Choice and Decision

Greed/fear

Class Objective

• To understand nuances of human decision making

Decision Theory

Decision theory is concerned with identifying the values, uncertainties and other issues relevant in a given decision, its rationality, and the resulting optimal decision.

Bounded rationality is the idea that in decision-making, rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision.

Choice under uncertainty

• Expected value– Value X Probability

• Prospect theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics.

Choice under uncertainty

• Heuristics: People often make decisions based on approximate rules of thumb and not strict logic.

• Framing: The collection of anecdotes and stereotypes that make up the mental emotional filters

• Market inefficiencies: These include mis-pricings, information asymmetry and non-rational decision making.

Preferences

• Get a 100 rupee discount or avoid a 100 rupee surcharge?

• Mall parking reimbursement or 20 rupee discount?

• Which has a bigger impact on customer switching, price increase or discount?

Loss aversion

• loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains.

• endowment effect—the fact that people place a higher value on a good that they own than on an identical good that they do not own

• IIMpact ‘merit pay’• Insurance

Ratio of words starting with a K and those having K later in the word?

• Availability heuristicThe ease with which a particular idea can be brought to mind

• RepresentativenessStereotypingBrand extensions

Conjunction fallacy – a combination of two is more probable than just one

• Is the per capita income of Malaysia more than $4000?

• How much is it?• Anchoring and adjustment• TV infomercials

• Heuristics are fast and frugal

1. Ambiguity effect – the tendency to avoid options for which missing information makes the probability seem "unknown.

2. Backfire effect – when people react to disconfirming evidence by strengthening their beliefs

3. Bandwagon effect – the tendency to do (or believe) things because many other people do (or believe) the same

4. Choice-supportive bias – the tendency to remember one's choices as better than they actually were.

5. Clustering illusion – the tendency to over-expect small runs, streaks, or clusters in large samples of random data

6. False-consensus effect – the tendency of a person to overestimate how much other people agree with him or her.

7. Forer effect or Barnum effect (astrology)

Summary

• Decision Theory• Prospect theory• Bounded rationality• Loss aversion• Heuristics– Availability– Representativeness – Anchoring and adjustment

Further reading

• Cognitive Bias: Systematic errors in decision making by Loren Gary, HBR

• Prospect Theory: An Analysis of Decision under Risk by Daniel Kahneman and Amos Tversky

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