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Business DecisionsSOC 138/ECO 148

Professor: Carter T. ButtsTime: M/W/F 11:00-11:50

URL:http://eee.uci.edu/13w/69360

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Decisions Matter Betting on a "Sure Thing"

Bernard Madoff, former NASDAQchairman and respectedfinancier and philanthropist,claimed to offer clients modestbut surprisingly steady returns

Attractive to many, especiallynon-profit organizations

In 2009, admitted that his entirebusiness was a scam

Wall Street Journalestimatedtotal loss of over $26 billiondollars to hundreds of clients

Scam was a "classic," but went

uncaught for almost 20 years

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Decisions Matter

Extreme Management In late 1911, Robert F. Scott leads a

five person expedition to the southpole (racing against RoaldAmundsen)

Numerous questionable commanddecisions by Scott

Reliance on ponies and experimentalmotorized sledges

Disdain of dogs (thought unreliable and

ignoble)

Substantially insufficient food/resources

Unwillingness to listen to others

All five men perished. A supply depot

was 11 miles away.

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A Normative Lesson: The Price of Human Folly

Poor decision making costs time,money, jobs, and even lives

In business contexts, decisions can

make the difference betweensuccess and failure

Doing things right means knowinghow and why we so often dothings wrong

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A Descriptive Lesson: Predicting Decisions

Decision making as a behavioralmodel

Understanding decision processes

facilitates prediction of individual,group outcomes

Humans do not always do whatwould seem rational or intuitiveto an outside observer

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What Is a Decision?

Decision Maker

Beliefs

Values

Context Choice Set

States of theWorld

1

A B

4 3 2

50% 50% 90% 10%

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Example: Value at Risk and Bank Capital Requirements

In making lending decisions, banks must weigh value ofinterest against risk carried

Beliefs: estimates of default probability, opportunity costs, futurecapital availability, estimates of capital demand

Values: risk/return trade-off, discount rate

Choice set: loan terms (exposure, maturity, interest rate, etc.)

States of the world: possible income streams (including potentialfor firm failure)

Likewise, those investing in banks must considerexposure

Regulating exposure: capital requirements and the BaselAccords

Agreements determine how risk is assessed, communicated

Rules for rating risks set context for future investment decisions

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Domains in the Study of Decision Making

Judgment

What we believe, how we learn?

Choice

What do we value, how to we choose?

Strategic Behavior

How do we respond to other decisionmakers?

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Decisions in Business Contexts

Accounting/forecasting

Consumer behavior

Human resourcesTask performance

Managerial decision making/strategy

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Class Overview

Three Components:

Part 1: Models of Rational andIrrational Decision Making Behavior

Part 2: Pathologies in IndividualDecision Making

Part 3: Decision Making in Social

ContextsNine lectures, one exam per

component

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Requirements and Grading

Assignments

Lecture

Reading

Discussion sectionsEvaluation

Three exams [3x28% = 84%]

Decision making exercises[4x2.5% = 10%]

Case study exercises [6%]

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Discussion Sections

TAs Steve Doubleday (sdoubled@uci.edu)

Daniel Jessie (djessie@uci.edu)

Erez Maantz (emarantz@uci.edu)

Rottem Sagi (rsagi@uci.edu)

Activities Review/discuss lecture and readings

Distribute study notes

Prepare for exams

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Back to Decisions

Decision Maker

Beliefs

Values

Context

Choice Set

States of theWorld

1

A B

4 3 2

50% 50% 90% 10%

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What Do We Mean by a Rational Decision?

A quick and dirty approximation: One which considers the probable states of

the world associated with each potentialoption;

Weights states of the world based onprobability and personal values in a logicallyconsistent manner; and

Selects the option which puts the most

weight on the most desirable states.

Choice consistent with our valuesand beliefs

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Modern Rational Choice Theory

Provides a precise, minimalimplementation of consistentreasoning

Future oriented

Avoids pathological behavior

Builds on probability theory, logic

Concerned only with consistency, notwith content of values or beliefs

(Well see this in more detail in the

next several lectures)

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Pseudo-irrationality

Myths and confusions aboundregarding rational behavior What seems rational may not be andwhat seems irrational may be rational!

Must turn to the theory, rather thanintuition

Before discussing what the theory

says, we consider some things itdoes notsay

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Myth: Rationality is Cold or Emotionless

Rational behavior depends onvalues The content of these values is not in

question only their consistency

There is no rule against sentimental values Ignoring ones values is not rational

Emotion per se is neither rational

nor irrational Rationality involves decisions, not feelings;

it neither predicts nor prescribes emotionalstates

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Myth: Rationality Is Inherently Egoistic

Rational behavior is assessed interms of the decision makersvalues

thus, if the decision makersvalues are altruistic, it is rational forhim or her to behave altruistically. Altruistic behavior can satisfy the axioms of

rational choice

Egoism is sometimes assumed but notrequired

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Myth: Rational Players Always Win

Actors are constrained by the choice set The action chosen will be the best available,

but may not be the best conceivable Popularity is not always a signal of desirability

Strategic factors may make some choicesineffectual Dilemma games

Actors also face limited information We cant choose options if we dont know

about them! Incorrect beliefs may be rational if derived

from faulty information

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Myth: Weird Things are Beyond Rationality

Rational choice requires action which is

consistent with our beliefs Even if we are dealing with a strange or far-fetched

notion, we can (and must) consider it

Rational judgment as scientific skepticism Update prior beliefs based on the weight of

evidence

That which is logically consistent is not ruled out(although it may be extremely improbable)

The same rules of judgment apply to all claims

F M h R li

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From Myth to Reality

Rational decision making stressesconsistency with values and beliefs

All decisions or questions of

judgment are fair gameContext, subject matter, or

emotional states do not render

decisions intrinsically rational orirrational

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Confusion: Normative and Descriptive Models

Descriptive Models What is

Rational behavior as a predictive device

Empirical it works or it doesnt

Normative Models What ought to be

Rational behavior as a prescription for makingdecisions

Evaluative we accept it or we dont

The same concepts can be used for bothpurposes, but the purposes are not the same!

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Example: Planning, Policy, Measurement, and Forecasting

Normative or Descriptive?

Basel Capital Accord

Annual sales forecast

S&P 500 index Mission statement

Investment plan

Sharpe ratio

How could each of these be usedin

an alternate role?

A idi C f i

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Avoiding Confusion

Determine if a given use if normative

or descriptive Are we making prescriptions, or

predictions?

Keeping our is out of our ought We do not have to view real behavior

as optimal or desirable Our ideas of optimal or desirable

behavior do not have to reflectcommon practice

Fi l N t

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Final Notes

Remember to check the web site for

syllabus and updates(http://eee.uci.edu/13w/69360)

Discussion sections start this weekDecision Exercise 1 on Wednesday

If you aren't registered, be sure to see a TA!