Uncertainty and risk Flashcards
Affect heuristic
Tendency to overestimate the risk of an event that generates strong emotional response
* People rate sharks as one of the most dangerous animals, especially after being exposed to media about shark attacks
Regression to the mean
When a process is somewhat random (i.e. weak correlation), extreme values will be closer to the mean (i.e. less extreme) when measured a second time (because over time, variation reeduces with more observations)
Bounded rational
he theory that humans are rational relative to environmental constraints (e.g. time pressure) and individual constraints (e.g. working memory, attention)
* People are Satisficers: we look for solutions that are “good enough”
* Although heuristics sometimes provide incorrect answers and lead to biases; they also work
Ecological rationality
The view proposed by Gerd Gigerenzer (1999) which sees heuristics not as a “good enough” approach to solving a problem but as the optimal approach
* A heuristic is the best solution to a particular problem; given all of my constraints
Perceptual Decision Making
- Objective (externally defined) criterion for making your choice : right answer defined by the outside world
E.g. Are the dots moving left or right when shown moving dots
Value-based Decision making
Subjective (internally defined) criterion for making your choice
* Depends on motivational state and goal
E.g. Do I want cake or ice cream for dessert? no right answer in the environment
Decisions under risk
Decisions when outcomes are uncertain
* Ambiguity: when you have incomplete information out the consequences
- there are objective answers, but the types of decisions people actually make make when there are risks involved are very subjective.
Extremes in risk taking (high or low) can be very harmful :
- Stagnant living if risk averse
- Addiction and impulsivity if too much risk
Risk premium
Difference between expected gains of a risky option and a certain option
- Risk attitude depends on how much premium you need to motivate a risky decision
Risk averse attitude
Positive risk premium
* Need a chance at winning a lot more than a certain option to select the risky option
Risk neutral attitude
zero risk premium
* No difference in the options
Risk seeking attitude
- Decision maker has negative risk premium
- Doesn’t need the chance at winning more than the certain option to gamble
expected value in classical economy theory
Classical economic theory explained rational choice in terms of expected value
* The rational thing to do is choose the option that maximizes expected value
𝐸𝑉 = 𝑃 (probability of) 𝑊𝑖𝑛 × 𝑅𝑒𝑤𝑎𝑟𝑑
Do we follow expected value when making risky decisions ?
it has been empirically observed that people are inconsistent in their preferences which has been taken as a bias
* We do not follow expected value
The framing effect
The display of inconsistent risk preferences depending on the framing (loss vs gains) of the problem
Gain framing
- If Program A is adopted, 200 lives being saved.
- If Program B is adopted, there is a 1 in 3 probability of saving 600 lives and a 2 in 3 probability of saving no lives.
Program A: 200 lives could be definitely be saved : more likely to choose this
Program B: if the risky option doesn’t work out, those are 200 lives I could have saved!
Conclusion : People are risk-averse when the options are described as gains
* They prefer the sure thing and go for safety
* The cup is half full – do I need more?
Loss framing
- If Program A is adopted, exactly 400 people will die
- If Program B is adopted, there is a 1 in 3 probability that nobody will die and a 2 in 3 probability that all 600 people will die
Program A: I am for sure killing 400 people
Program B: If the risky option does work out, nobody will die! People are more likely to choose this
Conclusion : People are risk-seeking when the options are described as losses - They can tolerate an uncertain thing and risk a loss
- The cup half empty – don’t take any more away!
____loss/gain framing is more effective at getting students to register for a conference
Loss
The endowment effect
The tendency to ascribe higher value to objects people own or possess compared to identical objects they do not own.
Prospect Theory
A psychological theory that explains how people make decisions and predictions under uncertainty
2 major features of prospect theory
- Shape of Utility function (Losses vs Gains)
-
Shape of Probability weighting function (Unlikely vs Likely events)
* Describes how people do act; not how people should ac
Utility
Subjective value assigned to an object (i.e. satisfaction)
Context dependent :
* Utility is assigned to a monetary amount as a function of someone’s current state (reference point) and not in absolute value
* Deviations from the reference point will determine risk preference : anchor and Adjustment heuristic
Utility function
Describes how people map money to utility
X axis = objective value
Y axis = utility (subjective value)
2 insights of prospect theory
- The extra utility earned from gaining a dollar is larger when you only have $1 vs when you have $1M
-
Utility for losses versus gain is asymmetrical
* The utility function is steeper for losses than gain
* $1 lost hurts more than $1 earned if you have little
* Losses loom larger than gains (framing effect)
