5 Nobel Prize-winning economic theories you should know

The Swedish Central Bank Memorial Alfred Nobel Prize in Economics has been awarded 52 times to 86 winners who have researched and tested dozens of breakthrough ideas. Here are five award-winning economic theories you want to be familiar with. These are ideas you might hear in news reports because they apply to the main aspects of our daily lives.

Key points

  • Elinor Ostrom was awarded in 2009 for his research and analysis on the economics of public pool resources.
  • Daniel Kahneman’s research on behavioral finance won him a 2002 award.
  • The Nobel Prize Committee recognized George A. Akerlof, A. Michael Spence, and Joseph E. Stiglitz in 2001 for their work on asymmetric information.
  • John C. Harsanyi, John F. Nash Jr. and Reinhard Selten were awarded in 1994 for their research on non-cooperative game theory.
  • James M. Buchanan developed the theory of public choice and won the Nobel Prize in 1986 for this.

1. Manage Common Pool Resources (CPR)

The term Common Pool Resource (CPR) refers to resources that do not belong to a specific entity. Instead, they are held by the government or allocated to private land available to the public. CPR (or public resources as we know them) are those that are available to everyone but have limited supply, including forests, waterways and waters, and fishing grounds.

Ecologist Garrett Hardin (The Tragedy of the Commons) by Garrett Hardin appears in science In 1968. In his thesis, he solved the human overpopulation problem related to these resources. Harding speculates that everyone will act in their best interests, which means they will eventually consume as much as possible. This will make it more difficult for others to find these resources.

In 2009, Elinor Ostrom, a professor of political science at Indiana University, became the first woman to receive the award. She was awarded “for her analysis of economic governance, especially the commons”.

Ostrom’s pioneering research

Ostrom’s research shows how groups can collectively manage public resources such as water supply, fish, lobster populations, and pastures through collective property rights. She showed that Harding’s universal tragedy of the commons theory is not the only possible outcome, even when people share common resources.

Ostrom showed that as long as the people using the resource are physically close to it and have a relationship with each other, CPR can be collectively managed effectively without government or private control.

Because outsiders and government agencies do not understand local conditions or regulations, and lack relationships with the community, they may not be able to manage public resources well. In contrast, insiders who have a say in resource management will self-regulate to ensure that all participants abide by the rules of the community.

You can read about Ostrom’s award-winning research in her book, Managing the commons: the evolution of the collective action systemAnd in her 1999 science Journal article, “Revisiting the Commons: Local Experience, Global Challenges”.

2. Behavioral Finance

Behavioral finance is a form of behavioral economics. It studies the psychological influences and biases that influence the behavior and decision-making of investors and financial professionals. These influences and prejudices can often explain various market anomalies, especially those found in the stock market. This includes sharp rises and falls in securities prices.

Psychologist Daniel Kahneman (Daniel Kahneman) was awarded in 2002 for “incorporating insights from psychological research into economic science, especially with regard to human judgment and decision-making under uncertainty”.

Kahneman’s works

Kahneman showed that people do not always act out of rational self-interest, as predicted by the economic theory of expected utility maximization. This concept is essential to behavioral finance. The study identified common cognitive biases that cause people to use wrong reasoning to make irrational decisions. These prejudices include anchoring effects, planning fallacies, and control illusions.

He conducted research with Amos Tversky, but Tversky died in 1996 and therefore was not eligible for the award.

Kahneman and Tversky’s theory

“Prospect Theory: Decision Analysis under Risk” is one of the most frequently cited articles in economic journals. Kahneman’s (and Tversky’s) award-winning prospect theory shows how people can really make decisions when they are uncertain.

They prove that we tend to use irrational guidelines, such as perceived fairness and loss aversion, which are based on emotions, attitudes, and memories, rather than logic. For example, Kahneman and Tversky observed that compared to saving the same amount on a large purchase, we spend more effort just to save a few dollars on a small purchase.

Kahneman and Tversky also showed that people use general rules (such as representation) to make judgments that contradict the laws of probability. For example, when describing a woman who is worried about discrimination and asked whether she is more likely to be a bank teller or a bank teller of a feminist activist, people tend to assume that she is the latter, even if the law of probability tells us that she is more likely to be. former.

The Nobel Prize is not awarded posthumously.

3. Information asymmetry

This discipline is also called information failure. This happens when one party participating in an economic transaction has more knowledge than the other. This phenomenon usually occurs when the seller of goods or services has more knowledge than the buyer. But in some cases, reverse dynamics are also possible. Almost all economic transactions involve information asymmetry.

In 2001, George A. Akerlof, A. Michael Spence and Joseph E. Stiglitz won awards for “Analysis of Information Asymmetric Markets.” The trio showed that economic models based on perfect information are often misled. That’s because one party usually has better information in the transaction.

Understanding information asymmetry improves our understanding of how various markets operate and the importance of corporate transparency. Today, these concepts are so common that we take them for granted, but when they were first developed, they were groundbreaking.

The study of Akerlov, Spencer and Stiglitz

Akerlof demonstrates the information asymmetry in the used car market. Sellers understand the quality of their vehicles better than buyers and how to create a lemon market (a concept called “adverse selection”). An important publication related to this award is the journal article “The’Lemon’ Market: Quality Uncertainty and Market Mechanism” published by Akerlof in 1970.

Spence’s research focuses on how signals or well-informed market participants pass information to well-informed participants. He showed how job seekers use education as a signal to potential employers about their possible productivity, and how companies can show investors their profitability by issuing dividends.

Stiglitz showed how insurance companies understand which customers are at greater risk of incurring high costs. He called this process screening. According to Stiglitz, asymmetric information occurs by providing different combinations of deductibles and premiums.

4. Game Theory

Non-cooperative game theory is a branch of strategic interaction analysis, commonly known as game theory. A non-cooperative game is a game in which participants reach a non-binding agreement. Each participant makes his or her decision based on what he or she expects other participants to do, without knowing how they will actually behave.

The college awarded the 1994 award to John C. Harsanyi, John F. Nash Jr., and Reinhard Selten, “for their pioneering analysis of equilibrium in non-cooperative game theory.”

Analysis of Harsanyi, Nash and Selten

One of Nash’s main contributions is the Nash equilibrium, which is a method of predicting the outcome of non-cooperative games based on equilibrium. Nash’s 1950 doctoral dissertation “Non-cooperative Game” introduced his theory in detail. Nash equilibrium expands the early research on two-person zero-sum games.

Selten applied Nash’s findings to dynamic strategic interactions, and Harsanyi applied them to scenarios with incomplete information to help develop the field of information economics. Their contributions are widely used in economics, such as oligopoly analysis and industrial organization theory, and have inspired new research fields.

5. Public Choice Theory

The theory attempts to provide the rationale behind public decision-making. This involves the participation of the public, elected officials, political committees, and bureaucracies established by society. James M. Buchanan Jr. and Gordon Tullock jointly developed the theory of public choice.

James M. Buchanan Jr. was awarded in 1986 for “developing the contract and constitutional basis for economic and political decision-making theory”.

Buchanan’s winning theory

Buchanan’s main contributions to public choice theory brought together political science and economics insights to explain how actors in the public sector (such as politicians and bureaucrats) make decisions. Contrary to conventional wisdom, he showed the following:

  • Actors in the public sector act in the best interest of the public (as civil servants).
  • Politicians and bureaucrats tend to act in their own interests, just as private sector participants (consumers and entrepreneurs) do.

He described his theory as “politics without romance.” Buchanan elaborated on his winning theory in a book co-authored with Gordon Tulloch in 1962. The Calculus of Consent: The Logical Basis of Constitutional Democracy.

We can use Buchanan’s insights on political processes, human nature, and free markets to better understand the motivations of political actors and to better predict the outcome of political decisions. Then, we can design fixed rules that are more likely to lead to the desired result.

For example, we can impose constitutional restrictions on government spending instead of allowing political leaders to have an incentive to participate in deficit spending, because every plan funded by the government will receive support from politicians from a group of voters, by limiting the tax burden.

Honorable Mention: Black-Scholes Theorem

Robert Merton and Myron Scholes won the Nobel Prize in Economics in 1997 for the Black-Scholes theorem, which is a key concept in modern financial theory and is often used to evaluate European Options and employee stock options.

Although the formula is complicated, investors can use the online option calculator to obtain results by entering the option’s strike price, underlying stock price, option expiry time, volatility, and market risk-free interest rates. Fischer Black also contributed to the theorem, but failed to win the prize due to his death in 1995.

Bottom line

There are dozens of Nobel Prize winners in economics, each of which has made outstanding contributions in this field, and other winning theories are also worthy of in-depth understanding. However, practical knowledge of the theories described here will help you establish your connection with the economic concepts essential to life today.

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