Judgment and Decision Making

1. Judgment and Decision Making How Rational Are We?

2. Normative Models • “Rational” = selecting optimally • What gets optimized? 2 normative models: • Expected Value: Highest monetary value • Expected Utility: Highest psychological value • Expected value vs. expected utility: Survey Results (in class) • Expected Value = objective value * probability • Expected Utility = subjective utility * probability

3. Violations of Expected Utility Theory • Certainty Effects • Allais Paradox • Certainty of Negative Outcomes • Preference Reversals • Context Effects • Framing Effects • Sunk Costs (each discussed in subsequent slides)

4. Certainty Effects • Which would you prefer? • A) 40% chance at $40 • B) 50% chance at $30 • Which would you prefer? • A) 80% chance at $40 • B) 100% chance at $30 • The “subjective utility” of the $30 changes from option 1 to option 2. Irrational.

5. Allais Paradox Which of each pair do you prefer? (Allais, 1953).

6. Certainty of Negative Outcomes Which of the two choices for treating an epidemic would you choose? (Tversky & Kahneman, 1981)

7. Class A Moderately interesting Moderately difficult Prof is so-so 10 am Class B Very interesting Very difficult Prof is very good 8 am Preference Reversals Choice 1: You must choose one to sign up for. Choice 2: You are enrolled in both, but must drop one.

8. Context Effects • Choosing between A and B should not be affected by what other alternatives are present (but it is) • Example: Attraction Effect • Having a third choice that is “dominated by” one of the two choices makes that one more attractive.

9. Car A Reliabiliy: 8 Cost: $24,000 Car B Reliabiliy: 5 Cost: $20,000 Car A Reliabiliy: 8 Cost: $24,000 Car B Reliabiliy: 5 Cost: $20,000 Car C Reliabiliy: 6 Cost: $25,000 Attraction Effect

10. Frame A: Without the new treatment, 700 soldiers will die With the new treatment, there is a 70% chance that all of them will die, and a 30% chance that none will die. Frame B: Without the new treatment, 300 will be saved. With the new treatment, there is a 70% chance that none of them will be saved, and a 30% chance that all of them will be saved. Framing Effects

11. Sunk Costs • Rationally, we should not consider sunk (unrecoverable) costs when deciding what to do next. But we do. • Would you walk out of a boring movie? • What if admission had been free? • What if you had paid $50 to see it? • Should you sell your stocks if you think they will go down in price? What if you paid twice the current price when you bought it?

12. Summary thus far • Are we rational in our decision making? • We do not follow Expected Value • We do not even follow Expected Utility • If we do not make decisions the way these prescriptive theories say we should, can we describe how we actually do make decisions?

13. Descriptive Theories of Decision Making • Prospect Theory • Evaluation is relative to a Reference Point rather than being absolute (accounts for framing effects) • Psychological Probabilities (pi) are used rather than objective probabilities. • Regret Theory • We try to minimize the anticipated feelings of regret for our decisions.

14. Shortcuts and Strategiesin Decision Making • “Satisficing” – Herb Simon • Searching for an acceptable answer, rather than for an optimal one. • Specific Heuristics: • Elimination by aspects • Availability Heuristic • Representativeness Heuristic • Anchoring