Behavioral Decision Making Lecture 1: Introduction

What is Behavioral Decision Research?  What is an optimal decision?  Normative: Decision Analysis / Economics  What do we need to understand in order to make good decisions?  Quality of information.  How do people actually make decisions?  Descriptive: Psychology  Limits on the quality of information or limits on the quality of decision making capabilities.  How can people be helped to make better decisions (by overcoming these biases)?  Prescriptive: Public Policy  Risk communication or limit choices

How many of the discs are spinning?

Cognitive Illusions  Cognitive illusions are similar to optical illusions in that they, too, can cause us to misperceive the world  Biases emerge in:  Drawing comparisons  Evaluating probabilities  Reasoning from the past  Extrapolating from limited data  Assessing our own values .....

Some things you might learn in this course  Why adding a product nobody buys may be beneficial to the seller  Why people might donate more to save one person rather than 1000s  Why someone might be risk-adverse sometimes and risk- seeking sometimes – even when facing the same choice  A reason why too many people start businesses that fail.

Course Overview

Course Logistics  This is a mini course.  Fast pace: a lot of material per meeting  almost a chapter per class and classes meet 3x a week.  Attendance and Participation  Required. Participation is not just coming to class.  Phones / computers  If you’d rather check FB/twitter/snapchat/instagram/etc than pay attention, don’t come to class.  Office hours:  Tuesday morning 10:30-12  Outside of set office hours, set up an appointment.

Course Grades Course grades will be based on:  Participation 5%  Problem Sets 15%  Midterm exam 15%  Three weeks from Thursday!  Final exam 20%  Quizzes 30% (10% each, best 3 of 4)  First quiz next Sunday (1 week from today!)  Group paper presentation: 15%

Course Schedule  See the last page of the syllabus for a tentative schedule  Readings after week two aren’t list; they will be.  There is a natural progression of material in Economics/Decision Analysis. Less so in BDR  BDR is a much younger field. A coherent theory for everything we’ll discuss still isn’t exactly worked out.  Doesn’t mean that it’s wrong – just that we’re still trying to figure things out.

Teaching this course. Second time I’ve taught this course  There will be changes throughout the course. Usually it takes about 3 times before I think a course is about right. Sorry, but you have to start somewhere.  But we’ll work together. The material is interesting. And the course is meant to give you an overview of a field you probably haven’t seen. I love my job. I want to teach the best that I can. But to do that I need to get to know you  Stop by my office this week for 5-10 min, even if you’ve had me before.

Recommended books  We’ll draw on these later in the course, but if you find the material interesting, definitely check out (in the library or on kindle):  Nudge, by Thaler and Sunstein  Thinking Fast and Slow, by Kahneman  Predictably Irrational, by Ariely

Questionnaire

Next time – by 26/8/14  Read Chapter 2 in JMDM  Meet with me this week

Decision Making Review

Decision Evaluation  I bought a lottery ticket and won $10,000  Was buying the ticket a good decision? Why or Why Not?  Ex post or ex ante?  How do you measure the quality of a decision?  Outcome Quality  Decision Process Quality

Optimal decision analysis 1. Define the problem  Do NOT define in terms of a proposed sol’n or diagnosed symptoms. 2. Identify the criteria  What’s the objective? Is there more than one? 3. Weigh the criteria  What matters? Some things matter more than others 4. Generate alternatives  What are the courses of action available? 5. Rate each alternative on each criterion  What are the payoffs?  Is there any uncertainty? Do you need to forecast future events? 6. Compute the optimal decision  What is your utility function? What is your tolerance for risk?

Evaluating the Process  The soundness of the decision-making process determines the quality of the decision, not the attractiveness of the outcome.  Making the optimal decision is tough.  Satisficing: making a choice that is “good enough” rather than optimizing to find the ideal choice (Herb Simon 1956). Example: choosing a college or university.  Heuristics: Decision aids or “shortcuts” that we rely on to make complex decisions manageable.  What might affect our decision-making processes  Reliance on heuristics often leads to biases --- deviations from normatively sound perceptions and judgments.  Optical Illusions as an Analogy: The image we see may lead us to a mistaken or biased representation of reality

Difference are not always mistakes  Two equally valid interpretations of the same data.  Can we justify differences?  Subjective probability: different interpretations of same set of evidence  (Leonard Savage 1954)  Personally value outcomes differently  Risk Judgments (e.g. cars vs. airplanes)  Value Elicitation (e.g. Fischhoff 1991)  Normative and descriptive analysis are interdependent!

Results from Psychology vs Economics Economics : Homo economicus Psychology Irrational Decision Makers (“humans”)  Stable, complete and transitive preferences  Utility maximizers  `Perfect’ foresight Normative  Unstable preferences  Context matters  Satisficing + systematic “errors” Descriptive