Lecture 1, Heuristics & Biases
Default option: the option the chooser will obtain if he or she does nothing
The Default Effect: making an option a default increases the likelihood that it is chosen
There are big difference in the percentages of the people who are registered as donors between
countries. This is because there two different policies:
- Check the box if you want to participate in the organ donor program, this is the Opt-In
option. But people don’t check so they don’t join
- Check the box if you do not want to participate in the organ donor program, this is the Opt-
out option. People don’t check so they do join.
Why do these tricks work?
- Decisions are often complex and difficult
- Individuals / consumers are bounded rational, they have to make decisions under several
constraints:
o Limited knowledge/information
o Limited cognitive resources (time, attention, memory). We don’t want to spend too
much time making a decision
o Limited motivation
▪ So people/consumers make use of Heuristics
Heuristics: cognitive shortcuts to make decisions quickly and efficiently
- Example: Default effect (i.e., people are more likely to accept default options)
- Problem: use of heuristics can lead to systematic errors and biases (e.g., deviations from the
true or objective value, violation of probability laws)
Suppose you would like to subscribe to ‘The Economist’. The magazine offers you the following
subscriptions:
1. Online Subscription: 59 USD
2. Print Subscription: 125 USD
3. Print & Online Subscription: 125 USD
Which subscription would you choose? The results were:
- Online Subscription 16%
- Print Subscription 0%
- Print & Online Subscription 84%
In the case where the only options were ‘Online Subscription: 59 USD’ and ‘Print & Online
Subscription: 125 USD’
- 68% chooses the online subscription
- 32% the print and online subscription
Decoy Effect: The choice of one option over the other changes when a third – asymmetrically
dominated – option is introduced
- Asymmetrically dominated: inferior in all properties to one option, but only inferior in some
properties to the other option (i.e., an irrelevant alternative)
- Choices are made in a context; Relative to other alternatives rather than based on absolute
preferences
Managerial Relevance: Adding an irrelevant alternative ‘helps’ consumers to decide → upselling
However!! Adding too much options can confuse the customers
Anchoring and Adjustment: Making an estimation based on a process of anchoring on a salient
number and adjusting up or down. Problem: Adjustments are typically insufficient, estimation is
biased towards the anchor
Managerial Relevance. General: Negotiations (wages, prices etc.), price expectations
Specifically: Sales techniques (prices, product portfolio): furniture, cars, home appliances etc
1
, - e.g. In negotiating about your salary you should start with a high number, this will serve as
the anchor and lead to a higher salary then when you introduce a low anchor.
- The anchor is the original price, a discount can look attractive. But if you discount too often,
then people will get used to lower prices. ‘it would be stupid to buy for the real price’.
- Besides it can also portray a lower quality when the anchor is too far apart from the current
price.
Imagine the following Scenario 1
You are about to buy an ice cream cone for 5€. As you stand in line at the Manhattan Beach
Creamery to buy your ice cream, you discover that you have dropped a 5€ bill on the Metro. You
are disappointed, of course. Will you still buy the ice cream for 5€ ? (here you lose money from
your regular account)
Imagine the following Scenario 2
You are about to enjoy your ice cream cone which you bought for 5€ in the Manhattan Beach
Creamery. However, to your dismay you accidently spill the entire ice cream on the floor. Will you
spend another 5€ for the ice cream? (here you lose money form the ice cream category)
Losing money from different ‘mental accounts’ influences purchase decisions
Scenario 1 88% will buy the ice cream
Scenario 2 46% will buy the ice cream
Mental Accounting: People keep track of their expenses in different mental accounts (i.e.,
categories); these mental accounts influence the decision making process
Managerial & Policy Relevance: Individuals / consumers spend money differently depending on the
‘account’ they pay from. E.g. Tax refunds, birthday money, investments, bonuses at work
- A bonus doesn’t belong to your normal salary account, it is a different account which you
might spend more easily
Availability Heuristic: Events are judged more likely to the extent that they are vivid or easily
recalled “If you can think of it, it must be important”
Managerial & Policy Relevance
- Ignoring relevant facts due to the vividness of recent examples → Overestimation of the
likelihood that something good or bad will happen
- Examples: seeing news (plane accident, job layoffs), lottery winners, sweepstakes
o When you see on Facebook that people win sweepstakes you think your chances are
also big to win one. You think it’s more likely to happen to you too.
o Also when we see more terror atacks in the news, we feel like there is a bigger
chance that it can also happen to us
Linda is 31 year old, single, outspoken and very bright. She majored in philosophy. As a
student, she was deeply concerned with issues of discrimination and social justice, and also
participated in anti-nuclear demonstration. What is more likely?
1. Linda is a bank teller
2. Linda is a bank teller and active in the feminist movement
Representative information influences our decision making
Option 1: T 15%
Option 2: T&F 85%
Representativeness Heuristics: When judging the probability that A belongs to B, people base their
judgment on the degree to which A resembles B – and neglect the general probability of B. If
something is more representative, people tend to think it is also more likely.
- example 1: Despite the resemblance, the likelihood of Linda being T&F is always lower than
the likelihood of Linda being T (conjunction fallacy)
- Example 2: A coin toss HTTHTH is not more likely than HHHTT
2
,Managerial Relevance
- Consumers’ judgments of product prices in supermarkets vs. discounters
- Investment decisions based on the success of a “representative” company
Framing Effect: the frame of a message influences the decision; i.e., people react differently
depending on how a message is presented. Two effects:
- People prefer positive outcomes over negative outcomes,
- People are risk averse over gains, but risk seeking over losses. Winning > Losing
o Winning → risk avers (win 1000,- for sure)
o Losing → risk taking (50% chance of losing 2100,- and 50% of losing 0,-)
Managerial & policy relevance
- Firing vs. saving employees: Out of 600, would you rather fire 400 or save 200? It sounds
better to say that you saved 200 employees than that you fired 400
- Health treatments: Would you rather have a 90% chance to live or a 10% chance to die?
Which business can really make money out of framing things right? Insurance for example, they will
say there is a 1% that all your luggage gets lost and you lose everything. So you scare people into
losing something/ paying for something etc.
Guy A has 10 million and loses 5 mill
Guy B had nothing and wins 5 mill
You would think that guy B is happier because he gained something.
o If you look at the absolute wealth that someone has. Both guys with 5 million euros
should be equally happy, because each of them have 5 mill.
o But it doesn’t make sense because one guy lost something and one guy gained
something. According to the theory you should consider where the guys came from.
▪ Guy B gained → happy
▪ Guy A lost → unhappy, people hate to lose
Expected Utility Theory (more than 275 years old)
- Utility as a function of absolute wealth
- Marginal utility decreases a wealth increases
Prospect Theory (since 1979)
- Reference dependence: value is measured in gains and losses relative to a reference point
- Diminishing sensitivity: marginal value of gains and losses decreases with their size
- Loss aversion: the pain of losing is psychologically bigger than the pleasure of gaining
Managerial & Policy Relevance
- Loss aversion: Potential losses motivate more than potential gains (e.g., firing vs. saving jobs,
selling insurances, structure of the tax system)
- Losses make people risk seeking (e.g., financial decision making, gambling)
Prospect Theory (Tversky& Kahneman, 1979)
Looking at the slope, losing hurts more than
gaining stuff. But if you can make up for a loss
you also become happy faster. e.g. Holding on
to a losing stock because you might still make
out of it in the future. You already lost so having
a chance of making that loss a bit smaller (while
it also can get much bigger) is worth it. People
sell winning stock quickly because they don’t
want to take the risk of losing that gain.
3
, IKEA effect: consumers place more value on products they have (at least) partially created.
However, this is only if they actually finish the product
Managerial Relevance
- Integrating consumers in the production process increases valuation instead of decreasing it.
This is called a co-creation
- However: too much effort can have adverse effects
- Examples: Cake instant mix, customization, Build-a-Bear
Key Takeaways
1. Decisions are often complex and difficult. To make decision quickly and efficiently consumer
use several heuristics (i.e., cognitive shortcuts)
2. Heuristics can lead to systematic errors and biases; mistakes people repeat over and over
again (i.e., not always rational but predictably irrational)
3. In decision making, we need to go beyond the standard economical model of expected
utility; prospect theory provides a relevant framework
4. Understanding both rational and irrational behavior is important for consumers, managers
and policy makers in financial decision making, HR management, product pricing, marketing
strategy, health policies etc.
4
Default option: the option the chooser will obtain if he or she does nothing
The Default Effect: making an option a default increases the likelihood that it is chosen
There are big difference in the percentages of the people who are registered as donors between
countries. This is because there two different policies:
- Check the box if you want to participate in the organ donor program, this is the Opt-In
option. But people don’t check so they don’t join
- Check the box if you do not want to participate in the organ donor program, this is the Opt-
out option. People don’t check so they do join.
Why do these tricks work?
- Decisions are often complex and difficult
- Individuals / consumers are bounded rational, they have to make decisions under several
constraints:
o Limited knowledge/information
o Limited cognitive resources (time, attention, memory). We don’t want to spend too
much time making a decision
o Limited motivation
▪ So people/consumers make use of Heuristics
Heuristics: cognitive shortcuts to make decisions quickly and efficiently
- Example: Default effect (i.e., people are more likely to accept default options)
- Problem: use of heuristics can lead to systematic errors and biases (e.g., deviations from the
true or objective value, violation of probability laws)
Suppose you would like to subscribe to ‘The Economist’. The magazine offers you the following
subscriptions:
1. Online Subscription: 59 USD
2. Print Subscription: 125 USD
3. Print & Online Subscription: 125 USD
Which subscription would you choose? The results were:
- Online Subscription 16%
- Print Subscription 0%
- Print & Online Subscription 84%
In the case where the only options were ‘Online Subscription: 59 USD’ and ‘Print & Online
Subscription: 125 USD’
- 68% chooses the online subscription
- 32% the print and online subscription
Decoy Effect: The choice of one option over the other changes when a third – asymmetrically
dominated – option is introduced
- Asymmetrically dominated: inferior in all properties to one option, but only inferior in some
properties to the other option (i.e., an irrelevant alternative)
- Choices are made in a context; Relative to other alternatives rather than based on absolute
preferences
Managerial Relevance: Adding an irrelevant alternative ‘helps’ consumers to decide → upselling
However!! Adding too much options can confuse the customers
Anchoring and Adjustment: Making an estimation based on a process of anchoring on a salient
number and adjusting up or down. Problem: Adjustments are typically insufficient, estimation is
biased towards the anchor
Managerial Relevance. General: Negotiations (wages, prices etc.), price expectations
Specifically: Sales techniques (prices, product portfolio): furniture, cars, home appliances etc
1
, - e.g. In negotiating about your salary you should start with a high number, this will serve as
the anchor and lead to a higher salary then when you introduce a low anchor.
- The anchor is the original price, a discount can look attractive. But if you discount too often,
then people will get used to lower prices. ‘it would be stupid to buy for the real price’.
- Besides it can also portray a lower quality when the anchor is too far apart from the current
price.
Imagine the following Scenario 1
You are about to buy an ice cream cone for 5€. As you stand in line at the Manhattan Beach
Creamery to buy your ice cream, you discover that you have dropped a 5€ bill on the Metro. You
are disappointed, of course. Will you still buy the ice cream for 5€ ? (here you lose money from
your regular account)
Imagine the following Scenario 2
You are about to enjoy your ice cream cone which you bought for 5€ in the Manhattan Beach
Creamery. However, to your dismay you accidently spill the entire ice cream on the floor. Will you
spend another 5€ for the ice cream? (here you lose money form the ice cream category)
Losing money from different ‘mental accounts’ influences purchase decisions
Scenario 1 88% will buy the ice cream
Scenario 2 46% will buy the ice cream
Mental Accounting: People keep track of their expenses in different mental accounts (i.e.,
categories); these mental accounts influence the decision making process
Managerial & Policy Relevance: Individuals / consumers spend money differently depending on the
‘account’ they pay from. E.g. Tax refunds, birthday money, investments, bonuses at work
- A bonus doesn’t belong to your normal salary account, it is a different account which you
might spend more easily
Availability Heuristic: Events are judged more likely to the extent that they are vivid or easily
recalled “If you can think of it, it must be important”
Managerial & Policy Relevance
- Ignoring relevant facts due to the vividness of recent examples → Overestimation of the
likelihood that something good or bad will happen
- Examples: seeing news (plane accident, job layoffs), lottery winners, sweepstakes
o When you see on Facebook that people win sweepstakes you think your chances are
also big to win one. You think it’s more likely to happen to you too.
o Also when we see more terror atacks in the news, we feel like there is a bigger
chance that it can also happen to us
Linda is 31 year old, single, outspoken and very bright. She majored in philosophy. As a
student, she was deeply concerned with issues of discrimination and social justice, and also
participated in anti-nuclear demonstration. What is more likely?
1. Linda is a bank teller
2. Linda is a bank teller and active in the feminist movement
Representative information influences our decision making
Option 1: T 15%
Option 2: T&F 85%
Representativeness Heuristics: When judging the probability that A belongs to B, people base their
judgment on the degree to which A resembles B – and neglect the general probability of B. If
something is more representative, people tend to think it is also more likely.
- example 1: Despite the resemblance, the likelihood of Linda being T&F is always lower than
the likelihood of Linda being T (conjunction fallacy)
- Example 2: A coin toss HTTHTH is not more likely than HHHTT
2
,Managerial Relevance
- Consumers’ judgments of product prices in supermarkets vs. discounters
- Investment decisions based on the success of a “representative” company
Framing Effect: the frame of a message influences the decision; i.e., people react differently
depending on how a message is presented. Two effects:
- People prefer positive outcomes over negative outcomes,
- People are risk averse over gains, but risk seeking over losses. Winning > Losing
o Winning → risk avers (win 1000,- for sure)
o Losing → risk taking (50% chance of losing 2100,- and 50% of losing 0,-)
Managerial & policy relevance
- Firing vs. saving employees: Out of 600, would you rather fire 400 or save 200? It sounds
better to say that you saved 200 employees than that you fired 400
- Health treatments: Would you rather have a 90% chance to live or a 10% chance to die?
Which business can really make money out of framing things right? Insurance for example, they will
say there is a 1% that all your luggage gets lost and you lose everything. So you scare people into
losing something/ paying for something etc.
Guy A has 10 million and loses 5 mill
Guy B had nothing and wins 5 mill
You would think that guy B is happier because he gained something.
o If you look at the absolute wealth that someone has. Both guys with 5 million euros
should be equally happy, because each of them have 5 mill.
o But it doesn’t make sense because one guy lost something and one guy gained
something. According to the theory you should consider where the guys came from.
▪ Guy B gained → happy
▪ Guy A lost → unhappy, people hate to lose
Expected Utility Theory (more than 275 years old)
- Utility as a function of absolute wealth
- Marginal utility decreases a wealth increases
Prospect Theory (since 1979)
- Reference dependence: value is measured in gains and losses relative to a reference point
- Diminishing sensitivity: marginal value of gains and losses decreases with their size
- Loss aversion: the pain of losing is psychologically bigger than the pleasure of gaining
Managerial & Policy Relevance
- Loss aversion: Potential losses motivate more than potential gains (e.g., firing vs. saving jobs,
selling insurances, structure of the tax system)
- Losses make people risk seeking (e.g., financial decision making, gambling)
Prospect Theory (Tversky& Kahneman, 1979)
Looking at the slope, losing hurts more than
gaining stuff. But if you can make up for a loss
you also become happy faster. e.g. Holding on
to a losing stock because you might still make
out of it in the future. You already lost so having
a chance of making that loss a bit smaller (while
it also can get much bigger) is worth it. People
sell winning stock quickly because they don’t
want to take the risk of losing that gain.
3
, IKEA effect: consumers place more value on products they have (at least) partially created.
However, this is only if they actually finish the product
Managerial Relevance
- Integrating consumers in the production process increases valuation instead of decreasing it.
This is called a co-creation
- However: too much effort can have adverse effects
- Examples: Cake instant mix, customization, Build-a-Bear
Key Takeaways
1. Decisions are often complex and difficult. To make decision quickly and efficiently consumer
use several heuristics (i.e., cognitive shortcuts)
2. Heuristics can lead to systematic errors and biases; mistakes people repeat over and over
again (i.e., not always rational but predictably irrational)
3. In decision making, we need to go beyond the standard economical model of expected
utility; prospect theory provides a relevant framework
4. Understanding both rational and irrational behavior is important for consumers, managers
and policy makers in financial decision making, HR management, product pricing, marketing
strategy, health policies etc.
4
