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Economists Awarded the Nobel Prize for their contribution in

Decision-Making

Submitted By: Group 4 Section A

22A, 26A, 27A, 40A, 44A, 45A

Daniel Kahneman and Decision-making in the face of Uncertainty

Field of judgment and decision-making is one of the areas of psychology andeconomics in which research activity grew most rapidly in the past few decades.

The enthusiasm is easily explained: the topic has much to make it appealing toinvestigators. Its focus is a large puzzle that will not go away- a search for thebounds of human rationality. It includes a deep normative theory that offerscriteria for rational action. It is also rich in amusing and interesting anecdotesand challenging brain-teasers. The study of judgment and choice sheds light onevents in the real world, including the decisions of world leaders and corporatehonchos alike. The doubts that psychologists have raised about the rationality ofhuman agents are having a modest effect on neighbouring disciplines, likeeconomics and political science, in which the assumption of human rationality isoften used to predict the outcomes of competitive interactions. The detailedstudy of bounded rationality has also has implications for the human engineering

of information systems, decision aids and organization procedures.

Daniel Kahneman is one such psychologist who studied economics and wasawarded the august Nobel Prize in 2002 in Economics along with Vernon Smith.Kahneman has integrated insights from psychology into economics, especiallyconcerning human judgment and decision-making under uncertainty.

Some of his useful insights are as under:

  Distrust Data- Rather than leaping to conclusions based on scant data,look at as many numbers as possible. Don’t just rely on recent

performance; look at several time periods. “It doesn’t take manyobservations to think you have spotted a trend”, warns Kahneman, “and

it’s probably not a trend at all”. 

   Anchors aweigh. When pundits like Goldman Sachs' Abby Joseph Cohenpredict where the Dow is heading, or when analysts like Morgan Stanley'sMary Meeker forecast Amazon.com's stock price, the market often movesmagnetically in their direction. But don't anchor your expectations to thetea leaves of the so-called experts. At best, they're making educatedguesses; at worst, they're manipulating you to make money for their owncompanies.

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  Use mad money. If you can't resist the temptation to trade stocks, put thebulk of your portfolio in a broad stock-index fund; then take a little (10%tops) to "play the market" yourself. This way, you keep your hunches onthe fringe, where they belong. "It's like going to the casino with only$200," says Kahneman. "It helps protect you from regret."

  Fly on autopilot . Irrational mood swings lead people to trade too muchas they veer erratically between glee and dismay. "All of us," saysKahneman, "would be better investors if we just made fewer decisions."

  Look within. Most financial advice, especially on TV and the Internet,suggests that investing is an endless race to beat the market. Every daybrings a breathless stream of bulletins about who's ahead or behind. Ifanyone else wins, it seems, you lose. But Kahneman's insights teach ussomething very different and vastly more profound: Investing isn't about

beating others at their game. It's about controlling yourself at your owngame. I'm not a penny poorer if someone in Dubuque beats the S&P 500and I don't. 

Daniel Kahneman has thus used insights from cognitive psychology regardingthe mental processes of answering questions, forming judgments, and makingchoices, to help us better understand how people make economic decisions.

Herbert Alexander Simon

American social scientist known for his contributions to a number of fields, including psychology, mathematics, statistics, and operations research, all of which he

synthesized in a key theory that earned him the 1978 Nobel Prize for Economics.

He is best known for his work on the theory of corporate decision making known as

“behaviorism.” In his influential book   Administrative Behavior  (1947), Simon sought

to replace the highly simplified classical approach to economic modeling —  based on a

concept of the single decision-making, profit-maximizing entrepreneur  — with an

approach that recognized multiple factors that contribute to decision making.

According to Simon, this theoretical framework provides a more realistic

understanding of a world in which decision making can affect prices and outputs.

Crucial to this theory is the concept of “satisficing” behavior— achieving acceptable

economic objectives while minimizing complications and risks — as contrasted with

the traditional emphasis on maximizing profits. Simon's theory thus offers a way to

consider the psychological aspects of decision making that classical economists have

tended to ignore.

In older, traditional economic studies, no distinction was made between enterprises

and entrepreneurs, and it was assumed that the entrepreneurs had only one goal:

 profit-maximizing. The purpose of this classic and rather rudimentary theory of the

firm was primarily to serve as a basis for studies of total market behaviour and not of

the behaviour of the individual firms. As long as these companies consisted of small, patriarchally-run units, their activities remained relatively uninteresting. As

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companies grew in size, however, as running them became separated more and more

from owning them, as employees began to form labour unions, as the rate of

expansion increased, and as price competition between many was replaced by

competition with regard to quality and service between few, the behaviour of the

individual companies attained quite another degree of interest.

In taking a decision, he said, no business could process satisfactorily all the “zillion

things” affecting the marketing of a product, in the hope that the right answer for

maximising profit would pop out at the end.

That was classical economic theory, he said, but it was “a ridiculous view of what

goes on”. Rather, a business tried to make a decision that was “good enough”. He

called his theory “bounded rationality” and invented a name to describe it:

“satisficing”, a composition of the words satisfy and suffice.

His views on economics tied in with his ideas on artificial intelligence. Even acomputer displayed its intelligence by making choices, he said. Like a human, a chess

computer would analyse the consequences of a move, but it would do better than even

a grandmaster, who would be unlikely to see beyond eight moves ahead. But what

about insight ? Or indeed wisdom and creativity? Mr Simon tended to be dismissive

of such vague human terms. His computers had created drawings, which he was

happy to display in his office, and music, which musicians said had aesthetic interest.

They had made choices, as a human artist or musician would.

Simon's theories and observations about decision-making in organizations apply very

well to the systems and techniques of planning, budgeting and control that are used in

modern business and public administration. These theories are less elegant and lesssuited to overall economic analysis than is the classic profit-maximizing theory, but

they provide greater possibilities for understanding and predictions in a number of

areas. They have been used successfully to explain and predict such diverse activities

as the distribution of access to information and decision-making within companies,

market adjustment to limited competition, choosing investment portfolios and

choosing a country in which to establish a foreign investment. Modern business

economics and administrative research are largely based on Simon's ideas.