1. Judgment and Decision Making How Rational Are We?

2. Normative Models “Rational” = selecting optimally What gets optimized? 2 normative models: –Expected Value: Highest monetary value –Expected Utility: Highest psychological value Expected value vs. expected utility: Survey Results (in class) –Expected Value = objective value * probability –Expected Utility = subjective utility * probability

3. Violations of Expected Utility Theory Certainty Effects –Allais Paradox –Certainty of Negative Outcomes Preference Reversals Context Effects Framing Effects Sunk Costs (each discussed in subsequent slides)

4. Certainty Effects 1.Which would you prefer? –A) 40% chance at $40 –B) 50% chance at $30 2.Which would you prefer? –A) 80% chance at $40 –B) 100% chance at $30 The “subjective utility” of the $30 changes from option 1 to option 2. Irrational.

5. Allais Paradox Which of each pair do you prefer? (Allais, 1953). Choice 1Choice 2 A)100% * $1000A)11% * $1000 89% * $0 B)89% * $1000 10% * $5000 1% * $0 B)10% * $5000 90% * $0

6. Certainty of Negative Outcomes Which of the two choices for treating an epidemic would you choose? (Tversky & Kahneman, 1981) Choice 1Choice 2 Treatment A: 80% chance of 100 deaths 20% chance of no deaths Treatment A: 8% chance of 100 deaths 92% chance of no deaths Treatment B: Certainty of 75 deaths Treatment B: 10% chance of 75 deaths 90% chance of no deaths

7. Preference Reversals Class A Moderately interesting Moderately difficult Prof is so-so 10 am Class B Very interesting Very difficult Prof is very good 8 am Choice 1: You must choose one to sign up for. Choice 2: You are enrolled in both, but must drop one.

8. Context Effects Choosing between A and B should not be affected by what other alternatives are present (but it is) Example: Attraction Effect –Having a third choice that is “dominated by” one of the two choices makes that one more attractive.

9. Attraction Effect Car A –Reliabiliy: 8 –Cost: $24,000 Car B –Reliabiliy: 5 –Cost: $20,000 Car A –Reliabiliy: 8 –Cost: $24,000 Car B –Reliabiliy: 5 –Cost: $20,000 Car C –Reliabiliy: 6 –Cost: $25,000

10. Framing Effects Frame A: 1.Without the new treatment, 700 soldiers will die 2.With the new treatment, there is a 70% chance that all of them will die, and a 30% chance that none will die. Frame B: 1.Without the new treatment, 300 will be saved. 2.With the new treatment, there is a 70% chance that none of them will be saved, and a 30% chance that all of them will be saved.

11. Sunk Costs Rationally, we should not consider sunk (unrecoverable) costs when deciding what to do next. But we do. –Would you walk out of a boring movie? –What if admission had been free? –What if you had paid $50 to see it? Should you sell your stocks if you think they will go down in price? What if you paid twice the current price when you bought it?

12. Summary thus far Are we rational in our decision making? –We do not follow Expected Value –We do not even follow Expected Utility If we do not make decisions the way these prescriptive theories say we should, can we describe how we actually do make decisions?

13. Descriptive Theories of Decision Making Prospect Theory –Evaluation is relative to a Reference Point rather than being absolute (accounts for framing effects) –Psychological Probabilities (pi) are used rather than objective probabilities. Regret Theory –We try to minimize the anticipated feelings of regret for our decisions.

14. Shortcuts and Strategies in Decision Making “Satisficing” – Herb Simon –Searching for an acceptable answer, rather than for an optimal one. Specific Heuristics: –Elimination by aspects –Availability Heuristic –Representativeness Heuristic –Anchoring