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1 Intuitive Irrationality: Reasons for Unreason

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2 Epistemology Branch of philosophy focused on how people acquire knowledge about the world Descriptive Descriptive Theories Describe what people actually do when making judgments and decisions PrescriptiveNormative Prescriptive or Normative Theories Describe how people should make judgments and decisions

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3 Example: Normative Theory Expected Utility Theory Choose between two games: Game A: Game A: You have a 20% chance of winning $10 You have an 80% chance of winning nothing Game B: Game B: You have a 10% chance of wining $50 You have a 90% chance of winning nothing

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4 Example: Normative Theory Expected Utility Theory Two dimensions of choice Probability of winning (p) Value of outcome (v) EUT = (p)(v) So, game A EUT: $2, game B EUT: $5

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5 Example: Normative Theory Choose between two games: Game A: Game A: You have a 1% chance of winning $1000 You have a 99% chance of winning nothing Game B: Game B: You have a 100% chance of wining $5 Game A EUT: $10 Game B EUT: $5

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6 Framing Effects Imagine Madison is preparing for an outbreak of an unusual disease that is expected to kill 600 people. Two programs have been proposed: If they adopt Program A, 200 people will be saved. If they adopt Program B, there is a 1/3 chance that 600 people will be saved, and a 2/3 chance that none will be saved.

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7 Framing Effects Imagine Madison is preparing for an outbreak of an unusual disease that is expected to kill 600 people. Two programs have been proposed: If they adopt Program C, 400 people will die. If they adopt Program D, there is a 1/3 chance that nobody will die, and a 2/3 chance that 600 will die.

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8 Framing Effects Program A is identical to Program C! Program B is the same as Program D! Why the difference? The way the problem is framed greatly affects decisions People are risk-averse when thinking about gains People are risk-seeking when thinking about losses

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9 Judgment Heuristics shortcuts Mental shortcuts that people use to make various judgments, like: The frequency of past events The probability that something will happen The chances that some fact is true Dangerousness and risk

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10 Why do people use heuristics? Cognitive misers Time constraints Missing information

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11 Why do people use heuristics? The use of heuristics is not in itself irrational or illogical Heuristics are adaptive shortcuts HOWEVER! Sometimes heuristics lead us to wrong judgments and false beliefs

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12 Availability Heuristic Judging the frequency, probability, likelihood of an event according to how easily examples come to mind more available Whatever is more available in memory will be more likely to be used in judgments

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13 The problem with availability unrelated How easily things come to mind are influenced by things unrelated to how it works in the real world Salience, e.g., occurrences rather than nonoccurences Vividness Recency Individual interests and experiences

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14 Representativeness Heuristic Judging the frequency, likelihood, probability of an event according to how much it resembles or is similar to its group Problem: Fails to consider other factors that drive the actual frequencies or chances of that event

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15 Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations. Which is more likely? Linda is a bank teller Linda is a bank teller and is active in the feminist movement.

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16 Conjunction Fallacy Occurs when people believe that a conjunction of two properties can occur more often than either of the properties alone There cannot be more red apples than there are just apples! There cannot be more feminist bank tellers than there are either feminists or bank tellers!

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17 Base-Rate Fallacy Base Rate: Likelihood of a particular event When given no additional information, people generally use the base rate correctly HOWEVER, when people have more information, they tend to ignore the base rate

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18 In a room there are 70 lawyers and 30 engineers. Jack is a 45 year old man. He is married with four children. He is generally conservative, careful, and ambitious. He shows no interest in political and social issues and spends most of his time on his many hobbies, which include carpentry, sailing, and mathematical puzzles. Which is more likely? Jack is an engineer Jack is a lawyer

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19 The Confirmation Bias Tendency to seek information consistent with our expectations and discount information inconsistent with our expectations Self-fulfilling prophecy Behavioral confirmation

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1 BAMS 517 – 2011 Decision Analysis -IV Utility Failures and Prospect Theory Martin L. Puterman UBC Sauder School of Business Winter Term 2 2011.

1 BAMS 517 – 2011 Decision Analysis -IV Utility Failures and Prospect Theory Martin L. Puterman UBC Sauder School of Business Winter Term 2 2011.

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