Decision Making

choice…maximizing utility

framing effects

Value

• Round 1: Raise your hand if your birthday occurs in the first half of the year (jan-june 30th)

• Congratulations, you just won! • You are entitled to one of our prizes:

– Prize A: $15– Prize B: $ 10

• Which one do you choose?– Duh! – Prize A value > Price B value

Expected value• Round 2: choose prize first • Winners will be decided based on the last digit of

their SSN:– Prize C: $15

• if your SSN digit matches the number that comes out • for example, if ‘7’ comes out and your SSN ends in ‘7’

– Prize D: $ 10 • if your SSN digit is in the selected category (larger/smaller

than 5)• For example, if ‘7’ comes out, and your SSN ends in ‘5’, ‘6’,

7, 8 or 9

• Which one do you choose to play?

Expected value• Obviously, you chose prize D. Why?

• Expected value: – Prize C = $15 x .1 = $1.5– Price D = $10 x .5 = $5.0– EV = Value x Probability

Expected Utility

How desirable a bet is depends on:- Expected value (size of Payout x Probability )

- How much an individual values that payout (Saving a tree, $, etc.)- This provides a single scale for the goodness of any particular choice

Utility: how happy or satisfied something makes you (how desirable something is)

Utility theory: A Normative Theory of Choice

• Describes how people should make decisions

• In making a decision, you should:- Assess how worthy each outcome is to you (subjective utility)

- Assess how likely each outcome is

- Compute the expected utility of each possible option

- Compare those expected utilities

- Select the choice with largest expected utility

Example: should you buy a lottery ticket?

--Largest powerball jackpot ever = $195,000,000 !!--Probability of winning the powerball 1 in 10,000,000,000.

--The expected value: .00000000001 x 195,000,000 = 2 lousy cents.

Should you buy a ticket? Only if it costs 2c or less.

Utility theory: Criticism

• There are several problems with Utility theory:

– Probability outcomes are often unknown• What is the probability that he will say ‘yes’ if I ask him out?

– It’s tricky to assess the expected utility of future outcomes• How happy would I be to have chosen ‘Nova?

– Lots of evidence that people do not reason this way

Please make your selection...Option A. Winning $40 with

probability .80

Option B. Getting $30 for sure

Certainty Effect: People tend to prefer sure gains (risk averse for gains)

Eva: $40 x .8 = $32EVb: $30 x 1 = $30

Framing effects: Positive FrameStudents in right side of class will answer:

Imagine that the US is preparing for the outbreak of an unusual tropical disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. The estimates of the program’s effects are as follows:

Program A:

200 people will be saved.

Program B: 1/3 chance that 600 people will be saved.

2/3 chance that 0 people will be saved.

Negative Frame Students in right side of class will answerImagine that the US is preparing for the outbreak of

an unusual tropical disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. The estimates of the program’s effects are as follows:

Program C: 400 people will die.

Program D: 1/3 chance that 0 people will die2/3 chance that 600 people will die.

Program A:

200 people will be saved.

Program B: 1/3 chance that 600 people will be saved.

2/3 chance that 0 people will be saved.

Program C:

400 people will die.

Program D:

1/3 chance that 0 people will die

2/3 chance that 600 people will die.

0

20

40

60

80

A B0

20

40

60

80

C D

72% of subjects pick Program A when the problem is framed in terms of “lives saved.” With the positive frame, subjects are “risk averse.”

Negative FramePositive Frame

Only 20% of subjects pick Program C when the problem is framed in terms of “deaths.” With the negative frame, subjects become “risk takers.”

Donating money & saving lives

• Each life is worth the same

1 2 3 4 5 6

number of lives saved

Val

ue o

f life

sav

ing

Series1

• How much money would you give to save

• Rokia

• To save people from the village where Rokia lives

Value

losses gains} }

A Hypothetical Value Function

- “The pain of a loss is greater than the pleasure of a gain.”- “ small loses hurt (proportionally more) than big losses”

Cash or Credit??$1.30/gal5 cent discountfor cash...

$1.25/gal5 cent chargefor credit...

Discount seems negligible, peopleuse credit card.

Surcharge isoutrageous…people pay cash.

gains

losses

Framing effects are everywhere…

What’s better?

A basketball player who makes 75% of his free-throws, or one who misses 25% or his free-throws?

Summary

• Utility theory fails to describe how people make decisions:– Frame effects– Influence of justifications (minimize regret)