decision making

Question 1

multi attribute choice

Answer 1

one must select between 2 or more options that differ in 2 or more attributes

Question 2

inter-temporal choice

Answer 2

one of the attributes that varies is time

e.g., 10£ today or 25£ in a month

Question 3

risky choice

Answer 3

one or more of the possible outcomes are probabilistic

sometimes the probabilities are not known precisely, in which case the decision may be referred to as “under certainty” or “under ambiguity”

Question 4

expected value

Answer 4

the expected value (EV) of an option is the sum of each possible outcome weighted by its probability

EV = P1A1 + P2A2 …
A= value of outcome, P = probability of outcome
n = number of total outcomes

most people are ‘risk averse’

Question 5

expected utility

Answer 5

• a replacement for expected value
• utility can be thought of as the subjective value of an outcome and is some transformation u(a) of the objective amount
  EU = p1u(a1) + p2u(a2) + ….
• u is the identity function
• utility function is concave, people have diminishing sensitivity to increasingly large gains

Question 6

reference dependence

Answer 6

Kahneman and Tversky 1979
- presented 2 decision tasks, one gaining money, one losing
- found people less risk averse when losing money (reversed conditions)
- violates rationality and the expected utility account of decision making

Question 7

prospect theory - K + T 1979

Answer 7

• posits an S shaped value function which is concave for gains and convex for losses
• defined with respect to reference point
• peole show diminishing sensitivity to progressively large decreases from the reference point, and diminishing sensitivity to progressively larger decreases from the reference point too

Question 8

the endowment effect

Answer 8

people value an item they already own more that they would be prepared to pay for the same item if they did not own it

demonstrated by Knetsch, 1989,
- used chocolate bars and a coffee mug finding endowment effects for both

economists argue these effects are rational - transactional cost

Question 9

decision weights

Answer 9

reflects a person’s subjective interpretation of an objective probability

allais’ paradox

Question 10

certainty effect

Answer 10

peole disproportionately weight outcomes which are guaranteed to occur so that “a reduction of the probability of an outcome by a constant factor has more impact when the outcome was initially certain than when it was merely probable” K+ T

Question 11

non-linear treatment of probabilities

Answer 11

people seem to overweight extreme probabilites and under-weight moderate to large ones

e.g., Gonzalez and Wu
2 lotteries to win 250, 1 offers a 5% chance to win, the other 30%
A: you can improve the chances of winning first to 10%
B: improve second to 35%

75% of people said A seemed like a more significant change

Question 12

core components of prospect theory

Answer 12

1. an editing stage, where a number of principles are used to simplify the options and ready them for evaluation.
2. a reference point is selected which determines whether outcomes are construed as gains or losses, with the value of these outcomes being determined by the S-shaped value function
3. The subjective value of outcomes are multiplies with the decision weight transformations of their associated probabilities

Question 13

valuation vs choice critique - prospect theory

Answer 13

• peoples valuations of 2 gambles can contradict their choices when asked to pick between them
• preferences are constructed by elicitation procedures rather than reflected in people’s responses in those tasks. Imply no stable value function relating objective and subjective value

explanation
- in the task used responses are on the same scale as the rewards/losses offered by the bet, so that aspect of the gamble will dominate

Question 14

decoy effects critique - prospect theory

Answer 14

asymmetric dominance effect
Ariely, 2009
- describes economist ad
A : 1 year online only 59$
B : 1 year print 125$
C: 1 year both 125$
16% chose A, 84% chose C
when print option removed
68% A, 32% chose c

these context effects are not captured by probability theory

Question 15

the similarity effect

Answer 15

when the decoy is similar to option A it draws choice share from A and boosts relative preference for B

Question 16

the compromise effect

Answer 16

when the decoy is more extreme than option A on both dimensions, it boosts choice share for A

Question 17

empirical issues with prospect theory

Answer 17

• when outcomes have high probabilities people are less risk averse when stakes are low - peanuts effect
• prospect theory cant readily accommodate this, we’d have to assume that the value function is less concave when values are low, but it doesnt really make sense to posit that the subjective value of an amount of money depends on the probability of receiving it

Question 18

conceptual problems wirh prospect theory - the lack of mechanism

Answer 18

the prospect theory is purely descriptive; it says decisions will be “as if” people combine amounts and probabilities in a particular way, but makes no claims or predictions about the processes