W9 Decision-Making✅ Flashcards
What is meant by Expected Value?
The expected value (EV) of an option: is the sum of each possible outcome weighted by its probability
EV = p1a1 + p2a2 +…+ pnan
a = the value of the outcome
p = the probability of the outcome
n = the total number of outcomes
What is meant by Expected Utility theory?
Based on expected value of choices, Expected Utility Theory assumes a rational, prescriptive account of choice
-> BUT! Often a poor description of reality
Evidence for violations of expected utility:
Been given £1000, choose either:
A. 50% chance of £1000 (16%)
B. £500 for sure (84%)
—-
Been given £2000, choose either:
A. 50% chance £1000 lost (69%)
B. £500 lost for sure (31%)
=> These evidence give rise to Prospect Theory
What is meant by Prospect Theory?
- Outcomes considered as gains or losses with respect to a reference point.
-> Often the status quo - Described by a graph:
x = Real value
y = Subjective value
Origin = reference point
(x,y) = diminishing sensitivity to gains
(-x,-y) = diminishing sensitivity to losses - 2 risk attitudes:
1. Risk averse for (perceived) gains
2. Risk seeking for (perceived) losses
What are meant by the Certainty Effect and Endowment Effect in decision-making?
- Certainty effect: changes in probability will have a much bigger impact when when they approach certainty (0% or 100%).
-> Evidence: there is not much difference in choosing between 5% or 10% chance (67% - 33%)
Endowment effect: Ps are less likely to swap and object they started with for another one (loss aversion)
What are the 4 factors that influence decision-making proposed by Prospect Theory?
1.Value Function:
- S-shape of graph
- People are more sensitive to losses than gains with the same magnitude (Loss aversion)
-> lose £1000 > gain £1000
- Reference Points:
- Individuals evaluate outcomes relative to a reference point.
- Reference point can be from past experiences, expectations, or situational factors. - Diminishing Sensitivity:
- Psychological impact of changes in outcomes diminishes as the magnitude of those changes increases
- People are less sensitive to larger changes and more sensitive to smaller ones.
(losing £500 > losing £1000, losing £1000 ~ losing £1500) - Decision Weights:
- The subjective probabilities that individuals assign to different outcomes.
- People often overweight low-probability events and underweight high-probability events.
=> Decision-making is difference from expected probability around 0 and 1 (probability)
What are the 2 problems with Prospect Theory?
- Limited Scope:
- Valuation vs. Choice
- Attraction effect - Purely Descriptive: the Prospect curve only describe statistics, lacking the cognitive mechanism behind it. (e.g. how relative rank data corresponds with sampling statistics)
-> work on this tomorrow
Why is Limited Scope a problem with Prospect Theory + 2 effects to prove this?
- Valuation vs. Choice: People construct their own decision, not just by looking purely at the value
-> Prospect theory doesn’t assess HOW people reach their preference, only HOW they react
Evidence:
1. In P-bet: 95% chance (win $2.50) and 5% chance (lose $0.75) -> extreme probs
2. In $-bet: a 40% chance (win $8.50) or 60% chance (lose $1.50)
-> 73% of people who choose the P-bet sell the $-bet for a higher price
—
2. Attraction effect: occurs when the introduction of a third, less attractive option influences individuals to prefer a particular option among the original two.
-> Decision-making is also influenced by how the choice are framed + no. of choices
Evidence:
1. Choose:
A. £460, 59 miles (60%)
B. £707, 104 miles (36%)
C. £471, 52 miles
- BUT!
A. £460, 59 miles (22%)
B. £707, 104 miles (78%)
C. £718, 97 miles
Summary of people’s decision-making ability?
- Decisions and choices are often “irrational”
- Prospect theory explains these effects by invoking reference points, the value function, and probability weighting
- Prospect Theory is enormously influential, but we need to understand cognitive processes
