Tag: Nobel Prize

Why Did Fama, Hansen, and Shiller Win the Nobel?

Eugene Fama, Lars Peter Hansen, and Robert Shiller won the Nobel Prize in Economics this morning for their work studying asset prices. In one sense, they are a motley trio: Fama is famous for emphasizing efficient markets, Shiller for emphasizing investor psychology and inefficient markets, and Hansen for high-tech econometric techniques that are used well beyond finance. The unifying theme is their shared interest in understanding the predictability, if any, of asset prices.

The Royal Swedish Academy of Sciences posted an accessible summary of their work. Here’s the intro:

There is no way to predict whether the price of stocks and bonds will go up or down over the next few days or weeks. But it is quite possible to foresee the broad course of the prices of these assets over longer time periods, such as, the next three to five years. These findings, which may seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller.

Fama, Hansen, and Shiller have developed new methods for studying asset prices and used them in their investigations of detailed data on the prices of stocks, bonds and other assets. Their methods have become standard tools in academic research, and their insights provide guidance for the development of theory as well as for professional investment practice. Although we do not yet fully understand how asset prices are determined, the research of the Laureates has revealed a number of important regularities that are helping us to arrive at better explanations.

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The predictability of asset prices is closely related to how markets function, and that’s why researchers are so interested in this question. If markets work well, prices should have very little predictability. This statement may seem paradoxical, but consider the following: suppose investors could predict that a certain stock would increase a lot in value over the next year. Then they would buy the stock immediately, driving up the price until it is so high that the stock is no longer attractive to buy. What remains is an unpredictable price pattern, with random movements that reflect the arrival of news. In technical jargon, prices then follow a “random walk.”

There are, however, reasons why prices may follow somewhat predictable patterns even in a well-functioning market. A key factor is risk. Risky assets are less attractive to investors, so on average, a risky asset will need to deliver a higher return. A higher return for the risky asset means that its price can be predicted to rise faster than for safe assets. To detect market malfunctioning, then, one would need to have an idea of what a reasonable compensation for risk ought to be. The issue of predictability and the issue of normal returns that compensate for risk are intertwined. The three Laureates have shown how to disentangle these issues and analyze them empirically.

Shapley and Roth Get the Nobel Prize for Economic Engineering

A much-deserved Nobel prize today for Lloyd Shapley and Alvin Roth for their theoretical and practical work on designing markets. In particular, matching markets where you don’t have prices to help you.

The Royal Swedish Academy of Science released a very readable account of their contributions here. Here’s the introduction:

This year’s Prize to Lloyd Shapley and Alvin Roth extends from abstract theory developed in the 1960s, over empirical work in the 1980s, to ongoing efforts to find practical solutions to real-world problems. Examples include the assignment of new doctors to hospitals, students to schools, and human organs for transplant to recipients. Lloyd Shapley made the early theoretical contributions, which were unexpectedly adopted two decades later when Alvin Roth investigated the market for U.S. doctors. His findings generated further analytical developments, as well as practical design of market institutions.

Traditional economic analysis studies markets where prices adjust so that supply equals demand. Both theory and practice show that markets function well in many cases. But in some situations, the standard market mechanism encounters problems, and there are cases where prices cannot be used at all to allocate resources. For example, many schools and universities are prevented from charging tuition fees and, in the case of human organs for transplants, monetary payments are ruled out on ethical grounds. Yet, in these – and many other – cases, an allocation has to be made. How do such processes actually work, and when is the outcome efficient?

Along with his colleague David Gale, Shapley provided theoretical answers to these questions based on the idea of finding stable allocations (i.e., allocations in which no one would later have an incentive to change their mind). Roth then studied how those answers apply in real markets, e.g., designing algorithms to match doctors to hospitals.

Roth also blogs at the aptly-named Market Design. What did he write about yesterday? How Nobel Prizes correlate with chocolate consumption.

P.S. For a moving example of how well-designed matching markets improve human lives, see this post about kidney exchanges.