Judgment and decision making – Summary
Samirah Bakker
Lecture 1: Introduction
When executives make business decisions (even important strategic ones), their thought process does
not remotely resemble the rational, thoughtful, analytical approach described in business textbooks.
Bad decisions
- Errors in strategic decision making are not exceptional.
- When it comes to certain types of decisions, failures are much more frequent than successes.
- Every successful strategy is successful in its own way. But all strategic failures are alike.
- Bad decisions are not necessarily made by bad leaders. They are good, even great, who make
predictable bad decisions.
Humans are not perfect decision makers. Not only are we not perfect, but we depart from perfection
or rationality in systematic and predictable ways. The understanding of these systematic and
predictable departures is core to the field of judgment and decision making. By understanding these
limitations, we can also identify strategies for making better and more effective decisions.
Lecture 2: Loss aversion + Framing decisions
Lecture
Types of reflective decisions:
- Major reflective decisions (e.g., Whether or not to buy a house? Which house to buy?).
- Low level decisions (e.g., Shopping in a supermarket).
What factors should affect a decision?
- What you want and what you want to avoid. How you feel about different ways the decision
could turn out.
- Strength of preferences (and dislikes) for particular outcomes?
- What factors or events will affect whether the outcome will be good/mediocre/bad, and to
what degree?
- How likely are the different possibilities?
How should decisions be made?
Rational decision making process:
- Define the problem.
- Identify the decision criteria.
- Weight the identified decision making criteria.
- Generate possible alternatives.
- Rate each alternative against the decision maker’s criteria.
- Compute the optimal decision.
,Assumptions:
- Assumes the decision maker is rational.
- Assumes the problem is clear and unambiguous.
- Assumes the decision maker has complete information.
- No time or cost constraints.
- Choice will be one with the maximum payoff.
Normative decision analysis
- Enumerate options.
- Enumerate outcomes.
- Construct a decision analysis for the decision.
- Evaluate the probabilities of different possible outcomes.
- Determine which option has the greatest “expected utility”.
Decision making research before the 1970s: Normative theories that prescribe how people “ought” to
make decisions in a perfectly rational way, and many implicitly assumed that most people, in daily
lives, followed these normative rules.
You are given 1,000€ for sure. Which of the following two options would you prefer?
– to get an additional 500€ for sure.
– to get another 1,000€ with probability 50%, and otherwise nothing (and be left with the first
1,000€).
You are given 2,000€ for sure. Which of the following two
options would you prefer?
– to lose 500€ for sure.
– to lose 1,000€ with probability 50%, and otherwise to lose nothing.
→ This highlights the all-important role of reference point from which the options are evaluated.
Reference dependence (Kahneman and Tversky, 1979): “When we respond to attributes such as
brightness, loudness, or temperature, the past and present context of experience defines an adaptation
level, or reference point, and stimuli are perceived in relation to this reference point. Thus, an object
at a given temperature may be experienced as hot or cold to the touch depending on the temperature to
which one has adapted.”
Expected utility theory
- This theory assumes that people think about uncertain events in terms of gambles.
- These gambles have two components:
- Probability p
- Value v
- The expected value of a gamble (EV) = p x v
,Expected utility theory: axioms
- Dominance principle → Alternative gambles can be ranked from best to worst in terms of
expected value.
- Cancellation → A choice between gambles should depend only on those outcomes that differ.
A choice between 2 alternatives should depend only on those outcomes that differ, not on
outcomes that are the same for both alternatives. Common factors should cancel out.
- Transitivity → i.e., If you prefer A to B and B to C, then you must prefer A to C.
- Invariance → Preference should remain invariant or stable, no matter how choices are
described.
Asian disease problem: Framing effect
The U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600
people. Two alternative programs to combat the disease have been proposed:
A. 200 people will be saved.
B. 33% chance that all 600 will be saved; 67% chance that none will be saved.
A. 400 people will die.
B. 33% chance that none will die; 67% chance that all 600 will die.
Expected utility theory assumes description invariance → Different formulations of the same choice
problem should give rise to the same preference order.
- Evidence that variations in the framing of options (in the description) yield systematically
different preferences.
- Framing effects lead to violation of the invariance and the dominance axioms of expected
utility theory.
Lecture + (Tversky & Kahneman, 1981): The framing of decisions and the psychology of choice:
Prospect theory - value function
, Prospect theory captures reference dependence through the value function: v(x - r).
→ r is the reference point.
→ x can be perceived as a gain or loss relative to r.
But why a reference point?
- People compare income to friends, parents, goals etc.
- Easier to compare with a reference point than evaluate absolute utility.
- Natural degree of adaptation (e.g., brightness, loudness, temperature etc.).
The theory is developed for simple prospects with monetary outcomes and stated probabilities, but it
can be extended to more involved choices. Prospect theory distinguishes two phases in the choice
process:
- An initial phase in which acts, outcomes, and contingencies are framed.
- And a subsequent phase of evaluation. In the second phase, the edited prospects are evaluated
and the prospect of highest value is chosen.
Prospect theory is a psychological/behavioral economic theory that describes how people make
decisions involving risk and uncertainty.
In prospect theory, outcomes are expressed as positive or negative deviations (gains or losses) from a
neutral reference outcome, which is assigned a value of zero. Although subjective values differ among
individuals and attributes, we propose that the value function is commonly S-shaped.
Another property of the value function is that the response to losses is more extreme than the response
to gains. The displeasure associated with losing a sum of money is generally greater than the pleasure
associated with winning the same amount.
The pain of loss is greater than pleasure of a similar gain.
This relates to Loss aversion.
- Loss aversion → The disutility (displeasure/pain) associated with a loss of a given amount is
larger than the utility associated with a gain of the same (or similar) magnitude.
- |v(x)|<|v(-x)|
- The utils lost from losing €100 are worth more than the utils gained from earning €150.
Approaches to decision making
Normative decision analysis
- Decision making research before 1970s: Normative models that prescribe how people “ought”
to make decisions in a perfectly rational way.
- Expected utility theory.
Descriptive decision analysis
- Descriptive models describe how people actually make decisions.
- Prospect theory (1979) provides a better description of choice under risk and uncertainty.
- Key ingredient: value function.
Samirah Bakker
Lecture 1: Introduction
When executives make business decisions (even important strategic ones), their thought process does
not remotely resemble the rational, thoughtful, analytical approach described in business textbooks.
Bad decisions
- Errors in strategic decision making are not exceptional.
- When it comes to certain types of decisions, failures are much more frequent than successes.
- Every successful strategy is successful in its own way. But all strategic failures are alike.
- Bad decisions are not necessarily made by bad leaders. They are good, even great, who make
predictable bad decisions.
Humans are not perfect decision makers. Not only are we not perfect, but we depart from perfection
or rationality in systematic and predictable ways. The understanding of these systematic and
predictable departures is core to the field of judgment and decision making. By understanding these
limitations, we can also identify strategies for making better and more effective decisions.
Lecture 2: Loss aversion + Framing decisions
Lecture
Types of reflective decisions:
- Major reflective decisions (e.g., Whether or not to buy a house? Which house to buy?).
- Low level decisions (e.g., Shopping in a supermarket).
What factors should affect a decision?
- What you want and what you want to avoid. How you feel about different ways the decision
could turn out.
- Strength of preferences (and dislikes) for particular outcomes?
- What factors or events will affect whether the outcome will be good/mediocre/bad, and to
what degree?
- How likely are the different possibilities?
How should decisions be made?
Rational decision making process:
- Define the problem.
- Identify the decision criteria.
- Weight the identified decision making criteria.
- Generate possible alternatives.
- Rate each alternative against the decision maker’s criteria.
- Compute the optimal decision.
,Assumptions:
- Assumes the decision maker is rational.
- Assumes the problem is clear and unambiguous.
- Assumes the decision maker has complete information.
- No time or cost constraints.
- Choice will be one with the maximum payoff.
Normative decision analysis
- Enumerate options.
- Enumerate outcomes.
- Construct a decision analysis for the decision.
- Evaluate the probabilities of different possible outcomes.
- Determine which option has the greatest “expected utility”.
Decision making research before the 1970s: Normative theories that prescribe how people “ought” to
make decisions in a perfectly rational way, and many implicitly assumed that most people, in daily
lives, followed these normative rules.
You are given 1,000€ for sure. Which of the following two options would you prefer?
– to get an additional 500€ for sure.
– to get another 1,000€ with probability 50%, and otherwise nothing (and be left with the first
1,000€).
You are given 2,000€ for sure. Which of the following two
options would you prefer?
– to lose 500€ for sure.
– to lose 1,000€ with probability 50%, and otherwise to lose nothing.
→ This highlights the all-important role of reference point from which the options are evaluated.
Reference dependence (Kahneman and Tversky, 1979): “When we respond to attributes such as
brightness, loudness, or temperature, the past and present context of experience defines an adaptation
level, or reference point, and stimuli are perceived in relation to this reference point. Thus, an object
at a given temperature may be experienced as hot or cold to the touch depending on the temperature to
which one has adapted.”
Expected utility theory
- This theory assumes that people think about uncertain events in terms of gambles.
- These gambles have two components:
- Probability p
- Value v
- The expected value of a gamble (EV) = p x v
,Expected utility theory: axioms
- Dominance principle → Alternative gambles can be ranked from best to worst in terms of
expected value.
- Cancellation → A choice between gambles should depend only on those outcomes that differ.
A choice between 2 alternatives should depend only on those outcomes that differ, not on
outcomes that are the same for both alternatives. Common factors should cancel out.
- Transitivity → i.e., If you prefer A to B and B to C, then you must prefer A to C.
- Invariance → Preference should remain invariant or stable, no matter how choices are
described.
Asian disease problem: Framing effect
The U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600
people. Two alternative programs to combat the disease have been proposed:
A. 200 people will be saved.
B. 33% chance that all 600 will be saved; 67% chance that none will be saved.
A. 400 people will die.
B. 33% chance that none will die; 67% chance that all 600 will die.
Expected utility theory assumes description invariance → Different formulations of the same choice
problem should give rise to the same preference order.
- Evidence that variations in the framing of options (in the description) yield systematically
different preferences.
- Framing effects lead to violation of the invariance and the dominance axioms of expected
utility theory.
Lecture + (Tversky & Kahneman, 1981): The framing of decisions and the psychology of choice:
Prospect theory - value function
, Prospect theory captures reference dependence through the value function: v(x - r).
→ r is the reference point.
→ x can be perceived as a gain or loss relative to r.
But why a reference point?
- People compare income to friends, parents, goals etc.
- Easier to compare with a reference point than evaluate absolute utility.
- Natural degree of adaptation (e.g., brightness, loudness, temperature etc.).
The theory is developed for simple prospects with monetary outcomes and stated probabilities, but it
can be extended to more involved choices. Prospect theory distinguishes two phases in the choice
process:
- An initial phase in which acts, outcomes, and contingencies are framed.
- And a subsequent phase of evaluation. In the second phase, the edited prospects are evaluated
and the prospect of highest value is chosen.
Prospect theory is a psychological/behavioral economic theory that describes how people make
decisions involving risk and uncertainty.
In prospect theory, outcomes are expressed as positive or negative deviations (gains or losses) from a
neutral reference outcome, which is assigned a value of zero. Although subjective values differ among
individuals and attributes, we propose that the value function is commonly S-shaped.
Another property of the value function is that the response to losses is more extreme than the response
to gains. The displeasure associated with losing a sum of money is generally greater than the pleasure
associated with winning the same amount.
The pain of loss is greater than pleasure of a similar gain.
This relates to Loss aversion.
- Loss aversion → The disutility (displeasure/pain) associated with a loss of a given amount is
larger than the utility associated with a gain of the same (or similar) magnitude.
- |v(x)|<|v(-x)|
- The utils lost from losing €100 are worth more than the utils gained from earning €150.
Approaches to decision making
Normative decision analysis
- Decision making research before 1970s: Normative models that prescribe how people “ought”
to make decisions in a perfectly rational way.
- Expected utility theory.
Descriptive decision analysis
- Descriptive models describe how people actually make decisions.
- Prospect theory (1979) provides a better description of choice under risk and uncertainty.
- Key ingredient: value function.
