Rational Choice Theory Flashcards
Irrational Thinking
Impulsive
Emotional
No control over themselves
Basic Principles
All behaviour- apart from reflexes/ involuntary physio responses- all interesting actions- based on decisons
Rationality (Decision Theorists)
means: making a choice that is best for decision maker given circumstances/ preferences
if thirsty, buy £1.50 drink etc
making choice that aligns with yourself
choosing right option to achieve preferred result
Decisions
Deliberate Actions
Choosing between atleast two alternatives
If only one decision, doing nothing- alternative
Normative Theory
Descriptions of how someone SHOULD behave or choose if rational
Positive/Descriptive Theory
How people ACTUALLY choose in practice
Risk/ Uncertainty
Decision making under risk- knowing possible outcomes- some ability to estimate probabilities
Under uncertainty- lack of information- cannot assign probability to outcome. Decision process - more complex/ less predictable
History
Early thinking- Jeremy Bentham 1738- 1832
Utilitarianism- later, John Stuart Mill
Theory of development- economists
Expected utility theory- Neumann and Morgenstern 1947
Psychological theory
Decision Scientists
Maths- Probability of Conjunction
Probablity- ranges 0 (nothing) to 1 (certain)
Making a decision, the probability of all outcomes must = 1 (add up to)
Probab. of Conjunction- prob of two independent events- if one happens wont effect likelihood of the other = pq (p x q)
- e.g head coin toss, p= 0.5. to get a six = 1/6= q = 0.167.
- Conjunction of getting both heads and a three- pq= 0.5 x 0.167= 0.083
MULTIPLY
INDEPENDENT EVENTS
Maths- Probability of Disjunction
Prob. of two mutually exclusive events happening
- one or the other. cant happen at the same time
ADD probabilities up
p + q or p + q + r so on
for event of either 5 or 6 on the dice, p = 0.167 + 0.167= 0.333
Expected Value Theory
Gamble- draw a named card from deck- get 120£ if correct- e.g pick 4 of spades
Theory- what is expected value with mutually exclusive outcomes
Expected- means AVERAGE if we play over and over, whats expected value likely to be
Must include calculating all possibilities
Two outcomes- get gamble or not
EV (G amble) = prob of getting 4spades (1/52 x £120) + (51/52 x £0) = £2.31
expected value of playing that gamble- expected payoff- what you would earn on average if played multiple times over/over
Rational People/ EV
Rational people gamble and buy insurance
- altho they shld know- EV of buying must be less than cost
-if it wasn’t- companies wldnt make profit - they’re gambling on you buying and not needing
EV- shld be negative- yet we still buy it- reduce uncertainty
St Petersburg Paradox
Daniel Bernoulli 1738- exploded idea- not always rational to maximise EV
Coin toss- if win, get £1- game over
If lose, get another toss- payoff doubles- if win, take increased double- keep getting tails- keep double
Payoff doubles, each toss- if House has unlim £ - what is ev of game?
EV= 1/2 + 1/2 + 1/2 … = £INFINITY - if house has unlimited funds
To maximise EV- you should always play game- no matter the entry cost- because infinity always higher than entry cost
most ppl put £10 to play game- 50% chance u lose it all for £1 on first toss- heads
Balanced by small prob of winning fortune if theres. long string of tails
-irrational- led to development of expected utility theory
Expected Utility Maximisation
Bernoulli- not always maximising value- but maximising,
Utility- value to us of things as well as literal value- money
presents idea: Utility function— graph- as monetary value goes up, the utility of it goes up- but not at same rate- at a decreasing rate
£10 might give u ten in Utility but £20 wont give you twenty in utility- not doubled- slow decreasing slope- MARGINAL UTILITY
We dont try to maximise value- maximise utility to ourselves- not always the same thing
Subjective Expected Utility Theory
Von Neuman & Morgenstern
realised, formalised as mathematical approach
subjective means we calculate the likelihoods and possiblilites
dont know them but we have a way of gauging them
EU theory says we maximise
formalisation of what utility is- interval scale- have nothing- arbitary nature- more is more than less
maximise utility over value
EU = p1u1 + p2u2+ …
must include all possibilites that something can happen
