Judgement and Decision Making Part 2
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What is the normative theory for risky decisions?
expected utility theory (EUT)
What is the expected utility theory?
To make a decision, calculate the expected utility between options, and choose the option with the highest expected utility you can apply this in any context
What is the expected utility theory equation?
Expected utility (outcome) = utility (outcome) x probability (of outcome)
What are people typically referring to risk?
People are generally risk-averse, possibly because the relationship between amount and utility is not linear.
But what is the problem of EUT?
People do not follow/act normatively so they don’t follow EUT People treat 100% probability differently from other probabilities (certainty effect)
What is the prospect theory?
A descriptive theory
What is Prospect Theory Insight 1?
Probabilities are distorted Prospect theory multiplies utilities by decision weights Low probabilities are overestimated, and high probabilities are underestimated
What is Prospect Theory Insight 2?
People treat gains differently from losses People are risk averse for potential gains, risk seeking for potential losses So our decisions depend on what it the status quo We hate losses about 2x as much as we like gains
What is the prospect theory equation for perceived gains?
Expected utility (outcome) = Utility (outcome) x decision weight (outcome)
What is the prospect theory equation for perceived losses?
Expected utility (outcome) = loss aversion (Utility (outcome)) x decision weight (outcome)
What is the criteria for a rational choice?
Procedure invariance Independence of irrelevant alternatives Transitivity
What does procedure invariance mean?
If the outcomes are the same, then choices should not change if the question is framed differently
How is procedure invariance not followed by people?
The framing effect exist even though they mean the same thing; the fact that is framed differently affects what people choose, as in the epidemic problem People are more risk-seeking simply when the problem is framed as a loss even though the actual outcomes are the same Also, the sunk cost fallacy: the phenomenon whereby a person is reluctant to abandon a strategy or course of action because they have invested heavily in it, even when it is clear that abandonment would be more beneficial. (mental accounting)
What is independence of irrelevant alternatives?
If you have a choice between two options and then a 3rd option is added that you would never pick, the presence of the 3rd option should not affect your choice between the original two options
How is the independence of irrelevant alternatives not followed by people?
Attraction effect - uses a “decoy” or asymmetrically dominated option to make a preferred target product seem more appealing by comparison, thereby increasing its selection It depends on the attributes of the things being considered, like affordability or quality
What is transitivity?
If you prefer A over B, and B over C, you must prefer A over C.
Do people violate transitivity?
Not really known because if something changes it can be based on mood changes or circumstance changes