Summary Judgment and Decision Making (JDM)
JDM Lecture 1 l Introduction to the course and minor
The minor ‘understanding and influencing decision making in business and society’ implies:
- Understanding and influencing human decision making and behavior, both in the context of
organizations (employees, managers, teams) as well as in their interactions with the world
outside.
- To achieve this goal, we rely on recent insights from behavioral economics and psychology.
JDM Lecture 2 l Loss aversion and framing of decisions
Types of decisions?
1) Major reflective decisions
a) Whether or not to invest in a stock or business?
b) Whether or not to buy a house? Which house to buy?
c) Whether to start a relationship with someone? Whether to end a relationship with
someone?
d) Medical decisions - whether or not to have surgery for a problem?
2) Low level decisions
a) Shopping in a supermarket
b) Which way to go when driving a car to a particular location
c) What to wear today
What factors should affect a decision?
Three concrete decision examples:
- Whether or not to take a particular course.
- Whether or not to buy a new, better computer.
- Whether or not to end a relationship with someone.
➔ What you want. Also, 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 or bad, and to
what degree?
➔ How likely are the different possibilities?
How should decisions be made?
The 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’
Framing effect → people will be ‘saved’ versus people will ‘die’
Expected utility theory:
● People think about uncertain events in terms of gambles:
● Gambles have two components:
○ Probability, p
○ Value, v
● The expected value of a gamble (EV) = p x v
● The expected value of a gamble that offers a
25% chance of winning €100 = €25
Cancellation: you should cancel the things that are
completely equal in choosing between two decisions.
Framing effect (Asian disease problem):
- 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.
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
● Why reference point? → people compare income to friends, parents, goals,
expectations, etc.
○ Easier to compare with a r than evaluate absolute utility
○ Natural degree of adaptation (e.g. brightness, loudness, temperature, etc.)
➔ The reference point is very subjective: it depends
on the person, on the situation, on the context, etc.
➔ People prefer certainty to uncertainty.
,Loss aversion → definition: 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.
- The utils lost from losing 100 euros are worth more than the utils gained from earning 150
euros.
Risky prospects → losses versus gains:
● People asked to choose between prospects, one riskier than the other (outcome is a gain
versus a loss):
○ Gains: 80% chance of $4000, versus $3200 for sure
○ Losses: 80% chance of -$4000 versus -$3200 for sure
➔ People choose the uncertain option if
it’s about losses.
➔ People choose the certain option if it’s
about gains.
Prospect theory is a descriptive theory: it
describes what people do.
A problem (A):
Imagine that you face the following pair of
concurrent decisions. First examine both
decisions, then indicate the options you prefer:
Decision 1 choose between:
a) a sure gain of $240
b) 25% chance to gain $1000 and
75% chance to gain nothing
Decision 2 choose between:
a) A sure loss of $750
b) 75% chance to lose $1000 and 25% chance to lose nothing
Another problem (B):
Choose between:
1) 25% chance to gain $240 and 75% chance to lose $760
2) 25% chance to gain $250 and 75% chance to lose $750
Compare problem (B) with problem (A):
- 1 in (B) = A & D in (A)
- 2 in (B) = B & C in (A)
Compare problem B:
Respondents in problem (A) failed to combine options, although:
- Relatively simple
- Encouraged by instructions
Certainty effect:
We tend to weigh certainty more than uncertainty →
difference between problem 1 and 3: reduction of
probability of an outcome by a constant factor has
more impact when the outcome was initially certain
than when it was merely probable.
, - The closer you get to certainty, the more weight the choice has.
Pseudocertainty effect:
Discrepancy in response to objectively identical problems 2 and 3. The potential ‘certainty’ in problem
2 is contingent upon reaching the second stage of the game (still uncertain)
Pseudocertainty → disease vaccination.
Prospect theory: people do not multiply by the decision weight.
Gains, losses and adaptation:
Difference between a 8m² cell and a 10m² is insignificant when one has just lost freedom.
- But, very important after adapting to the new level.
Status quo:
● We want to keep things the way they are
○ Even if we didn’t originally choose it
● We want to avoid potential losses generated by
change: losses loom larger than gains.
Loss aversion in sport competitions:
- You don’t want to lose your service (2nd service).
- They change from 2 points for a win to 3
points → 2 points is fairer but it has been
changed because teams are really loss
averse → with 2 points per win teams would
only play for a draw.
JDM Lecture 3 l Mental accounting
What is mental accounting?
- Compared with financial-managerial accounting.
- ‘Set of operations used by individuals and households to organize, evaluate, and keep track
of financial activities.’
‘Mental accounting betekent zoveel als de verzameling cognitieve handelingen van een individu of
huishouden om financiële activiteiten te organiseren, evalueren en te beheren. Of anders gesteld: de
mens brengt verschillende keuzeproblemen als het ware onder in aparte ‘boekhoudingen’ en ziet
daarbij over het hoofd dat het rationeel zou zijn rekening te houden met de mogelijke wisselwerking
tussen de keuzes.’ (www.beurseffecten.nl)
A or B?
- Version 1: pen in shop A around the corner = 20 euros, the same pen in shop B 20 minutes
away = 10 euros.
- Version 2: Suit in shop A around the corner = 390 euros, the same suit in shop B 20 minutes
away = 380 euros.
10 euros is 10 euros because in both situations you win 10 euros for 20 minutes away.
- Money is not relative in value → what matters is what you want for 20 minutes.
Framing outcomes:
JDM Lecture 1 l Introduction to the course and minor
The minor ‘understanding and influencing decision making in business and society’ implies:
- Understanding and influencing human decision making and behavior, both in the context of
organizations (employees, managers, teams) as well as in their interactions with the world
outside.
- To achieve this goal, we rely on recent insights from behavioral economics and psychology.
JDM Lecture 2 l Loss aversion and framing of decisions
Types of decisions?
1) Major reflective decisions
a) Whether or not to invest in a stock or business?
b) Whether or not to buy a house? Which house to buy?
c) Whether to start a relationship with someone? Whether to end a relationship with
someone?
d) Medical decisions - whether or not to have surgery for a problem?
2) Low level decisions
a) Shopping in a supermarket
b) Which way to go when driving a car to a particular location
c) What to wear today
What factors should affect a decision?
Three concrete decision examples:
- Whether or not to take a particular course.
- Whether or not to buy a new, better computer.
- Whether or not to end a relationship with someone.
➔ What you want. Also, 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 or bad, and to
what degree?
➔ How likely are the different possibilities?
How should decisions be made?
The 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’
Framing effect → people will be ‘saved’ versus people will ‘die’
Expected utility theory:
● People think about uncertain events in terms of gambles:
● Gambles have two components:
○ Probability, p
○ Value, v
● The expected value of a gamble (EV) = p x v
● The expected value of a gamble that offers a
25% chance of winning €100 = €25
Cancellation: you should cancel the things that are
completely equal in choosing between two decisions.
Framing effect (Asian disease problem):
- 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.
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
● Why reference point? → people compare income to friends, parents, goals,
expectations, etc.
○ Easier to compare with a r than evaluate absolute utility
○ Natural degree of adaptation (e.g. brightness, loudness, temperature, etc.)
➔ The reference point is very subjective: it depends
on the person, on the situation, on the context, etc.
➔ People prefer certainty to uncertainty.
,Loss aversion → definition: 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.
- The utils lost from losing 100 euros are worth more than the utils gained from earning 150
euros.
Risky prospects → losses versus gains:
● People asked to choose between prospects, one riskier than the other (outcome is a gain
versus a loss):
○ Gains: 80% chance of $4000, versus $3200 for sure
○ Losses: 80% chance of -$4000 versus -$3200 for sure
➔ People choose the uncertain option if
it’s about losses.
➔ People choose the certain option if it’s
about gains.
Prospect theory is a descriptive theory: it
describes what people do.
A problem (A):
Imagine that you face the following pair of
concurrent decisions. First examine both
decisions, then indicate the options you prefer:
Decision 1 choose between:
a) a sure gain of $240
b) 25% chance to gain $1000 and
75% chance to gain nothing
Decision 2 choose between:
a) A sure loss of $750
b) 75% chance to lose $1000 and 25% chance to lose nothing
Another problem (B):
Choose between:
1) 25% chance to gain $240 and 75% chance to lose $760
2) 25% chance to gain $250 and 75% chance to lose $750
Compare problem (B) with problem (A):
- 1 in (B) = A & D in (A)
- 2 in (B) = B & C in (A)
Compare problem B:
Respondents in problem (A) failed to combine options, although:
- Relatively simple
- Encouraged by instructions
Certainty effect:
We tend to weigh certainty more than uncertainty →
difference between problem 1 and 3: reduction of
probability of an outcome by a constant factor has
more impact when the outcome was initially certain
than when it was merely probable.
, - The closer you get to certainty, the more weight the choice has.
Pseudocertainty effect:
Discrepancy in response to objectively identical problems 2 and 3. The potential ‘certainty’ in problem
2 is contingent upon reaching the second stage of the game (still uncertain)
Pseudocertainty → disease vaccination.
Prospect theory: people do not multiply by the decision weight.
Gains, losses and adaptation:
Difference between a 8m² cell and a 10m² is insignificant when one has just lost freedom.
- But, very important after adapting to the new level.
Status quo:
● We want to keep things the way they are
○ Even if we didn’t originally choose it
● We want to avoid potential losses generated by
change: losses loom larger than gains.
Loss aversion in sport competitions:
- You don’t want to lose your service (2nd service).
- They change from 2 points for a win to 3
points → 2 points is fairer but it has been
changed because teams are really loss
averse → with 2 points per win teams would
only play for a draw.
JDM Lecture 3 l Mental accounting
What is mental accounting?
- Compared with financial-managerial accounting.
- ‘Set of operations used by individuals and households to organize, evaluate, and keep track
of financial activities.’
‘Mental accounting betekent zoveel als de verzameling cognitieve handelingen van een individu of
huishouden om financiële activiteiten te organiseren, evalueren en te beheren. Of anders gesteld: de
mens brengt verschillende keuzeproblemen als het ware onder in aparte ‘boekhoudingen’ en ziet
daarbij over het hoofd dat het rationeel zou zijn rekening te houden met de mogelijke wisselwerking
tussen de keuzes.’ (www.beurseffecten.nl)
A or B?
- Version 1: pen in shop A around the corner = 20 euros, the same pen in shop B 20 minutes
away = 10 euros.
- Version 2: Suit in shop A around the corner = 390 euros, the same suit in shop B 20 minutes
away = 380 euros.
10 euros is 10 euros because in both situations you win 10 euros for 20 minutes away.
- Money is not relative in value → what matters is what you want for 20 minutes.
Framing outcomes:
