Kydland and Prescott: New Nobel Laureates

This year’s Nobel Prize in economics went to Finn Kydland and Edward Prescott . Kydland and Prescott wrote a famous 1977 piece (Journal of Political Economy) on time inconsistency. Ever wonder why government policy toward prescription drugs is so problematic? Kydland and Prescott had the answer. The optimal policy will first award the drugmakers a patent and allow them to charge a high price. But once the drug is developed, the “rents” will be confiscated. Optimal policy will revoke the patent and lower the price. After all, once you have the drug. why not let everybody have it cheaply? Of course the drugmakers are aware of this danger in advance, and they are correspondingly reluctant to develop new drugs. Alex posted on this logic just days ago.

In more formal language, the optimal policy is not a time consistent policy. This develops earlier ideas from Thomas Schelling on game theory. Schelling’s point was that nuclear deterrence can fail because, once destruction is aimed your way, you don’t necessarily wish to retaliate.

The logic of time consistency is quite general. It applies to regulatory policy issues, tax policy, monetary policy, foreign policy (threaten Saddam, but do you really want to have go to through with it?), and strategic behavior in a wide variety of settings.

Here are my earlier comments on Prescott, which link to other facets of his work. He arguably has enough contributions to win the prize twice. Kydland is less well known but is an important figure nonetheless. And it doesn’t hurt that he is Scandinavian (Norwegian).

Are the pair deserving? Absolutely yes.

Why did they win this year? I’m guessing that in the midst of a partisan U.S. election, the Swedes did not want to pick Paul Krugman or Robert Barro (pro-Bush), for fearing of appearing too political. Note that the economics prize has stood under criticism for some time now, for not being “scientific” enough.

And this pick the betting market got right. Prescott had opened up a clear lead in the betting market some time ago.