Here is  the introduction to Michael Schrage’s classic interview of Daniel Kahneman, published by Strategy+Business magazine (2003). I have also included the first two Q&As.

To read the complete interview, check out other resources, and obtain subscription information, please click here.

Photograph by Matthew Septimus

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A bat and a ball cost $1.10 in total. The bat costs $1 more than the ball. How much does the ball cost?

Almost everyone feels the temptation to answer “10 cents” because the sum $1.10 so neatly separates into $1 and 10 cents, and 10 cents seems the right price for a ball (small and light) relative to a bat (big and heavy). In fact, more than half of a group of students at Princeton and at the University of Michigan gave precisely that answer — that wrong answer.

The right answer is: The ball costs a nickel.

“Clearly, these respondents offered their responses without first checking,” observes Daniel Kahneman, the Eugene Higgins Professor of Psychology and a professor of public affairs in the Woodrow Wilson School of Public and International Affairs at Princeton University, and the winner of the 2002 Nobel Memorial Prize in Economics. “People are not accustomed to thinking hard and are often content to trust a plausible judgment that comes quickly to mind.”

You might choose to dismiss the baseball query as a trick question. But the pathological mistakes and the persistent miscalculations smart people make when they’re making up their minds is at the core of Professor Kahneman’s path-breaking research. With his late collaborator Amos Tversky of Stanford University, Professor Kahneman completely reframed how economics and finance define and measure rational behavior. Their provocative thinking about thinking and simple — yet remarkably powerful — experiments have revealed the quirks, logical inconsistencies, and flaws in human decision making that represent the rule rather than the exception in cognitive processing.

Prospect Theory — the researchers’ empirical exploration of risk assessment, loss aversion, and reference dependence — explains why individuals consistently behave in ways that traditional economic theory, predicated on the optimization of individual self-interest, would not predict. This work directly spawned the controversial and exciting field of behavioral finance. Championed by economists such as the University of Chicago’s Richard Thaler and Yale’s Robert Shiller, author of Irrational Exuberance (Princeton University Press, 2000), behavioral finance defies the rational investor/random walk algorithms of market analysis in favor of models of judgment under uncertainty.

Research undertaken decades ago by Professor Kahneman, Professor Tversky, and their intellectual allies now influences hundreds of billions of dollars put into corporate investments worldwide. Their insights into the nature of human judgment have prompted fundamental reevaluation of how individuals spend their time, their money, and their thought. It’s hard for an intellectually honest person to read a paper by Professor Kahneman without feeling a shock of recognition, self-consciousness, and concern for the dysfunctions in his or her own thought processes. Professor Kahneman’s work invites — and occasionally demands — serious introspection by executives who profess to care about the quality and consistency of their decisions.

While graciously crediting collaborators and colleagues, Professor Kahneman has strong personal perspectives about how the discipline he helped create has evolved. The challenge of how — and where — psychologists should draw the lines between intuition, cognition, and emotion is one that clearly haunts his thoughts about thinking.

Professor Kahneman talked with strategy+business over coffee in Cambridge, Mass.

In your classic work on inconsistencies in individual decision making, the focus seemed to be on the fact that people make irrational choices even when they have pretty good information.

When you are interpreting old results or old thoughts, you have to think what was in the background of the scientific conversation at the time. And at that time, in the 1970s, irrationality was really identified with emotionality. It was also obvious that a lot of explicit reasoning goes on: It was absolutely clear to us that people can compute their way out of some things. But we were interested in what comes to mind spontaneously. That led to the two-system theory.

Can you describe the two-system theory?

Many of us who study the subject think that there are two thinking systems, which actually have two very different characteristics. You can call them intuition and reasoning, although some of us label them System 1 and System 2. There are some thoughts that come to mind on their own; most thinking is really like that, most of the time. That’s System 1. It’s not like we’re on automatic pilot, but we respond to the world in ways that we’re not conscious of, that we don’t control. The operations of System 1 are fast, effortless, associative, and often emotionally charged; they’re also governed by habit, so they’re difficult either to modify or to control.

There is another system, System 2, which is the reasoning system. It’s conscious, it’s deliberate; it’s slower, serial, effortful, and deliberately controlled, but it can follow rules. The difference in effort provides the most useful indicator of whether a given mental process should be assigned to System 1 or System 2.

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Here is a direct link to the complete interview.

Michael Schrage (schrage@media.mit.edu) is codirector of the MIT Media Lab’s e-Markets Initiative and a senior adviser to the MIT Security Studies program. Mr. Schrage is the author of Serious Play: How the World’s Best Companies Simulate to Innovate (Harvard Business School Press, 2000).