5 Nobel Prize-Winning Economic Theories You Should Know About

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded 52 times to 86 Laureates who have researched and tested dozens of ground-breaking ideas. Here are five prize-winning economic theories with which you'll want to be familiar. These are ideas you're likely to hear about in news stories because they apply to major aspects of our everyday lives.

1. Managing Common Pool Resources (CPRs)

The term common pool resources (CPRs) refers to resources that aren't owned by one particular entity. Rather, they are held by the government or are allocated to privately owned lots that are made available to the general public. CPRs (or commons as they're commonly known) are those that are available to everyone but are in finite supply, including forests, waterways and water basins, and fishing grounds.

Ecologist Garrett Hardin wrote "The Tragedy of the Commons," which appeared in Science in 1968. In his paper, he addressed the overpopulation of the human race in relation to these resources. Hardin surmised that everyone would act in their own best interests, meaning they would end up consuming as much as they possibly can. This would make these resources even harder to find for others.

In 2009, Indiana University political science professor Elinor Ostrom became the first woman to win the prize. She received it "for her analysis of economic governance, especially the commons."

Ostrom's Groundbreaking Research

Ostrom's research showed how groups work together to manage common resources such as water supplies, fish, lobster stocks, and pastures through collective property rights. She showed that Hardin's prevailing tragedy of the commons theory isn't the only possible outcome, or even most likely when people share a common resource.

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

Because outsiders and government agencies don't understand local conditions or norms, and lack relationships with the community, they may manage common resources poorly. By contrast, insiders with a say in resource management will self-police to ensure that all participants follow the community's rules.

2. Behavioral Finance

Behavioral finance is a form of behavioral economics. It studies the psychological influences and biases that affect the behavior and decisions of investors as well as financial professionals. These influences and biases tend to explain various market anomalies, especially those found in the stock market. This includes very drastic increases and drops in the price of securities.

Psychologist Daniel Kahneman was awarded the prize in 2002 "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty."

Kahneman's Work

Kahneman showed that people do not always act out of rational self-interest, as the economic theory of expected utility maximization would predict. This concept is crucial to behavioral finance. The research identified common cognitive biases that cause people to use faulty reasoning to make irrational decisions. These biases include the anchoring effect, the planning fallacy, and the illusion of control.

He conducted his research with Amos Tversky, but Tversky was not eligible to receive the prize because he died in 1996.

Kahneman and Tversky's Theory

"Prospect Theory: An Analysis of Decision Under Risk," is one of the most frequently cited articles in economics journals. Kahneman's (and Tversky's) award-winning prospect theory shows how people really make decisions in uncertain situations.

They demonstrated that we tend to use irrational guidelines such as perceived fairness and loss aversion, which are based on emotions, attitudes, and memories, not logic. For example, Kahneman and Tversky observed that we expend more effort just to save a few dollars on a small purchase than to save the same amount on a large purchase.

Kahneman and Tversky also showed that people use general rules, such as representativeness, to make judgments that contradict the laws of probability. For instance, when given the description of a woman concerned about discrimination and asked if she is more likely to be a bank teller or a bank teller who is a feminist activist, people tend to assume she is the latter even though probability laws tell us she is much more likely to be the former.

3. Asymmetric Information

This discipline is also known as information failure. It occurs when one party involved in an economic transaction has much more knowledge than the other. This phenomenon typically presents itself when the seller of a good or service possesses greater knowledge than the buyer. But in some cases, the reverse dynamic may also be possible. Almost all economic transactions involve asymmetric information.

In 2001, George A. Akerlof, A. Michael Spence, and Joseph E. Stiglitz won the prize "for their analyses of markets with asymmetric information." The trio showed that economic models predicated on perfect information are often misguided. That's because one party often has superior information in a transaction.

Understanding information asymmetry has improved our knowledge of how various markets work and the importance of corporate transparency. Today, these concepts are so widespread that we take them for granted, but when they were first developed, they were groundbreaking.

Akerlof, Spence, and Stiglitz's Research

Akerlof showed how information asymmetries in the used car market, where sellers know more than buyers about the quality of their vehicles, can create a market with lemons (a concept known as "adverse selection"). A key publication related to this prize is Akerlof's 1970 journal article, "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism."

Spence's research focused on signaling or how better-informed market participants can transmit information to lesser-informed participants. He showed how job applicants can use educational attainment as a signal to prospective employers about their likely productivity and how corporations can signal their profitability to investors by issuing dividends.

Stiglitz showed how insurance companies can learn which customers present a greater risk of incurring high expenses. He called this process screening. According to Stiglitz, asymmetric information occurs by offering different combinations of deductibles and premiums.

4. Game Theory

The theory of non-cooperative games is a branch of the analysis of strategic interaction commonly known as game theory. Non-cooperative games are those in which participants make non-binding agreements. Each participant bases his or her decisions on how he or she expects other participants to behave, without knowing how they will actually behave.

The academy awarded the 1994 prize to John C. Harsanyi, John F. Nash Jr., and Reinhard Selten "for their pioneering analysis of equilibria in the theory of non-cooperative games."

Harsanyi, Nash, and Selten's Analysis

One of Nash's major contributions was the Nash Equilibrium, a method for predicting the outcome of non-cooperative games based on equilibrium. Nash's 1950 doctoral dissertation, "Non-Cooperative Games," details his theory. The Nash Equilibrium expanded upon earlier research on two-player, 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 in the analysis of oligopoly and the theory of industrial organization, and have inspired new fields of research.

5. Public Choice Theory

This theory attempts to provide the rationale behind public decisions. This involves the participation of the general public, elected officials, political committees, along with the bureaucracy that is set up by society. James M. Buchanan Jr. developed the public choice theory with Gordon Tullock.

James M. Buchanan Jr. received the prize in 1986 "for his development of the contractual and constitutional bases for the theory of economic and political decision-making."

Buchanan's Award-Winning Theory

Buchanan's major contributions to public choice theory bring together insights from political science and economics to explain how public-sector actors (e.g., politicians and bureaucrats) make decisions. He showed, contrary to the conventional wisdom, the following:

• Public sector actors act in the public's best interest (as public servants).
• Politicians and bureaucrats tend to act in their own self-interest, the same way private sector actors (consumers and entrepreneurs) do.

He described his theory as "politics without romance." Buchanan laid out his award-winning theory in a book he co-authored with Gordon Tullock in 1962, The Calculus of Consent: Logical Foundations of Constitutional Democracy.

We can get a better understanding of the incentives that motivate political actors and better predict the results of political decision-making using Buchanan's insights about the political process, human nature, and free markets. We can then design fixed rules that are more likely to lead to desirable outcomes.

For example, instead of allowing deficit spending, which political leaders are motivated to engage in because each program the government funds earns politicians support from a group of voters, we can impose a constitutional restraint on government spending, which benefits the general public by limiting the tax burden.

Honorable Mention: Black-Scholes Theorem

Robert Merton and Myron Scholes won the 1997 Nobel Prize in economics for the Black-Scholes theorem, a key concept in modern financial theory that is commonly used for valuing European options and employee stock options.

Though the formula is complicated, investors can use an online options calculator to get its results by inputting an option's strike price, the underlying stock's price, the option's time to expiration, its volatility, and the market's risk-free interest rate. Fischer Black also contributed to the theorem, but could not receive the prize because he passed away in 1995.

The Bottom Line

Each of the dozens of winners of the Nobel memorial prize in economics has made outstanding contributions to the field, and the other award-winning theories are worth getting to know, too. Working knowledge of the theories described here, however, will help you establish yourself as someone who is in touch with the economic concepts that are essential to our lives today.