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UNIT 2: HEURISTICS AND EXPECTED UTILITY PARADOXES1) Definitions and introductory concepts
2) Heuristic 1: Representativeness
3) Heuristic 2: Availability
4) Heuristic 3: Anchoring effect
II. Expected Utility paradoxes
1) When does EUT work?
2) Violations of EUT
2.1 Allais paradox
2.2 Ellsberg paradox
2.3 Rabin’s Calibration Theorem
2.4 Reference dependence
2.5 Loss aversion
2.6 Endowment effect
2.7 Framing effect
III. Some applications
1) Application 1 : Target income and target wage
2) Application 2: Housing market
3) Application 3: Life Cycle Hypothesis
4) Application 4: Saving for the future
IV. Summary
1. INTRODUCTION
• In BE, we look at why and how people make decisions
• Modelling decision making under risk relies on the assumption of correct (subjective) probability
assessments
• We will start by looking at heuristics; how people use heuristics in their choices (certain way to do our
search, rule of thumb when we make decisions: search heuristics)
• Empirical challenges to the descriptive validity of expected utility theory from the lab: Paradoxes of
decisions under risk and uncertainty
• Some applications where heuristics play a role
2. HEURISTICS AND BIAS
2,1 DEFINITIONS
Heuristics: Is a “Rule of thumb” or a simple rule of behaviour by which a decision-maker makes decisions or
solves a problem. E.g.: buying what you usually do (groceries…. It is a mental shortcut that allows people to make
solve problems and make judgments quickly.
Usually leads to acceptable estimates (choose in the supermarket the products that I usually buy).
Imprecise and prone to errors and bias.
What is a bias? Bias: Systematic suboptimal judgments that can result as a consequence of the heuristic process.
That judgement that we make can result in errors or it is not the best decision that you could make.
, 2.2 SEARCH HEURISTICS
You could:
1. Try everything, what is costly and barely impossible
2. Choose Satisficing this is, try until your aspiration level is met. (Once you try one product that you actually
like enough, you stop your search)
3. Choose Elimination by aspects: Consider different aspects of choice (e.g., taste, price…) and eliminate from
consideration goods that fail to meet your aspiration level for each aspect.
4. Choose Directed cognition: Treat each chance to pick a good as your last. You look at choices/ options in
isolations. You direct your cognitive ability just to try binary or two couple of things at a time, so not many
choices. E.g., Ice cream choice: you always buy vanilla, and you want chocolate this time so you compare this
two in isolation, and if you like chocolate this time: you could change your mind and start buying chocolate
or you could stick with your first choice that is vanilla)
These heuristics can be seen as complimentary rather than alternatives.
2.3 UTILITY AND SEARCH
Utility function: represents your preferences over goods and services. It would tell you how much utility you
would get from a combination of goods and money.
The standard way in economics talks about maximizing your Utility function but in a way, you do maximize your
utility but as the standard model really prescribed. Instead, you would do a search heuristic to become more
informed being aware of the limits. We need to be aware of our limits in order to complement the two fields.
2.4 DUAL PROCESSING
Daniel Kahneman defends that we have two systems in our thinking, those two systems will come into play
depending on the type of decision that you have to make:
•Fast
SYSTEM 1 •Little cognitive effort
•Dependent on current emotion
SIMPLER WAY OF •Automatic
THINKING •Much more heuristic and rule of thumb than system
2
•Slow
SYSTEM 2 •High cognitive effort
•Affectively neutral
MORE COMPLICATED •Controlled
WAY OF THINKING
2.5 HEURISTICS
Let’s look at three well-known heuristics:
1. Representativeness
2. Availability
3. Anchoring and adjustment
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