

    Every
word of their papers, now classics studied by every graduate student in
psychology or economics, was debated until “a perfect consensus” was reached.
To decide who would appear as first author, they flipped a coin.

    Wiry,
charismatic, fizzing with intelligence, Dr. Tversky was younger by a few
years. Dr. Kahneman, as intellectually keen, was gentler, more intuitive,
more awkward.

    Together,
the psychologists developed a new understanding of judgments and decisions
made under conditions of risk or uncertainty.

    Economists
had long assumed that beliefs and decisions conformed to logical rules.
They based their theories on an ideal world where people acted as “rational
agents,” exploiting any opportunity to increase their pleasure or benefit.

    But
Dr. Kahneman and Dr. Tversky demonstrated that in some cases people behaved
illogically, their choices and judgments impossible to reconcile with a
rational model. These departures from rationality, the psychologists showed,
followed systematic patterns.

    For example,
the exact same choice presented or “framed” in different ways could elicit
different decisions, a finding that traditional economic theory could not
explain.

    In an
oft-cited experiment, the psychologists asked a group of subjects to imagine
the outbreak of an unusual disease, expected to kill 600 people, and to
choose between two public health programs to combat it.

    Program
A, the subjects were told, had a 100 percent chance of saving 200 lives.
Program B had a one-third chance of saving 600 lives and a two-thirds probability
of saving no lives.

    Offered
this choice, most of the subjects preferred certainty, selecting Program
A.

    But when
the identical outcomes were framed in terms of lives lost, the subjects
behaved differently. Informed that if Program A were adopted, 400 people
would die, while Program B carried a one-third probability that no one
would die and a two-thirds probability that 600 people would die, most
subjects chose the less-certain alternative.

    Over
more than two decades, working together or with others, Dr. Kahneman and
Dr. Tversky elaborated many situations in which such psychological “myopia”
influenced people’s behavior and offered formal theories to account for
them.

    They
established, among other things, that losses loom larger than gains, that
first impressions shape subsequent judgments, that vivid examples carry
more weight in decision making than more abstract ˜ but more accurate ˜
information.

    Anyone
who read their work, illustrated, as one admirer put it, with “simple examples
of irresistible force and clarity,” was drawn to their conclusions.

    Even
economists, unused to looking to psychology for instruction, began to take
notice, their attention attracted by two papers, one published in 1974
in Science, the other in 1979 in the economics journal Econometrica. Eventually,
the psychologists’ work provided the undergirding for behavioral economics,
the approach developed by Dr. Richard Thaler.

    In a
recent conversation, Dr. Kahneman, who carries both American and Israeli
citizenship, talked about what happens when psychology and economics meet.

Q. Did you set out to challenge
the way economists were thinking?

A. We certainly didn’t have
in mind to influence economics.

    In the
first years, economists, and philosophers, too, were simply not interested
in the trivial errors that we as psychologists were studying.

    I have
a clear memory of a party in Jerusalem around 1971, attended by a famous
American philosopher. Someone introduced us and suggested that I had an
interesting story to tell him about our research. He listened to me for
about 30 seconds, then cut me off abruptly, saying, “I am not really interested
in the psychology of stupidity.”

    Our work
was completely ignored until our 1974 paper, which eventually had an impact
on both economics and epistemology. Of course, we did not mind in the least
because economists were not our intended audience anyway; we were talking
to psychologists. It came as a pleasant surprise when others started to
pay attention.

Q. Why is the rational model
of human behavior so entrenched in economic theory?

A. There’s a very good reason
for why economics developed the way it did, and that is that in many situations,
the assumption that people will exploit the opportunities available to
them is very plausible, and it simplifies the analysis of how markets will
behave.

    You know,
when you’re thinking of two stalls next to each other selling apples at
different prices, then you’re assuming that the fellow who is selling them
at too high a price is just not going to have customers.

    So you
get rationality at this level, and it buys a lot of predictive power by
this assumption. When you are building a formal theory, you want to generalize
that assumption, and then you end up making people completely rational.

Q. You and Amos Tversky
are perhaps best known for prospect theory. Could you explain what this
is based on?

A. When I teach it, I go
back to 1738. In 1738, Daniel Bernoulli wrote the big essay that introduced
utility theory. Utility really means pleasure more than anything else.

    The question
that Bernoulli put to himself was “How do people make risky decisions?”
And he analyzed really quite a nice problem: a merchant thinking of sending
a ship from Amsterdam to St. Petersburg at a time of year when there would
be a 5 percent probability of the ship being lost.

    Bernoulli
evaluated the possible outcomes in terms of their utility. What he said
is that the merchant thinks in terms of his states of wealth: how much
he will have if the ship gets there, if the ship doesn’t get there, if
he buys insurance, if he doesn’t buy insurance.

    And now
it turns out that Bernoulli made a mistake; in some sense it was a bewildering
error to have made. For Bernoulli, the state of wealth is the total amount
you’ve got, and you will have the same preference whether you start out
owning a million dollars or a half million or two million. But the mistake
is that no merchant would think that way, in terms of states of wealth.
Like anybody else, he would think in terms of gains and losses.

    That’s
really a very simple insight but it turns out to be the insight that made
the big difference. Because, if that’s not the way that people think, if
people actually think in terms of gains and losses and not in terms of
states of wealth, then all the mathematical analysis that has been done
which assumed people do it that way is not true. It took us a long time
to figure it out.

Q. What kinds of things
does prospect theory explain?

A. I think the major phenomenon
we observed is what we called “loss aversion.” There is an asymmetry between
gains and losses, and it really is very dramatic and very easy to see.
In my classes, I say: “I’m going to toss a coin, and if it’s tails, you
lose $10. How much would you have to gain on winning in order for this
gamble to be acceptable to you?”

    People
want more than $20 before it is acceptable. And now I’ve been doing the
same thing with executives or very rich people, asking about tossing a
coin and losing $10,000 if it’s tails. And they want $20,000 before they’ll
take the gamble.

    So the
function for gains and losses is sort of kinked. People really discriminate
sharply between gaining and losing and they don’t like losing.

Q. How did prospect theory
influence economists?

A. Correcting Bernoulli’s
error was influential, because it was picked up by Richard Thaler, who
started behavioral economics. We provided cover for behavioral economics,
because the challenge to the rational model was taken seriously and presented
in a way that readers of the work found compelling.

    But it’s
not as if this has swept economics. It hasn’t, and for very deep structural
reasons, it’s not going to. The rational model has a hold on economics,
and it’s going to stay that way. Behavioral economists fiddle with it,
improving the assumptions and making them psychologically sensible. But
it’s not a completely different way of doing economic theory.

Q. One of the things you
are studying now is well-being. Does this connect in any way to economics?

A. I would like to develop
a measure of well-being that economists would take seriously, an alternative
to the standard measure of quality of life.

We’re attempting to measure
it not by asking people, but by actually trying to measure the quality
of their daily lives. For example, we are studying one day in the lives
of 1,000 working women in Texas. We have people reconstruct the day in
successive episodes, as recalled a day later, and we have a technique that
recovers the emotions and the feelings. We know who they were with and
what they were doing. They also tell us how satisfied they are with various
aspects of their lives. We know a lot about these ladies.

Q. What are you finding
out?

A. I’ll give you a striking
finding. Divorced women, compared to married women, are less satisfied
with their lives, which is not surprising. But they’re actually more cheerful,
when you look at the average mood they’re in in the course of the day.
The other thing is the huge importance of friends. People are really happier
with friends than they are with their families or their spouse or their
child.

Q. Why would divorced women
be more cheerful?

A. So far, I don’t understand
it, but that’s what the data says.