Summary Judgement and Decision Making
Lecture 1
Decision making should be a rational, thoughtful and analytical process, but very often this is not the
case. Bad decisions are errors in this process
Lecture 2: Loss aversion & Framing of decisions
Rational decision making
This process goes in some steps:
- Definition of the problem
- Identification of decision criteria
- Weighing of decision criteria
- Generation of possible alternatives
- Rating of alternatives against criteria
- Computing optimal decision
It is assumed here that the decision maker is rational and has complete information, the problem is
clear and unambiguous, there are no time or cost constraints and the choice will be the one with the
highest payoff.
Normative decision making analysis
Normative prescription of how decisions should be made in a rational way (according to the steps
above). Assumed is that you will always choose the option with the highest payoff for yourself. It was
assumed that people follow these rules in daily life. Very often people make decisions in a different
way.
Reference point
Your reference point is about how you perceive certain things. E.g. something feels more cold when
you are really hot (your reference point is you being hot). This is not taken into account in the
normative decision making analysis. Framing often has an impact on the decisions you make. This
example is about an Asian disease that could kill 600 people. All options are the same, but when the
problem is framed differently, people make different decisions:
Expected utility theory
When judging uncertain events, people look at the expected utility, which is the probability of
something happening, multiplied with the value (EV = P * V).
- Dominance principle: expected value can be used to rank alternatives from best to worse
- Cancellation: a choice between gambles should depend on the outcomes that differ
Both options have a 10% chance of being
killed by a gunmen. These are the same
so you can skip them, and the choice will
be between 1% chance of death in a car
crash and 20% chance of being mugged
, - Transitivity: preferring A to B, and B to C means preferring A to C
- Invariance: your preferences should be stable, no matter how the choices are described. This
contradicts with the framing effect, that states that different framings of problems lead to
different preferences.
In the Asian disease problem, the principles of dominance and invariance are violated
Prospect theory
What we see in this graph, are the main
points of prospect theory:
- There is a reference point, from
which gains and losses are
defined
- Diminishing sensitivity to
differences when moving away
from reference point
- Loss aversion
Conclusion: people hate losses more than
they like gains
Your value function according to prospect theory is: V(X – R), where R is your reference point, and X
is your gain or loss relative to R. A reference point is taken into account because: people compare
themselves all the time, it is easier to compare with than to evaluate absolute utility and there is a
natural degree of adaption.
Loss aversion = the displeasure associated with a loss of a given amount is larger than the utility
associated with a gain of the same magnitude (|v(x) < |v(-x)|
People will reject this offer because losing 100 is
more painful than winning 150
This is also why we reject something described as a loss easier than when it’s described as a gain,
even if it’s the same situation (Asian disease problem)
Normative Decision Analysis VS Descriptive Decision Analysis
How people should make decisions in a How people actually make their decisions
rational way Key ingredient: value function
> Expected Utility theory > Prospect Theory
Certainty effect
Certainty effect is when the impact on your decision is bigger when an outcome is certain than when
it is merely probable
Pseudocertainty effect
?
, Hedonic treadmill
People tend to quickly return into a relatively stable level of happiness, despite the major positive or
negative events or life changes. Once you make more money, your expectations and desires raise as
well, and you will need to get more to feel like you have more
Status quo bias
We want things to stay how they are, even if this isn’t what we originally want. Potential losses
generated by change should be avoided (this is a form of loss aversion)
Tutorial 2: Headwind/tailwind assymetry
Intuitive thinking – Kahneman
When a skill is fully required, it will become intuitive, and moves from your system 1 to your system
2. You don’t need cognitive effort to perform this skill. There are two things necessary for a skill to be
acquired. The first thing is immediate and unambiguous feedback from your environment. The
second thing is an associative network
Headwind/tailwind asymmetry
When you experience headwind, your desire is to have tailwind because you’re having a hard time.
But once the wind turns and starts blowing in you face, you forget how hard it was before, and you
take the headwind for granted. It is a phenomena where you notice the negative things and don’t see
what is positive.
Self-handicapping = finding a reason for yourself why you don’t succeed. This seems to be explaining
headwind/tailwind asymmetry, but this is creating negativity and in the asymmetry you really feel
like it’s there.
Lecture 3: Mental accounting
What is mental accounting?
Mental accounting is a set of operations used by individuals and households to organize, evaluate
and keep track of financial activities.
Economic theory of decision making VS Mental accounting
Normative Descriptive
Money is perfectly fungible/substitutable Money in one account is not a per-
(economic principle of fungibility) fect substitute for money in another
Framing cannot alter behavior Framing does alter choices
Hedonic editing
How do you want your losses or gains to be divided over
time? (Machiavelli)
Given the shape value function, you should want your losses
to come at the same time, and you want your gains to be
separated. You should integrate small losses with large gains,
Lecture 1
Decision making should be a rational, thoughtful and analytical process, but very often this is not the
case. Bad decisions are errors in this process
Lecture 2: Loss aversion & Framing of decisions
Rational decision making
This process goes in some steps:
- Definition of the problem
- Identification of decision criteria
- Weighing of decision criteria
- Generation of possible alternatives
- Rating of alternatives against criteria
- Computing optimal decision
It is assumed here that the decision maker is rational and has complete information, the problem is
clear and unambiguous, there are no time or cost constraints and the choice will be the one with the
highest payoff.
Normative decision making analysis
Normative prescription of how decisions should be made in a rational way (according to the steps
above). Assumed is that you will always choose the option with the highest payoff for yourself. It was
assumed that people follow these rules in daily life. Very often people make decisions in a different
way.
Reference point
Your reference point is about how you perceive certain things. E.g. something feels more cold when
you are really hot (your reference point is you being hot). This is not taken into account in the
normative decision making analysis. Framing often has an impact on the decisions you make. This
example is about an Asian disease that could kill 600 people. All options are the same, but when the
problem is framed differently, people make different decisions:
Expected utility theory
When judging uncertain events, people look at the expected utility, which is the probability of
something happening, multiplied with the value (EV = P * V).
- Dominance principle: expected value can be used to rank alternatives from best to worse
- Cancellation: a choice between gambles should depend on the outcomes that differ
Both options have a 10% chance of being
killed by a gunmen. These are the same
so you can skip them, and the choice will
be between 1% chance of death in a car
crash and 20% chance of being mugged
, - Transitivity: preferring A to B, and B to C means preferring A to C
- Invariance: your preferences should be stable, no matter how the choices are described. This
contradicts with the framing effect, that states that different framings of problems lead to
different preferences.
In the Asian disease problem, the principles of dominance and invariance are violated
Prospect theory
What we see in this graph, are the main
points of prospect theory:
- There is a reference point, from
which gains and losses are
defined
- Diminishing sensitivity to
differences when moving away
from reference point
- Loss aversion
Conclusion: people hate losses more than
they like gains
Your value function according to prospect theory is: V(X – R), where R is your reference point, and X
is your gain or loss relative to R. A reference point is taken into account because: people compare
themselves all the time, it is easier to compare with than to evaluate absolute utility and there is a
natural degree of adaption.
Loss aversion = the displeasure associated with a loss of a given amount is larger than the utility
associated with a gain of the same magnitude (|v(x) < |v(-x)|
People will reject this offer because losing 100 is
more painful than winning 150
This is also why we reject something described as a loss easier than when it’s described as a gain,
even if it’s the same situation (Asian disease problem)
Normative Decision Analysis VS Descriptive Decision Analysis
How people should make decisions in a How people actually make their decisions
rational way Key ingredient: value function
> Expected Utility theory > Prospect Theory
Certainty effect
Certainty effect is when the impact on your decision is bigger when an outcome is certain than when
it is merely probable
Pseudocertainty effect
?
, Hedonic treadmill
People tend to quickly return into a relatively stable level of happiness, despite the major positive or
negative events or life changes. Once you make more money, your expectations and desires raise as
well, and you will need to get more to feel like you have more
Status quo bias
We want things to stay how they are, even if this isn’t what we originally want. Potential losses
generated by change should be avoided (this is a form of loss aversion)
Tutorial 2: Headwind/tailwind assymetry
Intuitive thinking – Kahneman
When a skill is fully required, it will become intuitive, and moves from your system 1 to your system
2. You don’t need cognitive effort to perform this skill. There are two things necessary for a skill to be
acquired. The first thing is immediate and unambiguous feedback from your environment. The
second thing is an associative network
Headwind/tailwind asymmetry
When you experience headwind, your desire is to have tailwind because you’re having a hard time.
But once the wind turns and starts blowing in you face, you forget how hard it was before, and you
take the headwind for granted. It is a phenomena where you notice the negative things and don’t see
what is positive.
Self-handicapping = finding a reason for yourself why you don’t succeed. This seems to be explaining
headwind/tailwind asymmetry, but this is creating negativity and in the asymmetry you really feel
like it’s there.
Lecture 3: Mental accounting
What is mental accounting?
Mental accounting is a set of operations used by individuals and households to organize, evaluate
and keep track of financial activities.
Economic theory of decision making VS Mental accounting
Normative Descriptive
Money is perfectly fungible/substitutable Money in one account is not a per-
(economic principle of fungibility) fect substitute for money in another
Framing cannot alter behavior Framing does alter choices
Hedonic editing
How do you want your losses or gains to be divided over
time? (Machiavelli)
Given the shape value function, you should want your losses
to come at the same time, and you want your gains to be
separated. You should integrate small losses with large gains,
