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1 Copyright 2013 John Wiley & Sons Judgment in Managerial Decision Making 8e Chapter 5 Framing and the Reversal of PreferencesAs noted previously, we tend to use heuristics, or rules of thumb, to reduce the complexity of our decisions.Often, these heuristics allow us to make effective decisions in a short amount of time.However, under the right set of circumstances they can also lead us into making biased decisions.Avoiding the biases that come with the use of heuristics is so difficult that even the most intelligent people are prone to error.Before introducing key biases, take a few minutes to answer the following questions. Write down your answers.Copyright 2013 John Wiley & Sons
2 The Asian Disease Problem Imagine that the United States is preparing for the outbreak of an unusual Asian disease that is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientiﬁc estimates of the consequences of the programs are as follows. Program A: If Program A is adopted, 200 people will be saved. Program B: If Program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved. Which of the two programs would you favor?Consider this problem.You have a choice between two programs.Each program is expected to save 200 people.However, Program A is certain to save 200 people while Program B has a high degree of uncertainty, as either 200 or 0 people will be saved.Because people are risk averse, they tend to favor Program A.
3 Big Positive GambleYou can (a) receive $10 million for sure (expected value = $10 million) or (b) ﬂip a coin and receive $22 million for heads but nothing for tails (expected value = $11 million). An expected-value decision rule would require you to pick (b). What would you do?Now, consider this problem about a gamble and write down what you would do.Essentially, you can choose between a higher expected value that is uncertain or a sure gain that is slightly lower.Most people take the certain gain here due to risk aversion.
4 LawsuitYou are being sued for $500,000 and estimate that you have a 50 percent chance of losing the case in court (expected value = –$250,000). However, the other side is willing to accept an out-of-court settlement of $240,000 (expected value = –$240,000). An expected-value decision rule would lead you to settle out of court. Ignoring attorney’s fees, court costs, aggravation, and so on, would you (a) ﬁght the case, or (b) settle out of court?Now, consider this problem.In this case, we are considering the domain of losses rather than gains.You can choose between a sure loss of $240,000 or a 50/50 shot at losing either $500,000 or nothing.In this case, most people are risk-seeking and choose to fight the lawsuit in court.When comparing to the previous problem, where you had a choice between a certain gain and a slightly larger gain that is uncertain, people tend to be risk averse while here, they tend to be risk-seeking. Interestingly, this preferences differ despite the fact that the two problems are conceptually similar.
5 Asian Disease ProblemImagine that the United States is preparing for the outbreak of an unusual Asian disease that is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the scientiﬁc estimates of the consequences of the programs are as follows. Program C: If Program C is adopted, 400 people will die. Program D: If Program D is adopted, there is a one-third probability that no one will die and a two-thirds probability that 600 people will die. Which of the two programs would you favor?Now, let’s return to a problem that slightly varies from the Asian Disease problem that we went over earlier.Notice that this problem is quite similar to the one we originally encountered, except for that rather than referring to 200 people being saved in Program C or the 0 people that will be saved in Program D, it is pointing out the 400 people that will die in Program C and that 600 people will die in Program D.From an objective numerical standpoint, these two options are identical to Programs A and B in the original version of the problem.However, one version of the problem emphasizes lives saved while the other emphasizes deaths.Interestingly, despite the problems being identical from the standpoint of computing the expected number of deaths, people tend to be risk-seeking in this version of the problem and select Program D even though in the prior version of the problem, people tend to be risk-averse and select Program A.This illustrates the power of framing, a subtle change in the implicit reference point that is invoked when solving problems. Very subtle changes in the wording of a problem via framing can have a dramatic impact on preferences.We tend to be risk-averse in the domain of gains and risk-seeking in the domain of losses.Thus, if framing draws attention to deaths from a reference state of the world with all 600 people being alive, people will undertake significant risk to save all 600 people.However, if it draws attention to lives saved from a reference state of the world with all 600 people dying, people will be reluctant to risk not saving anybody.
6 Sell or Hold?You were given 100 shares of stock in XYZ Corporation two years ago, when the value of the stock was $20 per share. Unfortunately, the stock has dropped to $10 per share during the two years that you have held the asset. The corporation is currently drilling for oil in an area that may turn out to be a big “hit.” On the other hand, they may ﬁnd nothing. Geological analysis suggests that if they hit, the stock is expected to go back up to $20 per share. If the well is dry, however, the value of the stock will fall to $0 per share. Do you want to sell your stock now for $10 per share?Now consider this problem on whether you would like to sell or hold a stock.Here, framing is more ambiguous.Some people may frame this in terms of the amount that they receive for the stock above a reference point of $0 per share.Others may frame this in terms of the amount that the stock has fallen from a reference purchase price of $20 per share.Those who frame this in terms of gains above $0 will likely be risk averse and sell the stock while those who frame this problem in terms of losses from $20 will likely hold onto the stock out of hopes that they will break even on the stock.This illustrates that even a single problem can be framed multiple ways and the frame one adopts can have a dramatic influence on his or her decision making despite being faced with an objectively identical problem.
7 Preference Reversals Sub-optimal decision portfolios “Pseudocertainty” and our judgmentsInsuranceEvaluations of transactionsOwnership and framingMental accountingBonuses versus rebatesSeparate versus joint evaluationAs illustrated by these problems, the way options are framed can play an important role in impacting our decisions.As one could imagine, framing impacts our decisions in a variety of domains. We will review the following domains in which framing impacts our decision-makingFraming can have particularly strong effects when we consider the sum of our decisions as a portfolio.Imperfect perceptions of probability can influence our choices.Our decisions to purchase insurance are impacted by framing.We evaluate the quality of transactions according to how we frame the them.When we own an object, we frame it differently than when we do not.We tend to organize our finances by tracking our spending on different categories of purchases. The manner in which we frame purchases and categorize them can influence the manner in which we frame them.Our spending behavior is influenced by whether excess money is framed as a rebate or a bonus.Sometimes we consider options separately while in others, we make choices while having access to all possible alternative options. This has an impact on our decisions.
8 Framing and the Irrationality of the Sum of Our Choices Imagine that you face the following pair of concurrent decisions. First, examine both decisions, and then indicate the options you prefer. Decision A Choose between: a. a sure gain of $240 b. a 25 percent chance to gain $1,000 and a 75 percent chance to gain nothing Decision B c. a sure loss of $750 d. a 75 percent chance to lose $1,000 and a 25 percent chance to lose nothing- Consider the following two decisions and then indicate your preferred choices in each option.
9 What Do People Choose? Decision A Decision B As we would expect, on Decision A, which is framed in terms of potential gains, people tend to be risk averse and choose the option with a sure gain of $240.We also see that on Decision B, which is framed in terms of potential losses, people tend to be risk-seeking and choose the option with an uncertain loss over the one with a certain loss of $750.In combination, 73% of people choose options A and D.
10 Framing and the Irrationality of the Sum of Our Choices Choose between: e. a 25 percent chance to win $240 and a 75 percent chance to lose $760 f. a 25 percent chance to win $250 and a 75 percent chance to lose $750Now, think about this problem for a moment.Not surprisingly, most people prefer option F to option E, as option E provides a better expected value with more potential for gains and less potential for losses.If you looked at the problem carefully, you may have noticed that Option E combines the sure gain of $240 from Option A in Decision A of the previous problem with the uncertain loss of $760 from Option D in Decision B of the previous problem.This was the preferred pattern of choices that people made when considering the decisions separately.However, when combining choices across gains and losses, Choice F, which combines individuals’ less preferred options in the prior problem, is clearly superior.By merely considering choices framed as gains and losses separately, people have made suboptimal decisions.However, by jointly considering choices framed as gains and losses, people can improve the quality of their decisions.How might all of this be relevant for our managerial decisions?When budgeting and funding projects, managers often make allocation decisions separately.Different departments of organizations frame projects differently:Salespeople think in terms of acquiring corporate gains.Credit offices think of decisions in terms of avoiding losses.Overall, many of the decisions that occur in organizations are made sequentially or with separate frames as opposed to simultaneously and with consistent frames. This can lead to sub-optimal decisions at an organizational level.
11 Russian RouletteQuestion 1 How much would you pay to remove the bullet and reduce the likelihood of death from 1/6 (17%) to 0? Question 2 In a game with two bullets, how much would you pay to remove one bullet and reduce the likelihood of death from 1/3 (33%) to 1/6 (17%)?Take a moment to consider these two questions about a hypothetical game of Russian Roulette.In Question 1, we are considering a traditional game with a single bullet in a revolver and you are asked to indicate how much you would pay to remove the bullet.In Question 2, we are considering a riskier game with two bullets in a revolver and you are asked to indicate how much you would pay to remove one of the bullets.Though the likelihood of death is reduced the same amount by removing a bullet in both questions, people are willing to pay much more when considering question 1.This is because we place a much higher value on reducing the probability of harm to zero relative to reducing the probability of harm to a nonzero sum.We place a high overall value on the creation of certainty.However, perceived certainty can be easily manipulated via framing.For example, insurance companies can frame insurance as “full protection” from natural disasters or as a reduction of the probability of experiencing loss as the result of a natural disaster.Similarly, a vaccine could be framed as providing full protection against a strain of disease or as merely reducing the probability of contracting the disease.
12 Perceptions of Certainty Which of the following options do you prefer?a. a sure win of $30b. an 80 percent chance to win $45Consider the following two-stage game. In the ﬁrst stage, there is a 75 percent chance to end the game without winning anything and a 25 percent chance to move into the second stage. If you reach the second stage you have a choice between:c. a sure win of $30d. an 80 percent chance to win $45e. a 25 percent chance to win $30f. a 20 percent chance to win $45Take a moment to respond to this set of problems.In the left-most problem, you face a certain gain versus an uncertain gain.In the middle problem, you must make a decision in a two-stage game before knowing the outcome of the first stage. After the uncertain first stage of the game, the options are identical to the left-most problem.Now, consider the right-most problem. Essentially, this problem is equivalent to the decision that you faced before starting the game outlined in the middle problem.
13 Perceptions of Certainty Which of the following options do you prefer?a. a sure win of $30 (78%)b. an 80 percent chance to win $45 (22%)Consider the following two-stage game. In the ﬁrst stage, there is a 75 percent chance to end the game without winning anything and a 25 percent chance to move into the second stage. If you reach the second stage you have a choice between:c. a sure win of $30 (74%)d. an 80 percent chance to win $45 (26%)e. a 25 percent chance to win $30 (42%)f. a 20 percent chance to win $45 (58%)Now, let’s consider the choices that people actually make when faced with these three decisions.As you can see, people have similar preferences on the left-most and center problems.However, on the right-most problem, their preferences reverse even though this problem is identical to the middle problem from a probability standpoint.Essentially, when the middle problem is framed like the right-most problem, people now realize that no option allows them to achieve a certain outcome, so they place a lower value the most likely outcome.Basically, we perceive the middle problem to be a choice between a certain outcome relative to an uncertain outcome even though it is really a choice between two uncertain outcomes.This is yet another example of how strong our preference is for certain outcomes.
14 Framing and the Overselling of Insurance Insurance: A negative expected value“Insurance premium” versus “sure loss”Profits of insurance companiesInsurance is one thing that is always framed as preventing a loss. This has important implications for social norms dictating that you should buy insurance.Essentially, the idea of insurance is that we pay a premium to protect ourselves from potential losses of large sums of money.However, insurance has a negative expected value, as it would not exist were it not a profitable endeavor.But, if insurance were referred to as a certain loss of money in order to be protected rather than protection from an possible loss (“insurance premium”), people may be more hesitant to buy it.Instead, people think of insurance as protection from a possible loss and this leads to them spending large premiums for uncertainty reduction that go into the pockets of insurance company shareholders.
15 What’s it Worth to You?You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite brand of beer. A companion gets up to go make a phone call and offers to bring back a beer from the only nearby place where beer is sold (a fancy resort hotel) [a small, rundown grocery store]. He says that the beer might be expensive and asks how much you are willing to pay for it. He says that he will buy the beer if it costs as much as or less than the price you state. But if it costs more than the price you state, he will not buy it. You trust your friend, and there is no possibility of bargaining with the (bartender) [store owner]. What price do you tell him?Read this scenario twice: once by reading the words in parenthesis and again by reading the words in brackets.This problem has two key features:First, you get the same product in each version.Second, price cannot be negotiated.Third, the beer will be drank on the beach regardless of where it is purchased.When people were given these scenarios more than 20 years ago, they were willing to pay more than $1 more for the beer purchased at the hotel than the same beer purchased at the grocery store.Even though people were going to buy the same product to drink at the same location with no opportunity to negotiate price, they were willing to pay more for beer at a hotel because hotels typically charge higher prices. Basically, by being at a hotel, people frame their expectations of a reasonable price as being higher than they do at a grocery store, which typically is expected to charge lower prices.
16 What’s it Worth to You?Imagine that you are about to purchase a high-tech mouse for $50. The computer salesperson informs you that the mouse you wish to buy is on sale at the store’s other branch, located a 20-minute drive away. You have decided to buy the mouse today, and will either buy it at the current store or drive 20 minutes to the other store.What is the highest price that the mouse could cost at the other store such that you would be willing to travel there for the discount?Imagine that you are about to purchase a laptop computer for $2,000. The computer salesperson informs you that this computer is on sale at the store’s other branch, located a 20-minute drive from where you are now. You have decided to buy the computer today, and will either buy it at the current store or drive to the store a 20-minute drive away. What is the highest price that you would be willing to pay at the other store to make the discount worth the trip?Now, consider these two problems side-by-side.In both questions, you are essentially being asked how much value you place on spending 20 extra minutes of your time to drive for a discounted price on a product.In the left question, you are considering whether to drive for a discount on a cheap product (a mouse).However, in the right question, you are considering whether to drive for a discount on a relatively expensive product (a laptop).Though we should value our time and the effort of driving in an identical fashion on each problem, people require a much higher price on the scenario to the right.A $20 savings is a much more substantial saving as a percentage of product price on the left scenario than on the right scenario.However, we should think in terms of absolute savings rather than relative percentages. Too often, people go through great lengths to save small sums of money on cheap products while they don’t think twice about spending the same amount of extra money on expensive products.
17 The Value We Place on What We Own Real estateUsed car salesMinimum bids in auctionsMugsIn general, there is a tendency of people to overvalue the items that they own.This is problematic because in market settings, if sellers valued the items that they own more than any single buyer, then no items would ever be sold.In many cases, this happens:Home owners often overvalue their houses and leave it on the market for long periods of time.Car owners typically market their cars for much longer than they had hoped.In online auctions where sellers have the opportunity to set a minimum bid price, roughly 1/3 of items are never sold.In an experimental study, it was found that participants given mugs and the opportunity to sell them placed a higher value on the mugs than participants given money and the opportunity to purchase mugs.
18 The Endowment EffectIt is 1998, and Michael Jordan and the Bulls are about to play their ﬁnal championship game. You would very much like to attend. The game is sold out, and you won’t have another opportunity to see Michael Jordan play for a long time, if ever. You know someone who has a ticket for sale. What is the most you would be willing to pay for it?It is 1998, and Michael Jordan and the Bulls are about to play their ﬁnal championship game. You have a ticket to the game and would very much like to attend. The game is sold out, and you won’t have another opportunity to see Michael Jordan play for a long time, if ever.What is the least that you would accept to sell your ticket?Consider the following set of problems that were presented to some research participants at the University of Chicago in 1998.They are essentially identical problems, except the one to the left involves selling a ticket while the one to the right involves purchasing a ticket.
19 What People Say they Would Do Here is how people respond to these problems.For the left problem asking about willingness to pay for a ticket, people indicate being willing to pay $330 on average.This tendency to overvalue the items we own is known as the endowment effect.By merely possessing an item, we frame selling it as a loss, which leads to us demanding higher prices for the item.For the right problem asking about willingness to accept payment for a ticket, people indicate being willing to accept a payment of $1,920 for their ticket to the game.
20 Mental AccountingSuppose that you bought a case of a good 1982 Bordeaux in the futures market for $20 a bottle. The wine now sells at auction for about $75 per bottle. You have decided to drink a bottle. Which of the following best captures your sense of the cost of your drinking this bottle? a. $0 b. $20 c. $20 plus interest d. $75 e. –$55 (you’re drinking a $75 bottle for which you paid only $20)Take a moment to do this problem.
21 Mental Accounting Here is how most people answer this question. As you can see, there appears to be a fairly even distribution across options a, b, d, and e.However, very few choose option c.This shows that people think about costs in several different ways:They have expensed away the cost before consuming the item (i.e., drinking the wine after buying – option a).They think about consumption cost in terms of purchase price (option b).They perform an economic analysis of the opportunity cost associated with consuming the bottle (i.e., the auction price of $75 – option d)They made money and gained utility from the enjoyment of their great purchase (option e).This illustrates that the our evaluation of transactions is often quite malleable and subject to our own interpretation of the transaction.
22 Mental AccountingYou receive a letter from the IRS saying that you made a minor arithmetic mistake in your tax return and must send them $100. You receive a similar letter the same day from your state tax authority saying you owe them $100 for a similar mistake. There are no other repercussions from either mistake.You receive a letter from the IRS saying that you made a minor arithmetic mistake in your tax return and must send them $200. There are no other repercussions from the mistake.Consider both of the outcomes here.There outcomes are identical from the perspective that they both result in total losses of $200.However, people tend to be more upset by the outcome to the right than the one to the left.People develop different mental accounts for their federal taxes and their state taxes. As a result, the separate losses do not loom as large as the single loss of $200 from their federal tax mental account.Overall, the practice of splitting our expenditures into different accounts is a good way of tracking our expenses, but it causes some problems in that financial loss does not feel as large when it comes from many different accounts than when it comes from one large account. This may at times lead to us spending more money than we would normally have wanted to if we consider the sum total of the expenses rather than the spending that occurred in each of our mental accounts.
23 Rebate/Bonus Framing Federal stimulus spending Bonuses versus profit sharingMuch like we may frame our expenditures in different ways depending on how we mentally categorize them, simple changes in the framing of the money that we receive may alter our spending behavior.Federal stimulus spending is one example.In September 2001, the Federal government paid $38 billion to taxpayers as a part of a stimulus package.The stimulus spending was referred to as a “rebate”.However, subsequent research suggests that had the government referred to the stimulus as a “bonus”, it would have been far more effective.Similarly, the framing of any payments we receive at work may have similar effects on our consumption.Year-end bonuses are likely to be framed as an unanticipated gain while year-end payments framed as returns to employees resulting from excess profits may be viewed as “withheld salary” that is framed as a gain that brings somebody’s salary back to their reference point.The simple framing of rebates versus bonuses can alter reference points, which has a strong effect on subsequent spending behavior.
24 Joint Versus Separate Preference Reversals Salary Package ASalary Package B$27,000 Year 1 $26,000 Year 2 $25,000 Year 3 $24,000 Year 4$23,000 Year 1 $24,000 Year 2 $25,000 Year 3 $26,000 Year 4Consider the two hypothetical salary packages outlined here.Package A results in salary declines while Package B results in salary increases.However, Package B pays out less overall than Package A and as a result, it is a clearly superior option to Package A.Indeed, most people find Package A more acceptable than Package B.However, when people only look at Package A or Package B in isolation, they tend to exhibit a stronger preference for Package B.People generally feel dissatisfied with a declining salary, so without an understanding of alternative possibilities, Package A seems unfair when one does not know about the specifics of Package B.
25 Joint Versus Separate Preference Reversals Separate evaluation promotes emotional responsesPolling practices“Want/should” explanation“Evaluability” explanationAs illustrated by the previous problem, our preferences often reverse when we evaluate options together as opposed to separate.In the case of the salaries, the emotions triggered by the possibility of losing salary each year leads to low preferences for such a salary.However, when considered in conjunction with a salary that increases annually, but provides less overall income, people are able to override their emotions and can see the benefit to earning a higher overall salary despite the fact that it would decline each year.Sometimes we can see this occur in the context of polling.Some polls ask for candidate approval ratings where only a single candidate is considered by each person being polled (separate evaluation) while others ask for candidate choices among the list of all possible candidates (joint evaluation).In cases where a candidate has engaged in an unethical act, he or she is likely to receive less approval in approval polls than in voting polls.Scholars believe that these reversals of preferences when evaluating options separately as compared to jointly occur for one of two reasons.The first potential reason is referred to as the “want/should” explanation. The basic idea is that people rely on emotional arousal to guide their decisions when evaluating separately, but when evaluating jointly, people tend to rely more on logical and systematic thought.The second explanation is that some attributes are difficult to evaluate, quantify, or weight. In these cases, people often rely on more evaluable attributes to guide their decisions. However, when difficult-to-evaluate attributes can be compared, more information is available with which to evaluate the attributes and this increases the weight that they place on difficult-to-evaluate attributes in shaping their choices.
26 Conclusion Generalizability of framing effects Taxi driver hoursGolfer putting patternsStock market decisionsImproving your decisionsIdentify your reference pointConsider alternative reference pointsWe have covered a lot of examples of how framing can influence our decision-making.However, many of the examples come from laboratory experiments. This may lead people to wonder how generalizable these effects are. They seem to be very generalizable, as they can explain the following, among many other things:Why taxi drivers drive longer hours during slow days than on busy ones. They have a daily reference point for how much they expect to earn and when the meet the total early, they take off work. When they fail to meet the total, they continue working until they do achieve their daily earnings goal.Why golfers are more likely to leave a putt short when shooting for birdie than when shooting for par. In golf, a score of par represents an arbitrary reference point that shapes the decisions of golfers. When attempting a birdie, people may play more conservatively by leaving putts short so that they have a manageable par put. When attempting a par putt, people may play in a more risky fashion to avoid seeing their score drop after receiving a bogey after leaving a putt short.Traders tend to hold onto losing stocks for too long while getting rid of winning stocks too quickly. Because they have framed high-performing stocks as ones in which they have already earned positive returns, they are reluctant to hold onto them too long out of fear that they will eventually lose money. However, they often hold onto poorly performing stocks for too long because they are willing to take the risk that the stocks will continue to decrease in value so that they can have the opportunity to break even in the case that the stocks skyrocket in value.Equipped with the knowledge that framing can exert a strong influence on our decisions, people can undergo a few practices to improve their decisions.First, they should identify their own reference point when approaching a particular problem. As mentioned, reference points can be manipulated directly, but in many cases, reference points are ambiguous and a given individual can adopt multiple reference points. Regardless, understanding one’s own reference points when approaching a problem is crucial.Once an individual has identified his or her reference point in approaching a problem, he or she should consider alternative reference points. By thinking through other potential reference points, people can consider how their preferences may have changed with different reference points.