London

Two researchers who put practical ideas to work in a theory-dominated discipline have netted this year's Nobel prize in economics.

Daniel Kahneman of Princeton University in New Jersey integrated psychology into economics, showing how human judgement and decision-making help to shape economic processes. He shares the prize with Vernon Smith of George Mason University in Virginia, who pioneered the use of real experimental data as a check on economic theory.

“Economics textbooks are full of theory, but have no data or experimental results,” explains Herbert Gintis of the University of Massachusetts in Amherst. “We need to understand how people actually behave and how this affects economic institutions.”

Classical economic theory rests on the idea that people will behave rationally, in their own best interests. Kahneman was among the first to show that people's economic choices are not always rational, however, and can be strongly influenced by their perceptions and emotions. He found that people often display biases in their economic behaviour that lead to patterns of decision-making that are at odds with what traditional theory predicts.

Having vanquished orthodoxy, Kahneman and the late Amos Tversky proposed a new framework in a classic paper, “Prospect theory: An analysis of decision under risk” (D. Kahneman & A. Tversky Econometrica 47, 263–291; 1979). Unlike the ideas that it challenges, prospect theory uses empirical observations to generate specific hypotheses that can be tested experimentally.

Smith, meanwhile, has made extensive use of carefully controlled experiments to study how markets behave.

According to economist Samuel Bowles, at the Santa Fe Institute in New Mexico, Smith showed that the standard economic model of how markets work is correct, even as Kahneman proved that the model of rational economic decision-making is wrong. This apparent paradox makes sense, Bowles says, because market models “do not require any particular kind of rationality or high-level cognitive capacity” on the part of participants. He concludes that “the main difference between biological and economic competition — namely, the rationality of the human agents — may be overrated”.

Gintis says that Kahneman and Smith's ideas were slow to catch on in academia. But Harvard University, Massachusetts Institute of Technology and the University of Chicago have each now appointed senior faculty in the subdisciplines the duo pioneered.