Thinking and Decision Making Psychology 2235 Professor Elke Weber Segment 2 Descriptive Models Part 2

D. Risky Choice Tasks Prospect Theory Mental Accounting Modification of expected utility model that was designed to fit observed choice patterns Mental Accounting Endowment effect Sunk cost effect Other Phenomena Ambiguity Avoidance Omission vs. Commission effect

Prospect Theory Prospects are evaluated by: Value Function: a) Value function b) Decision Weights Value Function: a) Concave for gains, convex for losses. b) Defined over gains and losses on deviations from some reference point c) Steeper for losses than for gains.

Prospect Theory psychological extension of expected utility Prospect Theory psychological extension of expected utility theory by Kahneman and Tversky (1979) outcomes are evaluated as deviations from a reference point risk aversion for perceived gains; risk seeking for perceived losses; loss aversion (“losses loom larger”)

Risk Attitudes Prospect theory predicts concave risk attitudes in domain of gains (i.e., risk aversion) and convex risk attitudes in domain of losses (i.e., risk seeking). Example: ($100, 100%) vs. ($200, 50%) .72 .28 (-$100, 100%) vs. (-$200, 50%) .36 .64

REFERENCE POINTS (Prospect Theory) 1) Reference point assigned a value of 0 (neutral) 2) Reference point determined if outcomes are psychologically coded as gain or loss May or may not correspond to current asset position (depending on whether person has adjusted from recent wealth changes). 3) Reference point MAY be influenced by problem formulation. 4) Reference point shifts may change preferences.

REFERENCE POINTS: EXPECTATIONS & “EXPERIENCE” A) Sometimes reference point corresponds to an EXPECTED asset position (e.g., Christmas bonus, test grade). B) Sometimes our RELATIVE (not absolute) performance influences our coding of outcomes (e.g., stock market). C) Avoiding losses by coding them as costs (or even gains) e.g., insurance, divorce

CERTAINTY EFFECT Definition: Overweighting outcomes that are certain relative to those that are probably Another Definition: Reducing the probability by a constant factor has more impact when the outcome was initially certain than if it were merely probable. Question: How does the certainty effect reinforce the ideas of risk aversion in the domain of gains and risk seeking in the domain of losses? Imagine that you are a publisher and are considering which of two books to publish: One by Saul Bellow (a sure winner, but little potential for very big $) and one by a hot young author (a likely big # winner, but some chance for being a loser). You asses the sales volumes and probabilities as follows: Bellow: ( 3 mil, 100%) Young Author: ( 4 mil, 80%) Another Situation: Author A: ( 3 mil, 25%) Author B: ( 4 mil, 20%)

Concluding Remarks: FRAMING Why does framing work? 1) Nonlinearity of value function. 2) Options evaluated in relation to reference points. 3) Different risk attitudes toward gains and losses. Why does framing matter? Power to person who presents options to decision makers Framing may change our experience of outcomes. So what should we do? 1) Be aware of the phenomenon. 2) Think holistically. 3) Evaluate options in terms of actuarial consequences (not psychological ones). 4) Reframe: Systematic examination of alternate frames.

Mental Accounting Suggested by Thaler (1980) nonfungibility of money (and other resources) between “accounts” for reasons of limited attention and information processing capacity serves as self-control device

Imagine that you have decided to go to a play where the admission price is $40 per ticket. Just before entering the theatre, you discover that you have lost the ticket. The seat was marked and the ticket is not replaceable. Would you buy a new ticket for $40 (assuming that you have the money? Imagine that you have decided to go to a play where the admission price is $40 per ticket. Upon opening your wallet to pay for your ticket, you discover that you have lost $40 dollars in cash. Would you still pay $40 to see the play (assuming that you have the money)?

Opportunity costs and the “endowment effect” Underweighting of opportunity costs= endowment effect. * Tax cut= “Gain” or “Less of a loss”? * Credit card surcharge versus cash discount. Sunk costs Sunk cost effect= paying for the right to use a good or service will increase the rate at which the good/service will be used. * Snowstorm ballgame example * Tennis club membership/multipart pricing * Commitment to prior decisions (e.g., Vietnam War)

Ambiguity Avoidance People prefer to bet on known odds rather than on ambiguous odds of equal size Ellsberg’s paradox However, in domains of perceived competence, they prefer ambiguous odds Basketball game vs. game of chance

Ellsberg’s Paradox Imagine an urn known to contain 90 balls Ellsberg’s Paradox Imagine an urn known to contain 90 balls. Thirty of the balls are red, the remaining 60 are black and yellow in unknown proportions. One ball is to be drawn at random from the urn. Consider the following actions and payoffs: Situation X 30 60 Red Black Yellow Act 1. Bet on red $100 $0 $0 Act 2. Bet on black $0 $100 $0 Situation Y Act 3. Bet on red or yellow $100 $0 $100 Act 4. Bet on black or yellow $0 $100 $100

Omission vs. Commission Effect People prefer to be wrong (feel less regret) when the bad outcome is the result of a lack of action (an omission to act) than when the outcome is the result of an action they took (a commission) Vaccination example Paul and George’s stock market decisions example Natural car insurance example (Hershey & Johnson, 1988)