1. Two Ways to Study Decision Making Rational Choice Theory –Articulated by economists, philosophers and mathematicians –A normative approach: it prescribes how people ideally should make decisions Behaviorial Decision Theory –Developed by psychologists and cognitive scientists –A descriptive approach - it generalizes about how people actually make decisions

2. Sample Claims within Rational Choice Theory If you believe the Hoosiers have a 75% chance of winning their next game, then you must also believe that they have a 25% chance of losing it. If you prefer world music to rap and prefer jazz to world music, then you must prefer jazz to rap.

3. Sample Findings of Behavioral Decision Theory Jones may believe that: –the Hoosiers have a 75% chance of winning tonight –although if the game goes into overtime, they have only a 25% chance of winning –but, luckily, there is only a 50% chance of the game going into overtime

4. Violation of the Probability Calculus Let W be Winning O be Overtime and ~O be no Overtime Then according to the Theorem for Total Probability Prob(W) = Prob(O) x Prob(W/O) + Prob(~O) x Prob(W/~O)

5. Another Example: Jones is the commander of 600 soldiers caught in an ambush. An aide describes two possible escape routes: –If they take route A, 200 hundred soldiers are likely to die. –If they take route B, 400 are likely to survive. “The choice is obvious”, says Jones. “Clearly route B is the best. Let’s get these guys out of here.”

6. Framing Effects Jones’ mistake was to be misled by how the decision was framed. Investors in the stock market exhibit lots of subtle framing effects. In their book Why Smart People Make Big Money Mistakes, Gary Belsky & Thomas Gilovich call such cases examples where “When six of one isn’t half a dozen of the other”.

7. Overall Plan of this Course We will begin with a unit on Rational Choice theory. Here we will supplement the textbook with chapters from other books posted on the web site. Our text will provide most of the readings for a unit on Behavioral Decision Theory. We will then juxtapose the two approaches and look at some criticisms of each.

8. Terminological Equivalents Although the content of Rational Choice Theory is quite stable, different writers use different terms for basic concepts. Here are some synonyms: –We must {decide, choose} from a set of {options, actions} –The anticipated {outcomes, consequences, states of affairs} resulting from our {decision, choice} often depend on -{contingencies, conditions, states of the world} over which we have no control.

9. Talking the Talk Jones’ aide presented two {options, possible actions}, route A and route B. The {outcomes, consequences, final state of affairs) as described by the aide were identical. The outcome of a bet on the ballgame may well depend on {contingencies,conditions, states of the world} such as whether it went into overtime.

10. Swim Ticket Decision A ticket allowing the bearer to use a certain beach all weekend costs $3 if purchased during the week, while a single day’s admission costs $2 if paid on the day. Here is a matrix showing possible purchasing actions, various weather conditions, and the consequences of combinations of purchases and weather.

11. Matrix for Swim Ticket Problem 0 days of good weather 1 day of good weather 2 days of good weather Buy a week- end ticket Pay $3 for 0 swim days Pay $3 for 1 swim day Pay $3 for 2 swim days Buy daily tickets Pay $0 for 0 swim days Pay $2 for 1 swim day Pay $4 for 2 swim days

12. Which Swim Ticket Option Is Best? To decide between the options we would ideally like to have a weather forecast that would tell us {the probability of, how likely} each possible outcome is. We also need to assign a {value, desirability, utility} to each outcome. Here are some plausible assignment of probabilities and relative values to the outcomes.

13. Assigning Probabilities From the weather forecast Jones surmises that there is roughly a 50% chance of having exactly 1 day of good weather, 25% of the weather being good all weekend long and 25% chance that it will be bad both days. Jones also assumes that the weather is independent of whether he buys a weekend ticket or not!

14. Assigning Value Numbers In evaluating each outcome, Jones has to look at both the cost of the ticket and the benefit of getting to swim. For the moment, let’s assume that each day of actual swimming is worth $5 to Jones. In this case the overall value of each outcome can be represented as follows:

15. Matrix of Values 0 days of good weather 1 day of good weather 2 days of good weather Buy a week- end ticket - 35 - 310 - 3 Buy daily tickets 05 - 210 - 4