Behavioural Decision Making Samenvatting
Lecture 1
Standard models of economics
- People are rational and aim to maximize their utility
- People are driven by monetary incentive (more money -> more performance)
- Optimal decisions are made at the margin (benefits > costs)
Expected utility theory (normative theory of behaviour)
- Rational decision maker is able to maximize their utility by selecting among superior
alternatives
- When alternatives have similar outcomes, decision maker should be indifferent to these
alternatives
- Utility is dependent of final wealth (i.e., deviations from current state wealth are
inconsequential)
Expected utility theory is not real-life choice situations
Risk aversion: the tendency of people to prefer outcomes with low uncertainty to those outcomes
with high uncertainty
Economists adopted the expected utility model as:
1. A logic that defines how decision should be made and a theory of how people do make decision
people do follow
2. A descriptions of how economists make choices
Psychologists noticed that the expected utility model makes faulty predictions about human
decision-making that does not reflect how decision are made in real life. Therefore, they set out to
understand how humans actually make decision without making any assumptions about their
rationality
Prospect theory (descriptive theory of behaviour)
How do people value future outcomes or ‘prospects’?
1. People are loss aversive (people like gains, they hate losses even more)
2. Our risk propensity if determined by how options are framed
3. People evaluate the consequences in terms of deviation from a reference point (individuals status
quo)
4. People experience diminished sensitivity to losses and gain
,Prospect theory (framing choices and loss aversion)
Gain Frame → Risk aversion: you fear being disappointed if your luck does not hold and you land in
that 10% chance that would get nothing. This lead you to take the sure gamble
Loss Frame → Risk seeking: fear of loss leads most people to reject sure loss and gamble on the
chance of losing $1000 instead
Loss > Gain
Intensity of Sadness > Intensity of Happiness
, Prospect theory (Reference Dependence)
Reference point can shift to the point of their current wealth
What are the implications of prospect theory?
- Framing effect (positive: 90% fat free or negative: 10% fat)
- Loss aversion (avoid losses -> risk-averse)
- Endowment effect (overvalue the things they own)
- Mental accounting & sunk cost (mental rekeningen)
- Status quo bias (prefer current state)
Conventional (economic) wisdom
- Are exclusively motivated by financial self-interest
- Engage is cost-benefit analysis
- Make conscious decisions
Our ability to make conscious decisions is limited and therefore we rely on mental shortcuts (lecture
2)
Sometimes these mental shortcuts work in our favour and other times it biases our decisions (lecture
3, 4, 5, and 6)
However, not all is lost as we can be steered to making the right kind of choices (lecture 7)
Why experiments
The key features are control over variables, careful measurement, and establishing cause and effect
relationships (causal relationships)
o Independent variable (the cause) is manipulated and the dependent variable
(the effect) is measured and any extraneous variables are controlled
o Randomly allocating participants to independent variable conditions means that
all participants should have an equal chance of taking part in each condition. The
principle of random allocation is to avoid bias in the way the experiment is
carried out and to limit the effects of participant variables
Lecture 1
Standard models of economics
- People are rational and aim to maximize their utility
- People are driven by monetary incentive (more money -> more performance)
- Optimal decisions are made at the margin (benefits > costs)
Expected utility theory (normative theory of behaviour)
- Rational decision maker is able to maximize their utility by selecting among superior
alternatives
- When alternatives have similar outcomes, decision maker should be indifferent to these
alternatives
- Utility is dependent of final wealth (i.e., deviations from current state wealth are
inconsequential)
Expected utility theory is not real-life choice situations
Risk aversion: the tendency of people to prefer outcomes with low uncertainty to those outcomes
with high uncertainty
Economists adopted the expected utility model as:
1. A logic that defines how decision should be made and a theory of how people do make decision
people do follow
2. A descriptions of how economists make choices
Psychologists noticed that the expected utility model makes faulty predictions about human
decision-making that does not reflect how decision are made in real life. Therefore, they set out to
understand how humans actually make decision without making any assumptions about their
rationality
Prospect theory (descriptive theory of behaviour)
How do people value future outcomes or ‘prospects’?
1. People are loss aversive (people like gains, they hate losses even more)
2. Our risk propensity if determined by how options are framed
3. People evaluate the consequences in terms of deviation from a reference point (individuals status
quo)
4. People experience diminished sensitivity to losses and gain
,Prospect theory (framing choices and loss aversion)
Gain Frame → Risk aversion: you fear being disappointed if your luck does not hold and you land in
that 10% chance that would get nothing. This lead you to take the sure gamble
Loss Frame → Risk seeking: fear of loss leads most people to reject sure loss and gamble on the
chance of losing $1000 instead
Loss > Gain
Intensity of Sadness > Intensity of Happiness
, Prospect theory (Reference Dependence)
Reference point can shift to the point of their current wealth
What are the implications of prospect theory?
- Framing effect (positive: 90% fat free or negative: 10% fat)
- Loss aversion (avoid losses -> risk-averse)
- Endowment effect (overvalue the things they own)
- Mental accounting & sunk cost (mental rekeningen)
- Status quo bias (prefer current state)
Conventional (economic) wisdom
- Are exclusively motivated by financial self-interest
- Engage is cost-benefit analysis
- Make conscious decisions
Our ability to make conscious decisions is limited and therefore we rely on mental shortcuts (lecture
2)
Sometimes these mental shortcuts work in our favour and other times it biases our decisions (lecture
3, 4, 5, and 6)
However, not all is lost as we can be steered to making the right kind of choices (lecture 7)
Why experiments
The key features are control over variables, careful measurement, and establishing cause and effect
relationships (causal relationships)
o Independent variable (the cause) is manipulated and the dependent variable
(the effect) is measured and any extraneous variables are controlled
o Randomly allocating participants to independent variable conditions means that
all participants should have an equal chance of taking part in each condition. The
principle of random allocation is to avoid bias in the way the experiment is
carried out and to limit the effects of participant variables
