1.5. Managerial decision making

Question 1

Prospect theory

Answer 1

• Created by Kahneman and Tversky
• Assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses
• Proposed that losses cause greater emotional impact on an individual than does an equivalent amount of gain
• 3 parts:
  
  • diminishing sensitivity of the value function (right part of the graph)
  • loss aversion
  • reference point: amount to begin with

Question 2

Prospect theory and aspiration levels

Answer 2

• Firm has an aspiration level as reference point
• Firms that anticipate returns below that level will be risk seeking
• Firms that anticipate below will be risk avoiding

Question 3

Propsect theory and incentives

Answer 3

greater productivity increase when incentive is framed as potential loss than potential gains

Question 4

Prospect theory and marketing

Answer 4

Accounting for the effects of reference dependence and loss aversion can improve our understanding of brand choice

Question 5

Prospect theory and entrepreneuship/innovation

Answer 5

• Nothing is more expensive than a missed opportunity
• Framing an innovation project as a loss in case of not pursuing the idea would lead to a higher prospensity to take risk
• economic situation can have an impact on the decision to take risk and start business

Question 6

Preferences/ Attitudes

Answer 6

• Risk aversion for gains but risk seeking for losses
• Loss aversion
• Impatience and temporal inconsistency

Question 7

Intertemporal choice

Answer 7

An economic term describing how an individual’s current decisions affect what options become available in the future.

Question 8

Temporal/dynamic inconsistency

Answer 8

a situation in which a decision-maker’s preferences change over time in such a way that a preference can become inconsistent at another point in time.

Question 9

Temporal horizon

Answer 9

the length of time over which an investment is made or held before it is liquidated

Question 10

Impact of longer temporal horizon (more patience)

Answer 10

• Higher performance
• Higher investment in different fields. e.g. CSR
• Less use of bribery

Question 11

Types of biases

Answer 11

• Anchoring
• Availability
• Representativeness
• Overconfidence

Question 12

Overconfidence effect

Answer 12

people’s subjective confidence in their own ability is greater than their objective (actual) performance

Question 13

Issues from overconfidence

Answer 13

• high rates of entrepreneurs who enter a market despite the low chances of success
• planning fallacy: underestimate the length of time it will take them to complete a task
• overprecision leads to too little exploration

however,

• invest more in innovation, obtain more patents and patent citations, and achieve greater innovative success for given research and development (R&D) expenditure

Question 14

Anchoring bias

Answer 14

the use of irrelevant information as a reference for evaluating or estimating some unknown value or information

Question 15

Issues from anchoring

Answer 15

• cause a financial market participant, such as a financial analyst or investor, to:
  
  • reject a correct decision (buy an undervalued investment, sell an overvalued investment)
  • accept an incorrect decision (ignore an undervalued investment or buy/hold an overvalued investment)
• can be present anywhere in the decision-making process, from key forecast inputs (e.g., sales volumes, commodity prices) to final output (e.g., cash flow, securities price.)

Question 16

Availability bias/ heuristic

Answer 16

happens we people often judge the likelihood of an event, or frequency of its occurrence by the ease with which examples and instances come easily to mind.

Question 17

Issues from availability bias

Answer 17

Most consumers are poor at risk assessments – for example they over-estimate the likelihood of attacks by sharks or list accidents.

e.g.

• People are more likely to purchase insurance to protect themselves after a natural disaster they have just experienced than they are to purchase insurance on this type of disaster before it happens (Karlsson, Loewenstein, and Ariely, 2008)
• Individual investors display attention-based buying behavior: they tend to buy stocks of firms that have caught their attention (presence in news) the same day.
• “Managers give more weight to performance during the three months prior to the evaluation than to the previous nine months of the evaluation period because it is more available in memory.” (Bazerman)

Question 18

Representativeness bias

Answer 18

used when making judgments about the probability of an event under uncertainty

Question 19

Issues from representativeness bias

Answer 19

Risk to judge the probability of success based on small samples