It's The Economy, Stupid!
the nobel prize and you
2007-11-05
By Donna Johnson and Boyd Klingler

Unless your name ends with Greenspan or Bernanke, news of this year’s Nobel Prize in Economics probably made your eyes glaze over. Initially, we were right there with you, but, always willing to take a crack at deciphering the code, we thought we had spotted a trend in making this stuff accessible to the masses. Alas, we rejoiced too soon: the theories haven't become any easier to understand. But we can report that in recent years, economic Nobelists have been developing and refining theories that examine how and why we make the financial decisions that we do in everyday life.

First, some clarification. The prize for economics isn’t technically a Nobel Prize at all. The original categories established by Alfred Nobel in 1901 were for chemistry, physics, medicine, literature and peace. The economics prize became the bastard child of the Bank of Sweden set up in 1968 and awarded in "memory" of Alfred Nobel. So it’s a baby-daddy, so what. From that time efforts were made to clear a backlog of recognizing well-deserving pioneers of economics and it’s only been over the last 10 or 15 years in which the Sveriges Riksbank Prize in Economics as it’s formally called, has been awarded to newer theories.

Here's a quick -- okay, downright simplistic -- look at some of the more contemporary winners and their contributions:

One of the co-recipients of the 2000 Nobel Prize in Economics was for the theory of self-selection. It was based on a study published in 1974 that looked at educated, married women entering the workforce. What’s significant here is that this study took place during the heart of the Women’s Liberation Movement when women were entering the labor force in numbers not seen since World War II. The problem of selection bias was uncovered because it took into account certain factors that influenced an individual’s desire to work and unwittingly excluded others.

The 2001 winners looked at how decisions are made based on what’s called asymmetric information. In essence, it’s why some of us would choose a dealer over a private seller when we want to buy a reliable used car, or why insurance companies offer a choice of higher deductibles in exchange for a range of lower premiums. One participant has more knowledge about the product or himself than the other. Protectionist "lemon laws" grew out of this study first introduced in the early 1970’s by the 2001 Nobel recipients.

In 2002 Daniel Kahneman (who is actually a psychologist) shared the Nobel Prize in Economics for integrating psychology with economics. His position, which effectively opened the door to a new field of research, involved decision-making under uncertainty and concluded that human beings do not make decisions based solely on material incentives or always in a rational way, and often departed from ways forecasted by conventional economic theory. In other words, "behavioral finance" is the stock market in flux.

Leonid Hurwicz, Roger Myerson and Eric Maskin, winners of the 2007 Nobel Prize in Economics, were recognized for their work on the Mechanism Design Theory or MDT. It has to do with the auction process and analyzes how incentives compel us to reveal specific information when it comes to bidding on an item we value, especially when another person can affect the outcome whether we tell the truth or not. Mechanism Design Theory, initiated over 50 years ago, emerged just in time for E-bay.

According to its theorists, MDT is where participants transmit information to each other through a "message center," then a pre-specified rule assigns an outcome for every bundle of received messages. One offshoot of MDT is Game Theory, developed by fellow Nobel Laureate John Nash (1994) of "A Beautiful Mind" fame.

Another way to look at Mechanism Design is with the S-Chip, Congress’ solution to providing free health care for over 12 million children in the United States. A recent poll said that 88% of those surveyed support the passage of this bill. But the mechanism at work here is the political process resulting in a Presidential veto. What MDT says is that politics matters. In the Adam Smith world where decision was based on what the people wanted, we’d have the S-Chip. But in the marketplace of politics, Smith's "invisible hand" is showing us the middle finger.

So, yes, MDT has its place in the world as we know it, a place relevant to you at some point or another in time. There is even a mechanism design in place to address the perils of global warming, but thankfully this year that’s being acknowledged in another category. Peace.

Donna Johnson and Boyd Klingler are Giving You the BusinessSM, in an occasional column for EbonyJet.com. Send your business and finance-related questions to our e-mailbag.