Decision Making (2)

Question 1

What are the key words for decision making (2)?

Answer 1

Utility
Strategy
Loss aversion
Framing effects
Bounded rationality
Satisficing 
Dominance principle
Prospect theory
Expected utility theory

Question 2

What is Decision Making?

Answer 2

• Choosing from a menu of options

- strategy is used to describe ‘choice’

Question 3

What are the 2 types of theory?

Answer 3

Normative:

• How people ‘should’ behave if they have followed the rules
• rational
• e.g. game theory
• expected utility theory
• probability

Descriptive:
Psychological:
- How people actually behave
- e.g. behavioural economics
- cognitive biases
- prospect theory

Question 4

What is the Expected Utility Theory?

Answer 4

Von Neuman and Morgenstern, (1947):

• A normative theory
• how people ‘should’ behave if they have followed the rules
• rational
• classical theory
• Rational decision maker model
• assumes people have a fixed set of attitudes (no individual differences)
• decision makers = rational actors
• seek to maximise utility
• utility = subjective value we attach to an outcome
• in any situation, we seek to maximise utility
• to make a decision we adopt a strategy that will yield/provide the maximum utility for us

To derive the expected utility for a strategy/option we can use a formula:

• Expected utility = (outcome)* utility
• presents a mathematical theory underpinning decision making

Question 5

How can we evaluate the Expected Utility Theory?

Answer 5

EUT = strong theory because:

• It is the dominant theory in decision making research
• it allows us to make precise predictions
• it is formulated mathematically

There are many problems with the theory though:

• People aren’t (always) rational
• it doesn’t work in practise
• there are paradoxes regarding predictions
• it needs more workable alternatives

Question 6

What is the Expected Utility Theory Dominance Principle?

Answer 6

Dominance Principle:
- If strategy A is at least as good (if not better) as strategy B in all respects and dominates strategy B in at least 1 respect, then strategy A should be preferred (and dominant) to strategy B

Question 7

What is Kahneman and Tversky’s (1979) take/study on the Expected Utility Theory?

Answer 7

Problems with the EUT theory:

• E.g. participants don’t resolve dilemmas/problems using the EUT by adopting the dominance principle
• problems like this with predictions from EUT have led (the) researchers to develop their prospect theory

Question 8

What are the key differences with Expected Utility Theory? (following on from previous question)

Answer 8

Kahneman and Tversky, (1979):

• Prospect theory is a descriptive psychological theory
• utility = replaced with value
• value = considered in terms of gains or losses
• rather than net gain in EUT
• different value functions for gains and losses
• important implications

Question 9

What are the interpretations of the findings of Kahneman and Tversky’s (1979) creation/study of Prospect Theory?

Answer 9

• Shows that participants/people treat potential gains and losses differently to each other
• even though the problems are the same mathematically
• the choice made in 1 condition is risk averse and in the other is it risk seeking
• remember EUT predicts they would be the same (invariance principle) - suggesting EUT is not as useful, credible or correct

Framing Effect:

• Influence of aspects of formulation of a problem (e.g. wording) on decision making
• e.g. framing people as gain or loss changes decision makers from being risk averse to risk seeking

Question 10

What is Loss Aversion in the Prospect Theory?

Answer 10

Definition:
- The tendency to be more sensitive to potential losses than to potential gains

• has key differences compared to/with EUT
• prospect theory = rejected in place of value
• value considered in terms of gains and losses
• value function for gains and losses

Question 11

What is Bounded Rationality?

Answer 11

Simon (1957):

Unbounded Rationality:
In EUT:
- Rational decision makers
- have complete information available
- optimise the best strategy to maximise utility

Bounded Rationality:
- A descriptive theory
It recognises that:
Decision makers are limited by:
- A) the information available
- B) their powers to process it quickly and accurately

Question 12

What are the uses of Bounded Rationality?

Answer 12

• Workable solutions
• heuristics
• bounded decisions
  Bounded by:
• Environmental constraints
• cognitive constraints
  “Satisficing”:
• Satisfactory
• sufficient
• go through menu options to find the first 1 that meets the minimum requirements
• satisficers seek a good solution
• maximisers seek the best/a perfect solution