Prize-winners pioneered experimental approach to markets. Credit: © GettyImages

Two researchers who breathed new life into a theory-driven field have netted this year's Nobel Prize in economics. By integrating scientific method and the study of human nature into classical economics, they spawned behavioural and experimental branches of the discipline.

Daniel Kahneman of Princeton University in New Jersey bridged the gap between psychology and traditional economics by showing how human judgement and decision-making shape economic processes. Kahneman shares the US$1.1 million prize with Vernon Smith of George Mason University, Virginia, who was largely responsible for bringing economics into the laboratory.

Social scientist Herb Gintis of the University of Massachusetts in Amherst expressed delight at today's announcement. "Economics textbooks are full of theory but have no data or experimental results," he says. "We need to understand how people actually behave and how this affects economic institutions."

Traditional economic theory considers humans as self-interested agents, making rational decisions calculated to maximize personal benefit or profit. In reality, however, peoples' decisions are often idiosyncratic, coloured by perceptions, beliefs, emotions and other subtle psychological influences.

The theories assumed that these deviations from perfect rationality would cancel out in large numbers of people. But systematic deviations would spell trouble for traditional economic theory.

Recognizing this, Kahneman set out to explain how individuals really behave. He found compelling evidence that undermines the long-standing assumption of economic rationality.

Under conditions of uncertainty, he found, people often use short cuts, or heuristics, that bias their judgments. For example, people often overestimate the prevalence of violent crime if they personally know a victim of such a crime. Such errors of judgement lead to patterns of decision-making that cannot be accounted for by traditional economics.

With the orthodoxy in tatters, Kahneman and the late Amos Tversky proposed a theoretical framework for understanding human economic behaviour1. Unlike traditional theory, which is based on axioms, prospect theory is based on empirical observations that generate specific hypotheses that can be tested experimentally.

Vernon Smith pioneered this experimental approach to study markets. Participants acting as buyers and sellers are placed in settings similar to real financial- and commodity-market situations, but under carefully laboratory control. Energy deregulation in the United States, pollution permit trading and other public policy decision have all been informed using Smith's techniques.

Kahneman and Smith's ideas were slow to catch on, especially in academic departments, says Gintis: "But now the big boys are taking notice." Harvard University, the Massachusetts Institute of Technology and the University of Chicago have all recently made major appointments in the fields pioneered by Kahneman and Smith, he says.

Because of the duo's achievements, the future is bright for economics, says Gintis: "If the twentieth century was characterized by fragmentation in the social sciences, the twenty-first century will be one of cross-discipline integration, with all fields benefiting from the synergy."