Lecture 1 - How Do We Make Decisions? Flashcards
What is value based decision making?
Early work done in Economics
Cost Benefit analysis
Not looked at the psychology and reasoning
Rational Decision Making includes what 3 things
Utility - the option with the highest value, individual
Subjectivity - different values to different people so we act in a way that produces the highest utility for us
Uncertainty - don’t know for sure the consequences of the actions. Higher certainty the more likely to choose that option
What is the Subjective Expected Utility Theory?
Calculate the expected utility of very option
Value of outcome 1 x probability of outcome 1
Choose the highest expected utility - economics believed we used this equation
Seems rational but do we make decisions this way - Time?
Behavioral Economics - Kahneman & Tversky
Rationally we should be 50/50 in taking the bet or not but in class it was not
Depends how confident you are in the possible results
But often prepared to take the risk
What is Loss Aversion?
Feel 2x stronger about losses
They have greater weight than potential gains
More pain from losing money than pleasure finding the same amount
What are Certainty Effects?
Gamble – you get £100 for sure or flip the coin and win £200 or get nothing
Vast majority would take the guaranteed outcome
More weight on the certain win than the gamble to win twice as much
What are Risky Losses?
Lose £100 or take the gamble to either lose nothing or £200
There is a value this time in the gamble as there is a chance of not having to lose anything
If we think we are losing we will take the risk
What is the Prospect Theory?
Describes how people value losses and gains
• Function is concave for gains - reflects the diminishing marginal value and risk aversion
• Function is convex for losses - reflects risk-seeking
• Graphical mapping of findings
What is Diminishing marginal utility?
Where the pleasure and value of something good plateus
Winning 1m will feel the same as winning 2m
Tversky & Kahneman (1981) - from money to people
Or 33% chance of saving everyone or 67% chance of saving no one
Risk adverse in this case – saving some is better than saving no one
Or 67% that 600 will die and 33% that no one will die
Will often take the risk to save all
Both outcomes are the same but they are framed differently
Framing effects and Preference Reversals?
Decision based on framing
Rick Averse when outcome is framed as gain
Risk Seeking when outcome is framed as a loss
Prospect theory and Change vs Absolute Values
• Calculator £15 or £10 across town
• Jacket £125 or £120 across town
Which option would you take – context makes you alter the decisions?
Both cases is the same judgement and saving but the jacket is 4% off and the calculator is 33% off.
Judgement Points in Judgements of Fairness
• Inflation is 12% but wages are only increased by 5%
• No inflation but wages cut by 7%
Gaining 5% even in inflation feels better than loosing something you once had
Judgement based on reference point - shift reference point, shift the decision
What is the Endowment Effect?
More utility when something is your own
sell something for twice as much as its worth to cover the impact of losing it
Summary of the Prospect Theory
Predicts many aspects of human decision-making
Limitations
• Descriptive of what they do not why
• Doesn’t consider individual differences
