A Nobel Letdown in Economics


By Michael Mandel I like rationality as much as the next person. When I was in high school in Brooklyn in the 1970s, I laboriously worked my way through a thick book called Theory of Games and Economic Behavior, the founding bible of game theory (yes, I was an odd kid). It had chapter titles like "Qualitative Discussion of the Problem of Rational Behavior" and "The Symmetric Five-Person Game." A decade later, I used game theory in my doctoral dissertation.

It's customary, when the Nobel Prize in Economics is announced each year, for the members of the economics profession to gather around and proclaim how deserving the winners are and how important their research is to the field. I have to say, however, that this year's Nobel Prize in Economics, given to two game theorists, brings up mixed feelings for me.

Since I'm a journalist with a PhD in economics, I will go half the distance. I agree that Robert Aumann and Thomas Schelling, this year's Nobel laureates, deserve their awards. Schelling, in particular, wrote two of the best economic books ever, The Strategy of Conflict and Micromotives and Macrobehavior.

CONSISTENT WITH MANY OUTCOMES. In my opinion, however, game theory represents an evolutionary dead-end in the development of economics. Game theory tries to use the principle of rationality to explain conflict and cooperation in a wide range of economic and social situations. For example, game theory has been used to analyze why the apparently insane buildup of nuclear weapons in the postwar period was actually a rational method of deterring war, and why aggressive price-cutting by airlines was an effective means of deterring competition.

Game theory is no doubt wonderful for telling stories. However, it flunks the main test of any scientific theory: The ability to make empirically testable predictions. In most real-life situations, many different outcomes -- from full cooperation to near-disastrous conflict -- are consistent with the game-theory version of rationality.

To put it a different way: If the world had been blown up during the Cuban Missile Crisis of 1962, game theorists could have explained that as an unfortunate outcome -- but one that was just as rational as what actually happened. Similarly, an industry that collapses into run-amok competition, like the airlines, can be explained rationally by game theorists as easily as one where cooperation is the norm.

FRESHER THINKING. Rationality only gets you so far in terms of predicting behavior. In the aftermath of Katrina, news reports of widespread looting and crime in New Orleans were perfectly plausible. After all, it would be rational for criminals to take advantage of the absence of effective policing.

But now that we know that criminal activity after the hurricane was relatively rare, well, it also seems rational that everyone would band together in the face of a common disaster. Similarly, in Iraq today, either of two polar outcomes -- civil war or cooperation between the Sunnis and Shiites -- is perfectly compatible with game theory.

Instead, the real progress in economics these days is coming not from game theory, which has been around for 60 or more years, but from the much newer fields of behavioral and experimental economics. Behavioral and experimental economics don't start with the assumption of rationality used by game theory. Rather, as the name suggests, the focus is on looking at how individuals and organizations actually make decisions in practice, including systematic biases, misperceptions, and just general all-around bloody-mindedness.

DEFYING EXPECTATIONS. In fact, Daniel Kahneman and Vernon Smith won the 2002 Nobel Prize in Economics for their work on behavioral and experimental economics. The writeup that accompanied their award observed:

Real-world decision-makers frequently appear not to evaluate uncertain events according to the laws of probability; nor do they seem to make decisions according to the theory of expected-utility maximization.

In a series of studies, Kahneman -- in collaboration with the late Amos Tversky -- has shown that people are incapable of fully analyzing complex decision situations when the future consequences are uncertain.

SAYING TOO MUCH. In other words, Kahneman and Smith won their 2002 prize precisely for showing that people mostly don't behave the way that game theory assumes they do. Game theory is based on a finely honed sort of reasoning: "If I do this, then he'll do that, then I'll do this" ad infinitum, assessing the probability of different final outcomes. In reality, though, that's not how most people think or make decisions.

Now, nobody forces the Royal Swedish Academy of Sciences, which awards the Nobel Prize, to worry about intellectual consistency. But I do object when the Nobel Prize press release asks "Why do some groups of individuals, organizations, and countries succeed in promoting cooperation while others suffer from conflict?" and then calls game theory "the dominant approach to this age-old question." That's just overstatement.

Mandel is chief economist for BusinessWeek


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