1
Summary Index
1 Judgement & Decision making week 1.......................................................................................... 3
2 Judgement & Decision making week 2........................................................................................ 13
3 Judgement & Decision making week 3........................................................................................ 18
4 Judgement & Decision making week 4 (continued week 3) ....................................................... 24
5 Judgement & Decision making week 5........................................................................................ 32
6 Judgement & Decision making week 6........................................................................................ 37
7 Week 1: Baron (2004) – Normative models of judgment and decision making ......................... 47
8 Week 1: Kahneman (2003) – A perspective on judgment and choice ........................................ 50
9 Week 2: Brink & Rankin (2013) – The effects of Risk Preference and Loss Aversion on Individual
Behavior under Bonus, Penalty, and Combined Contract Frames. ............................................................. 54
10 Week 2: Nelson & Kinney (1997) – The effect of ambiguity and loss Contingency Reporting
Judgments. .................................................................................................................................................. 57
11 Week 3: Thaler et al. (2013) – Choice architecture ..................................................................... 60
12 Week 3: Joyce & Bidle (1981) - Anchoring and Adjustment in probabilistic Inference in Auditing
63
13 MISSING: Week 3: Ungemach et al. (2018) – Translated attributes as chocie architecture:
Aligning objectives and choices through decisions signposts. .................................................................... 67
14 MISSING: Week 4: Hribar et al. (2016) – CEO overconfidence and management forecasting ... 67
15 Week 4: Kadous et al. (2003) – The effect of quality assessment and directional goal
commitment on Auditor’s Acceptance of Client – Preferred Accounting Methods ................................... 67
16 Week 5: Hannan et al. (2012) – The effect of relative performance information on performance
and effort allocation in a multi-task environment. ..................................................................................... 73
17 Week 5: Koonce et al. (2015) – The effects of norms on investor reactions to derivative use .. 76
18 Week 6: Bauer et al. (2020) – The unintended consequences of material weakness reporting on
Auditor’s acceptance of Aggressive client reporting................................................................................... 80
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 2
19 Week 6: Brown (2014) - Advantageous Comparison and Rationalization of Earnings
Management ............................................................................................................................................... 84
20 MISSING: Church et al. (2012) Shared interest and honesty in budget reporting ...................... 88
21 Bibliography................................................................................................................................. 88
22 Weekly articles, Small summaries ............................................................................................... 90
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 3
Judgment & Decision making – Master Accountancy – 2020-2021
This summary contains all lectures on judgment & decision making. Furthermore, this summary
contains some information from the theoretical papers and all the papers that are discussed in
the classes. Additionally, this summary contains the abstracts and conclusions of the papers
and what is discussed about the paper during the classes.
1 Judgement & Decision making week 1
Papers related to week 1:
→ Baron (2004)
→ Kahneman (2003)
Descriptive decision-making models
Week 2: how we attach value to things.
Week 3: how we acquire information and use it to update our beliefs.
Week 4: how we use the information to answer questions and solve problems.
Week 5: how we are influenced by the presence of other humans.
(In week 6 we will talk about ethics, and return to the question of what it means to make a “good”
decision)
Discussed in week 1:
• Normative versus descriptive models
→ What does it mean to be ‘(ir)rational’
• Expected-Utility Theory
• Probability and Bayes’s theorem
Judgment & Decision making in accounting
The production, certification, and use of accounting
information (still) requires human judgment and
decision-making. Professionals engaging in these
activities need to understand something about the
psychology of judgment and decision making.
Judgment & Decisions
Judgment:
- Attaching a value to something
- Estimates, evaluations, opinions….
Decisions:
- Choosing between alternatives
Both aspects decisions and judgments are closely related.
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 4
The production of accounting information
A few examples are:
• Depreciation method for a class of assets
• Residual value and lifetime of an asset
• Valuation of an intangible asset
• Classification of an asset or liability
• Reporting requirements for organizational units
• Layout of performance reports
The certification of accounting information
A few examples are:
• Materiality
• Risk of material misstatement
• Analytical procedures
• Complex estimates
• Going concern
The Use of accounting information
A few examples are:
Owners and investors
• Estimate future cash flows
• Decide to sell or buy shares
Financial Analysts
• Estimate future cash flows etc.
• Make Buy / Hold/ Sell recommendation
Creditors
• Estimate default risk
• Decide about loans, interest rates, etc.
Managers and other employees
• Estimate the likely consequences of alternative courses of action
• Make business decisions
• Evaluate the performance of units, teams, and individuals
Government
• Examples: Tax, regulation, licenses, permissions, the integrity of financial reports,
macroeconomic planning, etc.
Suppliers and Customers
• Judge liquidity, solvability, etc.
• Contracting decisions
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 5
Normative, descriptive, and prescriptive models
Judgment and decision making consists of three different types of decisions, These are:
1. Normative decision making
→ How people should be making judgments and decisions
2. Descriptive decision making
→ How people actually make judgments and decisions
3. Prescriptive
→ Practical suggestions on designing judgment and decision-making processes based on
normative and descriptive models
Normative decision making
A normative decision is a rational process, so how things should be done:
Use all available information in an optimal way to maximize the expected net outcome
→ The most accurate judgment possible
→ The best choice possible
Rooted in:
1. Philosophy
2. Mathematics
3. Classical economics
4. Agency Model
Bazerman & Moore:
1. Define the problem
2. Identify the criteria
3. Weigh the criteria
4. Generate alternatives
5. Rate each alternative on each criterion
6. Compute optimal decision
People do NOT make decisions like that.
However, we tend to be ‘predictably irrational’ (Ariely)
→ We deviate from the normative framework in systematic, not just random, ways. How do we go to
this?
Descriptive models of decision making
Explain how people actually do make decisions
Think about insights from:
• Cognitive psychology
• Social psychology
• Neuroscience
• Biology
• Sociology
• Anthropology
• Behavioral economics
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 6
Humans have evolved over millions of years.
For 99.99% of that time, our ancestors faced a similar set of relatively straightforward decisions.
We are well prepared to make fast and simple decisions in a stable, predictable environment with
relatively few homogeneous actors and to spend no more energy than strictly necessary.
We are not well prepared to make complex economic decisions, in a dynamic, unpredictable
environment with many heterogeneous actors. When we face such decisions, we cannot simply ignore
our human nature and follow a rational process.
• However, we can try…
System 1 and System 2 thinking
Dual-process theory
• System 1 is our intuitive, fast, automatic, emotional, effortless, system of decision making.
→ It is employed when we interpret verbal language, process visual information, walk, talk, etc.
• System 2 is slow, effortful, conscious, and explicit.
→ You know you are thinking, you are deliberately making a decision…
Both systems are always on, System 2 typically in a ‘comfortable low effort mode” (Kahneman, 2011,
p.24). System 1 continuously provides system 2 with impressions, intuitions, feelings, etc. While System
2 is only mobilized when System 1 runs into difficulties.
→ The division of labor is highly efficient.
System 1 is not designed for complex decision-making, and it tends to make suboptimal decisions.
System 2 will often do a better job, BUT
• System 2 relies on System 1 for input.
• System 1 cannot be switched off
• System 2 may not be employed frequently enough
In sum, even if we try to be rational, we are unlikely to succeed. Our judgments and decisions will
deviate from normative benchmarks.
Examples of System 1 and System 2 thinking
1) A bat and a ball cost €1.10 in total. The bat costs €1.00 more than the ball. How much does the ball
cost (in cents)?
System 1: 10 cents
System 2: 5 cents
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 7
If it takes 5 machines 5 minutes to make 5 boxes, how long would it take 100 machines to make 100
boxes (in minutes)?
System 1: 100 minutes
System 2: 5 minutes
In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch
to cover the entire lake, how long would it take for the patch to cover half the lake (in days)?
System 1: 24 days
System 2: 47 days
System 2 relies on System 1 for input.
• System 1 cannot be switched off
• System 2 may not be employed frequently enough
Central notion: accessibility.
• How easily something comes to mind.
• Perceptions and intuitions come to mind effortlessly
Accessibility
Our brain is easily satisfied, it tends to ‘jump to conclusions’. The easily accessible perceptions,
impressions, intuitions, etc. from System 1 have a disproportionate weight on our judgments and
decisions.
(waarnemingen) Cognitive ease feels good.
Doubt and uncertainty are difficult and often feel bad.
→ Your brain tends to take immediate action to avoid ‘cognitive dissonance’ and to restore your
familiar and coherent notion of the world (and of yourself as a person).
→ You might not even become aware of information that, from a normative perspective,
requires you to change your mind.
Doubts and beliefs
“There is much cognitive resistance to treating one’s beliefs as falsifiable, probabilistic propositions.
People naturally gravitate towards thinking of their beliefs as ego-defining, quasi-sacred possessions” By
Philip Tetlock
Determinants of accessibility: (determinant: iets dat bepaalt of een eigenschap erfelijk )
1. Perceptual salience
2. Suprisingness
3. Familiarity
4. When things…
→ Are associated with emotion or associated with potential losses
→ are in line with our current ‘mindset’
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 8
Heuristics
Instead of answering a difficult question (using our System 2), our first impulse is to find an easier
accessible answer to a related question using our System 1. We substitute a difficult question for an
easier question.
Bazerman and Moore use the term heuristic in this respect. Heuristics are relatively simple procedures
that help find adequate, though often imperfect, answers to difficult questions (Kahneman 2011).
Bazerman and Moore identify four main heuristics:
1. Availability
→ When things that come to mind easier are judged to be more likely, frequent, probable, etc.
2. Representativeness
→ (Probability) judgments are influenced by how typical something is for its “category”
3. Confirmation
→ Judgements are influenced by what we expect. We interpret new information as confirming
our existing beliefs.
4. Affect
→ Judgements are affected by our emotional state or mood.
Recap to the three types of models
1) Normative
• How people should be making judgments and decisions
2) Descriptive
• How people actually make judgments and decisions
3) Prescriptive
• Practical suggestions on designing judgment and decision-making processes based on
normative and descriptive models
Normative models of decision making
How we should make judgments and decisions
• How do we distinguish between a good and bad choice?
A deeply philosophical question
• What should we be trying to achieve?
• “Moral intuition” (Rawls); religion;
• What does it mean to make a decision?
• Philosophical determinism
Baron (2004):
• Any normative model needs to start from the simple idea that some outcomes are better than
others.
• No claim about absolute truth, but “truth relative to assumptions” (the assumption that
something is better than the other thing)
• Normative models arise through the “imposition of an analytic scheme”
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 9
Utility
The utility is whatever is maximized (“good”; “goodness”)
• Normative models do not tell us what we should be maximizing, they tell us what we should be doing
to maximize whatever it is that we try to maximize.
The utility is a core concept in economics
Humans are assumed to have “utility functions”, things contribute positively or negatively to their utility.
• For example, agency theory assumes agents derive positive utility from wealth and negative utility
from the effort.
Comparing utility
Two core assumptions: transitivity and connectedness
Transitivity:
• If A > B and B > C, then A > C.
Connectedness:
• It is either the case that A > B, or that A < B, or that A = B.
• In other words: it is possible to compare A and B.
Expected-utility theory (EUT)
Theory underlies all theories we know (e.g. Agency theory) Individuals should choose the option with the
highest expected utility.
In absence of uncertainty, this is straightforward.
• If you can choose between €1 and €2, you should choose €2
• I am assuming money increases your utility!
When there is uncertainty, you should calculate which option has the highest expected utility.
Expected utility = Utility of outcome × Probability of outcome
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 10
What should be the objective of decision-making in firms?
A textbook answer closely aligned with EUT is that people in firms should always take the action that
maximizes the expected net present value of all future cash flows.
• Utility = net present value of all future cash flows
• Maximize the value of the firm.
Can we be certain about which cash flows will result from an action?
• Typically not
• We need to base our decisions on probabilities…
Probability
Savage (1954): logical, objective, and personal probability
Logical / necessary:
• “a fair dice must land on one of its six sides”
Objective: relative frequencies:
• “a fair dice thrown 1 million times will land equally frequently on each of its sides”
Personal:
• “what will happen in my specific unique situation”
Personal probability
For most real-world decisions we need to rely on personal probability Objective probability helps
determine personal probability, but not more than that:
• Your specific situation is unique in ways that are impossible to know.
• You face a one-off decision, not an infinite number of decisions.
If it is coherent, personal probability can still play an important role in normative models of judgment
and decision making.
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
Summary Index
1 Judgement & Decision making week 1.......................................................................................... 3
2 Judgement & Decision making week 2........................................................................................ 13
3 Judgement & Decision making week 3........................................................................................ 18
4 Judgement & Decision making week 4 (continued week 3) ....................................................... 24
5 Judgement & Decision making week 5........................................................................................ 32
6 Judgement & Decision making week 6........................................................................................ 37
7 Week 1: Baron (2004) – Normative models of judgment and decision making ......................... 47
8 Week 1: Kahneman (2003) – A perspective on judgment and choice ........................................ 50
9 Week 2: Brink & Rankin (2013) – The effects of Risk Preference and Loss Aversion on Individual
Behavior under Bonus, Penalty, and Combined Contract Frames. ............................................................. 54
10 Week 2: Nelson & Kinney (1997) – The effect of ambiguity and loss Contingency Reporting
Judgments. .................................................................................................................................................. 57
11 Week 3: Thaler et al. (2013) – Choice architecture ..................................................................... 60
12 Week 3: Joyce & Bidle (1981) - Anchoring and Adjustment in probabilistic Inference in Auditing
63
13 MISSING: Week 3: Ungemach et al. (2018) – Translated attributes as chocie architecture:
Aligning objectives and choices through decisions signposts. .................................................................... 67
14 MISSING: Week 4: Hribar et al. (2016) – CEO overconfidence and management forecasting ... 67
15 Week 4: Kadous et al. (2003) – The effect of quality assessment and directional goal
commitment on Auditor’s Acceptance of Client – Preferred Accounting Methods ................................... 67
16 Week 5: Hannan et al. (2012) – The effect of relative performance information on performance
and effort allocation in a multi-task environment. ..................................................................................... 73
17 Week 5: Koonce et al. (2015) – The effects of norms on investor reactions to derivative use .. 76
18 Week 6: Bauer et al. (2020) – The unintended consequences of material weakness reporting on
Auditor’s acceptance of Aggressive client reporting................................................................................... 80
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 2
19 Week 6: Brown (2014) - Advantageous Comparison and Rationalization of Earnings
Management ............................................................................................................................................... 84
20 MISSING: Church et al. (2012) Shared interest and honesty in budget reporting ...................... 88
21 Bibliography................................................................................................................................. 88
22 Weekly articles, Small summaries ............................................................................................... 90
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 3
Judgment & Decision making – Master Accountancy – 2020-2021
This summary contains all lectures on judgment & decision making. Furthermore, this summary
contains some information from the theoretical papers and all the papers that are discussed in
the classes. Additionally, this summary contains the abstracts and conclusions of the papers
and what is discussed about the paper during the classes.
1 Judgement & Decision making week 1
Papers related to week 1:
→ Baron (2004)
→ Kahneman (2003)
Descriptive decision-making models
Week 2: how we attach value to things.
Week 3: how we acquire information and use it to update our beliefs.
Week 4: how we use the information to answer questions and solve problems.
Week 5: how we are influenced by the presence of other humans.
(In week 6 we will talk about ethics, and return to the question of what it means to make a “good”
decision)
Discussed in week 1:
• Normative versus descriptive models
→ What does it mean to be ‘(ir)rational’
• Expected-Utility Theory
• Probability and Bayes’s theorem
Judgment & Decision making in accounting
The production, certification, and use of accounting
information (still) requires human judgment and
decision-making. Professionals engaging in these
activities need to understand something about the
psychology of judgment and decision making.
Judgment & Decisions
Judgment:
- Attaching a value to something
- Estimates, evaluations, opinions….
Decisions:
- Choosing between alternatives
Both aspects decisions and judgments are closely related.
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 4
The production of accounting information
A few examples are:
• Depreciation method for a class of assets
• Residual value and lifetime of an asset
• Valuation of an intangible asset
• Classification of an asset or liability
• Reporting requirements for organizational units
• Layout of performance reports
The certification of accounting information
A few examples are:
• Materiality
• Risk of material misstatement
• Analytical procedures
• Complex estimates
• Going concern
The Use of accounting information
A few examples are:
Owners and investors
• Estimate future cash flows
• Decide to sell or buy shares
Financial Analysts
• Estimate future cash flows etc.
• Make Buy / Hold/ Sell recommendation
Creditors
• Estimate default risk
• Decide about loans, interest rates, etc.
Managers and other employees
• Estimate the likely consequences of alternative courses of action
• Make business decisions
• Evaluate the performance of units, teams, and individuals
Government
• Examples: Tax, regulation, licenses, permissions, the integrity of financial reports,
macroeconomic planning, etc.
Suppliers and Customers
• Judge liquidity, solvability, etc.
• Contracting decisions
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 5
Normative, descriptive, and prescriptive models
Judgment and decision making consists of three different types of decisions, These are:
1. Normative decision making
→ How people should be making judgments and decisions
2. Descriptive decision making
→ How people actually make judgments and decisions
3. Prescriptive
→ Practical suggestions on designing judgment and decision-making processes based on
normative and descriptive models
Normative decision making
A normative decision is a rational process, so how things should be done:
Use all available information in an optimal way to maximize the expected net outcome
→ The most accurate judgment possible
→ The best choice possible
Rooted in:
1. Philosophy
2. Mathematics
3. Classical economics
4. Agency Model
Bazerman & Moore:
1. Define the problem
2. Identify the criteria
3. Weigh the criteria
4. Generate alternatives
5. Rate each alternative on each criterion
6. Compute optimal decision
People do NOT make decisions like that.
However, we tend to be ‘predictably irrational’ (Ariely)
→ We deviate from the normative framework in systematic, not just random, ways. How do we go to
this?
Descriptive models of decision making
Explain how people actually do make decisions
Think about insights from:
• Cognitive psychology
• Social psychology
• Neuroscience
• Biology
• Sociology
• Anthropology
• Behavioral economics
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 6
Humans have evolved over millions of years.
For 99.99% of that time, our ancestors faced a similar set of relatively straightforward decisions.
We are well prepared to make fast and simple decisions in a stable, predictable environment with
relatively few homogeneous actors and to spend no more energy than strictly necessary.
We are not well prepared to make complex economic decisions, in a dynamic, unpredictable
environment with many heterogeneous actors. When we face such decisions, we cannot simply ignore
our human nature and follow a rational process.
• However, we can try…
System 1 and System 2 thinking
Dual-process theory
• System 1 is our intuitive, fast, automatic, emotional, effortless, system of decision making.
→ It is employed when we interpret verbal language, process visual information, walk, talk, etc.
• System 2 is slow, effortful, conscious, and explicit.
→ You know you are thinking, you are deliberately making a decision…
Both systems are always on, System 2 typically in a ‘comfortable low effort mode” (Kahneman, 2011,
p.24). System 1 continuously provides system 2 with impressions, intuitions, feelings, etc. While System
2 is only mobilized when System 1 runs into difficulties.
→ The division of labor is highly efficient.
System 1 is not designed for complex decision-making, and it tends to make suboptimal decisions.
System 2 will often do a better job, BUT
• System 2 relies on System 1 for input.
• System 1 cannot be switched off
• System 2 may not be employed frequently enough
In sum, even if we try to be rational, we are unlikely to succeed. Our judgments and decisions will
deviate from normative benchmarks.
Examples of System 1 and System 2 thinking
1) A bat and a ball cost €1.10 in total. The bat costs €1.00 more than the ball. How much does the ball
cost (in cents)?
System 1: 10 cents
System 2: 5 cents
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 7
If it takes 5 machines 5 minutes to make 5 boxes, how long would it take 100 machines to make 100
boxes (in minutes)?
System 1: 100 minutes
System 2: 5 minutes
In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch
to cover the entire lake, how long would it take for the patch to cover half the lake (in days)?
System 1: 24 days
System 2: 47 days
System 2 relies on System 1 for input.
• System 1 cannot be switched off
• System 2 may not be employed frequently enough
Central notion: accessibility.
• How easily something comes to mind.
• Perceptions and intuitions come to mind effortlessly
Accessibility
Our brain is easily satisfied, it tends to ‘jump to conclusions’. The easily accessible perceptions,
impressions, intuitions, etc. from System 1 have a disproportionate weight on our judgments and
decisions.
(waarnemingen) Cognitive ease feels good.
Doubt and uncertainty are difficult and often feel bad.
→ Your brain tends to take immediate action to avoid ‘cognitive dissonance’ and to restore your
familiar and coherent notion of the world (and of yourself as a person).
→ You might not even become aware of information that, from a normative perspective,
requires you to change your mind.
Doubts and beliefs
“There is much cognitive resistance to treating one’s beliefs as falsifiable, probabilistic propositions.
People naturally gravitate towards thinking of their beliefs as ego-defining, quasi-sacred possessions” By
Philip Tetlock
Determinants of accessibility: (determinant: iets dat bepaalt of een eigenschap erfelijk )
1. Perceptual salience
2. Suprisingness
3. Familiarity
4. When things…
→ Are associated with emotion or associated with potential losses
→ are in line with our current ‘mindset’
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 8
Heuristics
Instead of answering a difficult question (using our System 2), our first impulse is to find an easier
accessible answer to a related question using our System 1. We substitute a difficult question for an
easier question.
Bazerman and Moore use the term heuristic in this respect. Heuristics are relatively simple procedures
that help find adequate, though often imperfect, answers to difficult questions (Kahneman 2011).
Bazerman and Moore identify four main heuristics:
1. Availability
→ When things that come to mind easier are judged to be more likely, frequent, probable, etc.
2. Representativeness
→ (Probability) judgments are influenced by how typical something is for its “category”
3. Confirmation
→ Judgements are influenced by what we expect. We interpret new information as confirming
our existing beliefs.
4. Affect
→ Judgements are affected by our emotional state or mood.
Recap to the three types of models
1) Normative
• How people should be making judgments and decisions
2) Descriptive
• How people actually make judgments and decisions
3) Prescriptive
• Practical suggestions on designing judgment and decision-making processes based on
normative and descriptive models
Normative models of decision making
How we should make judgments and decisions
• How do we distinguish between a good and bad choice?
A deeply philosophical question
• What should we be trying to achieve?
• “Moral intuition” (Rawls); religion;
• What does it mean to make a decision?
• Philosophical determinism
Baron (2004):
• Any normative model needs to start from the simple idea that some outcomes are better than
others.
• No claim about absolute truth, but “truth relative to assumptions” (the assumption that
something is better than the other thing)
• Normative models arise through the “imposition of an analytic scheme”
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 9
Utility
The utility is whatever is maximized (“good”; “goodness”)
• Normative models do not tell us what we should be maximizing, they tell us what we should be doing
to maximize whatever it is that we try to maximize.
The utility is a core concept in economics
Humans are assumed to have “utility functions”, things contribute positively or negatively to their utility.
• For example, agency theory assumes agents derive positive utility from wealth and negative utility
from the effort.
Comparing utility
Two core assumptions: transitivity and connectedness
Transitivity:
• If A > B and B > C, then A > C.
Connectedness:
• It is either the case that A > B, or that A < B, or that A = B.
• In other words: it is possible to compare A and B.
Expected-utility theory (EUT)
Theory underlies all theories we know (e.g. Agency theory) Individuals should choose the option with the
highest expected utility.
In absence of uncertainty, this is straightforward.
• If you can choose between €1 and €2, you should choose €2
• I am assuming money increases your utility!
When there is uncertainty, you should calculate which option has the highest expected utility.
Expected utility = Utility of outcome × Probability of outcome
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
, 10
What should be the objective of decision-making in firms?
A textbook answer closely aligned with EUT is that people in firms should always take the action that
maximizes the expected net present value of all future cash flows.
• Utility = net present value of all future cash flows
• Maximize the value of the firm.
Can we be certain about which cash flows will result from an action?
• Typically not
• We need to base our decisions on probabilities…
Probability
Savage (1954): logical, objective, and personal probability
Logical / necessary:
• “a fair dice must land on one of its six sides”
Objective: relative frequencies:
• “a fair dice thrown 1 million times will land equally frequently on each of its sides”
Personal:
• “what will happen in my specific unique situation”
Personal probability
For most real-world decisions we need to rely on personal probability Objective probability helps
determine personal probability, but not more than that:
• Your specific situation is unique in ways that are impossible to know.
• You face a one-off decision, not an infinite number of decisions.
If it is coherent, personal probability can still play an important role in normative models of judgment
and decision making.
Copyright © 2021 by mcAmsterdam. Subjects to the restictions to copyright regulations, mcAmsterdam
Copyright notice.
