Minor Understanding and influencing decisions in business and society
Period 1: Judgement and decision making
LECTURES
Week 1
Lecture 1: Introduction to the course & participation in individual decision-making task
& experiment | Kobe Millet | August 31, 2020
> How people make decisions, influence them both in context of organizations as well as in
their interactions with the world outside.
Course e-mail address: jdm.sbe@vu.nl (if it is in the course manual, you won’t get an answer)
Presence in tutorial 1 is essential (be there, be on time) → assigning to teams. Watch video
before Friday! The other tutorials you are free to join or not. If you do effort you get a better
participation grade, but you are not obligated to do so.
Not mandatory things (except the test at the end of this lecture, tutorial on Friday)
No recordings!
(Page 11 of the course manual)
Lecture 2: Loss aversion & framing of decisions | Kobe Millet | September 2, 2020
Tversky, A. & Kahneman, D. (1981). The framing of decisions and the psychology of choice,
Science, 211, 453-458.
What type of decisions are there?
Major reflective decisions → Whether or not to invest in a stock or business? Whether or not
to buy a house? Whether or not to start/end a relationship with someone?
Low level decisions → What to wear, what to eat
How should you make decisions?
• What do you want and what do you want to avoid?
• Strength of preferences and strength of dislikes for particular outcomes
• What factors will affect whether the outcome will be good or bad and in what degree
• How likely are the different possibilities to happen?
Decisions should be made based on the rational decision-making process which includes
(options should not reverse with changes of frame):
1. Defining the problem
2. Identify the decision criteria (what is important to you?)
3. Weight (what counts most according to you) of the identified decision-making
criteria
4. Generate possible alternatives
5. Rate each alternative against the decision maker’s criteria
, 6. Compute the optimal decision
But there are a few assumptions:
• the decision maker is rational
• that the problem is clear and unambiguous
• the decision maker has complete/all information
• no time or cost constraints
• choice will be the one with max profit!
Normative decision analysis
• Enumerate options (enumerate = een lijst maken van)
• Enumerate outcomes
• Construct a decision analysis for the decision
• Evaluate the probabilities of different possible outcomes
• Determine which option has the greatest “expected utility” (verwacht nut)
Decision making research before the 1970s → Normative theories that prescribe how people
ought to make decisions in a perfectly rational way, and many implicitly assumed that most
people, in daily lives, followed these normative rules.
BUT do we actually act like this? No, there is a deviation from what people should do versus
what they actually do. Research after 1970s is different.
This means, some decisions are rational, but some are clearly not. Think about own survey fill
in results! We’ll discuss them:
An example of this is the following:
Example: You are given 1000 for sure. Which do you prefer?
• Get an additional 500 for sure OR
• To get another 1000 with 50%
probability and otherwise nothing
OR you are given 2000 for sure. Which do
you prefer?
• lose 500 for sure
• lose 1000 with 50% probability
What you expect is via normative
decisions? → Most people have not
responded rationally.
Are other things that play a role, like framing maybe?
,Other experiment: Die or not die example
A. 200 people will be saved
B. 33% change all 600 will be saved; 67% change that
none will be saved
Others received:
A. 400 people will die
B. 33% change that none will die; 67% change that all
600 will die
Only difference is the framing! But results are different → Framing effect
This is a preference reversal! People are not coherent rational decision makers
Expected utility theory
People think about uncertain events in terms of gambles (operationalize it as gambles).
What is drawing specific decisions?
Gambles have 2 components:
1. Probability, p
2. Value, v
The expected value of a gamble: (EV) = p x v (probability X value)
Compare with rolling a dice: The expected value of a gamble that offers a 25% change of
winning 100 euro = 25 euro
Expected utility theory: Axioms (axioma = een niet bewezen maar als grondslag aanvaarde
bewering)
→ When faced with a choice, a rational decision maker will prefer the prospect that offers the
highest expected utility
• Dominance principle
o Alternative gambles can be ranked from best to worst in terms of expected
value
• Cancellation
o A choice between gambles should depend only on those outcomes that differ.
▪ Suppose you have two gambles, what you prefer should be based on
the outcome. You should cancel the things that are equal in the 2
options. Want to go home 10% murdered and 1% shot versus 10%
murdered and 6% kidnapped. You illuminate 10% murdered in both,
this won’t be taken into account.
• Transitivity
o I.e. if you prefer
A to B and B to
C, then you must
prefer A to C.
Preference
should remain
invariant or
stable, no matter how choices are described. Does not always count:
, Intelligence, emotional stability and social facility also counts. A preferred to
B higher on emotional stability. B to C, C to D. But not necessarily A to E! E
is much more intelligent than A so is this case, it does not count.
o This shows that true actions are different
• Invariance
o Preference should remain invariant or stable, no matter how choices are
described.
There is evidence that cancelation and transitivity does not always count
Framing effect (or: asian disease problem)
• Expected utility theory assumes description invariance: different formulations of the
same choice problem should give rise to the same preference order
• Evidence that variations in the framing of options (in the description) yield
systematically different preferences
• Framing effects lead to violation of the invariance and the dominance axioms of
expected utility theory.
• Complete flip of preference when framed the other way → not in line with expected
utility theory!
What is important in this study that the differences are systematic
Prospect theory
How people take decisions. This is a
descriptive theory. Not how people should
make decisions, but what they really do.
This graph is a value function of the prospect
theory. Prospect theory captures reference
dependence through the value function. v(x-r)
Value function:
❖ Outcomes are expressed as positive or negative deviations (gains or losses) from a
neutral reference outcome, which is assigned the value zero.
❖ The value function is s-shaped, convex below the reference point (favoring risk
seeking) and concave above it (favoring risk aversion).
❖ Loss aversion: the disutility (displeasure/pain) associated with a loss of a given
amount is larger than the utility associated with a gain of the same (or similar)
magnitude. The response to losses is more extreme than the response to gains.
People exhibit patterns of preference which appear incompatible with the expected utility
model.
