A simple definition of a decision:

Choosing between alternative courses of actionManagerial and Consumer Biases, Nov 20

Many decisions in life are guided by heuristics

Heuristics: simple, efficient rules that people use to make decisions when an exhaustive consideration of each alternative is infeasible

Usually, an exhaustive consideration is infeasible

These rules work well in most circumstances

But they can lead to systematic errors and biases

Some heuristics that normally work

Another heuristic that normally worksThe availability heuristic

Inferring frequency of an event from ease of recalling instances of that event

But this heuristic can lead to bias (here, mistaken inferences)

e.g., Name 2 vs. 10 bad things

If dont correct for question difficulty, availability heuristic will lead you to judge a lower frequency when asked for 10 things

Waste Not, Want Not (Sunk Cost Bias)Assume that you have spent $100 on a ticket for a weekend ski trip to Michigan. Several weeks later you buy a $50 ticket for a weekend ski trip to Wisconsin. You think you will enjoy the Wisconsin ski trip more than the Michigan ski trip. As you are putting your just-purchased Wisconsin ski trip ticket in your wallet, you notice that the Michigan ski trip and the Wisconsin ski trip are for the same weekend! Its too late to sell either ticket, and you cannot return either one. You must use one ticket and not the other. Which ski trip will you go on?

The economic predictionThe Data$100 ski trip to Michigan$50 ski trip to Wisconsin

Bundling can reduce attention to sunk costsErnie and Bert are serious skiers who have each prepurchased four days worth of lift tickets. Having gone to different vendors, Ernie paid $40 for each of four one-day lift tickets, and Bert paid $160 for a four-day ski pass. Both men have enjoyed three days of skiing in perfect conditions. Unfortunately, each wakes up on the fourth day to find that ski conditions have deteriorated considerably.

Who is more likely to ski in spite of the poor conditions Ernie, who has a nonrefundable, unused ticket for that fourth day, or Bert, who has a partially used pass that expires on that fourth day?

A more costly illustration of sunk cost bias

Sunk cost bias not just driven by waste-aversion, but also reputational concernsGiving up on a project means that somebody has to admit that they shouldnt have done it in the first place. And there are lots of executives who would rather be tortured than admit that theyre wrong.

Also, no one likes a quitter

Relatedly, people do not want to appear inconsistent

Inconsistency typically viewed as an undesirable personality trait

Consistency is associated with personal and intellectual strength

It is at the heart of logic and rationality

Consistency Traps

Can capitalize on this desire by eliciting agreement with seemingly innocuous questionse.g., people either asked or not asked to watch my things prior to a staged beach theft of a radio20% of those not asked to watch become vigilantes95% of those asked to watch become vigilantes

Consistency trapsCan you do me a favor?Do you think its important to save for retirement?Are you ready to buy a car today at the right price?

Another examplePs called and offered opportunity to earn extra credit by participating in an experiment

Control conditionThe room in which the experiment is being held is used during the day and evening by other people in the department; so we are running this experiment at 7:00 in the morning on Wednesdays and Fridays. Can I put you down for Wednesday or Friday morning at 7:00?

Consistency trap conditionWould you be willing to participate? If yes, then read paragraph above

24% in Control condition agree (and actually show up)53% in Trap condition agree (and actually show up)

Da Vinci on consistency trapsIt is easier to resist at the beginning than at the end.

We want to appear consistent

So much so that we underappreciate how much our tastes will change over time

Projection bias

Projection bias

$20 Auction

The carriers of value (utility) tend to be gains and losses relative to a reference point

How people tend to evaluate changes relative to a reference pointValue / UtilityGainsLossesTypical Gain Functionv(x) = x.88 (for x0)The reference pointTypical Loss Functionv(x) = -2|x|.88 (for x

Key properties of prospect theory value function

Concave for gains, convex for losses

Loss aversion: |v(-x)| > v(x)

Diminishing sensitivity (for both gains and losses)GainsLossesValue / Utility

Has received much empirical support

Helps to explain behavior that is anomalous from standard econ perspective

Some implications of the theory

How to maximize pleasure, or minimize pain

Segregate gainse.g., v(5) + v(5) > v(10), due to concavity of gain function

Integrate lossese.g., v(-5) + v(-5) < v(-10) due to convexity of loss function

Integrate small losses with large gainse.g., v(10) + v(-2) < v(10-2), to offset loss aversion

This can be taken to unrealistic extremes

e.g., Theory predicts that people would prefer to have losses integrated

An extreme implication is that you want everything bad in your life to happen all at once

Lets think about this from a prospect theory perspective

You can capitalize on loss aversion through enhanced active choiceHighlighting the losses associated with the non-preferred alternative

Example: Flu Shot Experiment

The CDC indicates that a flu shot significantly reduces the risk of getting or passing the flu virus. Your employer tells you about a hypothetical program that saves you $50 off your monthly health insurance contribution cost if you get a flu shot.

After message, Ps offered one of three choices

Opt-in condition

Will you get a flu shot this Fall?Yes, I will get a flu shot this Fall

Active Choice condition

Place a check in one box:I will get a flu shot this FallI will not get a flu shot this Fall

Enhanced Active Choice condition

Place a check in one box:

I will get a flu shot this Fall to reduce my risk of getting the flu and I want to save $50

I will not get a flu shot this Fall even if it means I may increase my risk of getting the flu and I dont want to save $50

Percent who decide to get a flu shot:Opt-in: 42%Active Choice: 62%Enhanced Active Choice: 75%

Highlighting the losses associated with the non-preferred alternative

But more often than not, loss aversion leads to suboptimal choicesOne example: The status quo bias

Status Quo Bias (Harmless Version)Three conditionsNo endowment. Choose between mug and candy barEndowed w/mug. Can keep it, or trade it for candy barEndowed w/candy bar. Can keep it, or trade it for mug

ProportionProportion Choosing MugChoosing CandyNo endowment56%44%Endowed w/mug89%11%Endowed w/candy10%90%

Status Quo Bias (More Costly Version)Auto insurance laws in PA and NJ introduced the option of a reduced right to sue (for pain and suffering from accidents), in exchange for lower insurance rates

NJ default: reduced right to sue; you must pay an additional fee to acquire full right to suePA default: full right to sue; refund for giving up those rights

When offered choice, only 20% of NJ drivers chose to acquire the full right to sueBut 75% of PA drivers chose to retain full rights

Status Quo Bias (Very Costly Version)

Status quo bias is pervasive because it has multiple causesLoss aversion

Regret avoidanceMore regret if action leads to bad outcome than if inaction leads to bad outcomee.g., fender-bender when taking normal route home vs. fender-bender when trying alternate route home

Implied endorsement

Status quo bias reminds us that preferences are often constructed on the flySome other important examples of constructed preferences

The Attraction Effect

DAffordabilityQualityBADecoy

BADAffordabilityQualityABD

16%0%84%68%32%

The Compromise Effect

QualityBADAffordability

Too expensive

Overconfidence and Unrealistic Optimism

Overconfidence can manifest itself in over-precise predictionse.g., Wharton students were asked, How many different colored crayons come in the BIG BOX from Crayola?

Give a 90% confidence intervala range of numbers you are 90% confident the true value falls in

How many different colored crayons come in the BIG BOX from Crayola?Answer: 96Correct answer should lie within 90% of confidence intervalsCorrect answer actually lies within 38% of confidence intervals

Classic study (from 1980) on unrealistic optimismCompared to other students at your universitysame sex as youwhat do you think are the chances that the following events will happen to you?

100% less than average (no chance), , 3 times average, 5 times average

Events included getting a good job, living past 80, dropping out of college, being sterile

On average, people say they are 50% more likely than average to like the job they get after graduation

On average, people say they are 58% less likely than average to develop a drinking problem

Where all the women are strong, all the men are good looking, and all the children are above average

Overconfidence in predictions partly driven by reference group neglectAsked why so many big-budget movies are released on the same big weekends:

Joe Roth, former Walt Disney Studios chairmanHubris. If you only think about your own business, you think, Ive got a good story department, Ive got a good marketing department, were going to go out and do this. And you dont think that everybody else is thinking the same way...Theres certainly not enough viewers to go around.

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