Deciding: EUT & Bounded Rationality

Question 1

Expected utility theory:
Tenants

Answer 1

• This model emphasises the term “rational actor” which means that a person acts rationally if they obey the principles of EUT. The six principles are;Initially proposed by Von Neuman and Morganstern in ’47 but now stands for a family of theories
• Proposed as a normative theory that is as a system of how people “should” think and reason about life and especially risky choice situations
• It assumes choices are made under ideal conditions
• It is focused on the future so combines ‘utilities’ with probability.
• The definition of utility is closely aligned to the achievement of ones goals. So a choices utility is the measure of how much the person’s goals will be achieved by the adoption of that choice.
• Essentially this theory asserts that people should calculate the return from any decision choice based on the expected utility (often in monetary terms).
• EUT is concerned with making a tradeoff between the probability of an outcome and its utility
• This model emphasises the term “rational actor” which means that a person acts rationally if they obey the principles of EUT. The six principles are;
  
  • Alternatives must be comparable
    Always adopt the dominant decision in terms of features of the decision and payoffs
  • Identical choices produce indifference
  • Transitivity should apply i.e. A>B, B>C then A>C
  • Betting on the odds -> take the choice with the best odds i.e. the greatest chance of benefit
  • Invariance i.e. it does not matter what order the alternatives are presented in
• The philosophical basis of EUT goes back to work of the Utilitarianism movement Bentham and John Stuart Mill The basic tenant of utilitarianism is that we attempt to maximise utility over all relevant options/features
• Utility theory is concerned with inference NOT search. It Is assumed that we know our goals. A full theory of normative decision making would therefore include a model of a thorough search for alternative actions
• Baron notes (2000, p225) that probability theory provides an additional element of a full normative theory of decision making. The most common way to explore EUT is to examine ‘gambles’. These are often put in the following form:​
  
  • Which would you choose?
  • $4 for drawing a heart card OR
  • $1 for drawing a red card?
• The formula is designed to handle the cumulative effects of a number of such gambles, hence the summing term
• A development of this approach is known as MUAT or multi-attribute utility theory and is used in situations of multiple goals.

Question 2

Pascal’s Wager

Answer 2

• Philosophical questions about decisions and their consequences
• Maximise chances of eternal life
• Starting positions were;
  
  • God exists or he doesn’t
  • A person can live either a Christian life or not
• Result,
  
  • Heaven, hell, small invconvienience or normal life
• Good example of EUT
  
  • Future focus
  • Consequences are clearly related to ones goals (life) and
  • The decision criteria can be notionally calculated
• Also good eg of inherent problems with EUT

Question 3

St Petersburg paradox

Answer 3

• Consistent of tossing coin
• Rate of payment: $1 if heads on 1^st throw; $2 for heads on the second; $4 for heads on 3^rd throw etc formula 2_­­­­^n-1 where n is throw number
• The value of the gamble is potentially infinite over a number to of throws
• The test was to put to potential gamblers the q “what would you sell the right to receive the benefits of this gamble for?”
• Most reasonable people would sell for $3-4
• Author postulated that the utility of additional wealth is proportional to the wealth they already have. This is the concept of declining marginal utility
• Not easily explained by EUT. In essence this is a context effect and shows that people do not act merely on the information before them but assess it against other related information

Question 4

Allais Paradox

Answer 4

• Demonstrated violations of the cancellation principle. This says that any feature in common b/w 2 alternatives should not influence the resultant choice
• 1st scenario
  
  • Why risk any chance of losing when you can get 1m
• 2nd scenario
  
  • The difference b/w 10% and 11% is small and you have to take a chance to so make it as beneficial as possible
• Participants who choose A in the first gamble should choose C in the second one otherwise the cancellation principle is violated

Question 5

Ellsberg Paradox

Answer 5

• Violations of the cancellation principles
• Alternatives presented with picking a ball from a jar. 3 colours with diff payoff amounts
• People are found to choose alternatives again not based on calculated utility

Question 6

Comment of EUT

Answer 6

• These types of paradoxes have been explored in betting on races, personnel selection when ranking candidates and other ‘real life’ activities
• These and other problems with actual rather than idealised human reasoning and decision making presented problems for the theory from especially a psychological perspective.
• The criticisms that have been levelled at this type of research include the unreality of the laboratory tasks and bets that participants have been tested with
• Other criticisms have been made that focus on the view of HIP and definitions of expected utility. A variant of expected utility is subjective expected utility theory that recognises the subjective nature of value that is the basis of Prospect Theory.

Question 7

Bounded Rationality

Answer 7

• 3 critical assumptions
  
  • Decision makers have complete info relevant to the decision under consideration
  • Decision makers understand all the info that is relevant to the decision under consideration, and
  • They are able to calculate the advantages and disadvantages of each and every alternative.
• These assumptions were early on seen as unrealistic. The division b/w normative and descriptive approaches is apparent here. EUT assumes that people attempt to optimise utility, choose THE best of all possibilities
• Simon proposed the concept of “bounded rationality” as a more accurate representation of how people actually make decisions and process info
• “ideas of limited rationality emphasise the extent to which individuals and groups simplify a decision problem because of the difficulties of anticipating or considering all alternatives and all information
• Simon emphasised that BR is not to be equated with irrationality. In criticising EUT Simon asserts that “the received theory of rational choice is a theory that almost completely ignores the limits of humans as mechanisms for computation and choice – what we have called the principle of bounded rationality
• The concept of BR will be taken up by many researchers from both the normative and descriptive camps.