Week 1:
The framing of decisions and the psychology of choice (Kahneman 1981)
Doel: This paper researches preference reversals found when similar problems are framed in
different ways. These preference reversals violate the rational choice theory.
The framing effect arises when similar problems that are framed in different ways give rise to
preference reversals. This can be due to the fact that most people are risk-averse when problems
are framed in terms of gains and risk-taking when problems are framed in terms of losses.
The expected utility model of decision-making poses that people make decisions based on
maximizing their expected utility. This paper proposes a different model that accounts for
irregularities found with the expected utility model. This model is called the prospect theory and it
takes into account the reference point of people. The value function below is the value function of
prospect theory and shows a reference point at zero and shows that people are twice as sensitive to
losses as they are to gains (loss aversion). It also shows that the subjective value between 10$ and
20$ is way higher than between 110$ and 120$ (diminishing sensitivity). Prospect theory also poses
that high probabilities are not given enough weight and low probabilities are given too much weight
in decision making processes. In prospect theory both the gain and the loss functions display
diminishing sensitivity.
Summary: The psychological principles that govern the perception of decision problems and the
evaluation of probabilities and outcomes produce predictable shifts of preference when the same
problem is framed in different ways. Reversals of preference are demonstrated in choices regarding
monetary outcomes, both hypothetical and real, and in questions pertaining to the loss of human
lives. The effects of frames on preferences are compared to the effects of perspectives on perceptual
appearance. The dependence of preferences on the formulation of decision problems is a significant
concern for the theory of rational choice.
,Week 2:
Mental accounting matters (Thaler 1999)
Doel: This article is a summarization of the current knowledge on the concept of mental accounting
in the scientific literature to show that mental accounting ‘matters’. It is laid out in three distinct
parts, the first component delves into how outcomes are perceived and experienced and how
decisions are made and then evaluated. The second component of mental accounting goes into the
assignment of activities to specific ‘accounts’. The third component then goes into how frequently
different types of mental accounts are evaluated and the process of ‘choice-bracketing’.
Mental accounting: the set of cognitive operations used by individuals and households to organize,
evaluate and keep track of financial activities. The process of mental accounting violated the
economic principle of fungibility, money in one mental account is not a perfect substitution for
money in another account.
There are three ways in which an outcome may be framed:
1. In terms of a minimal account, in this account only the differences between the options are
examined and the common features are disregarded.
2. In terms of a topical account, in this account the consequences of the options are related to
a reference level that is determined by the context within which the decision arises.
3. In terms of a comprehensive account, in this account all other factors including current
wealth, future earnings etc. are incorporated into the decision making process. Using this
account, people should not be influenced by different framings of questions.
In a transaction customers get two kinds of utility:
1. Acquisition utility: the difference between value of the good in the eyes of the consumer and
its price.
2. Transaction utility: the difference between a reference price (the regular price the customer
expects to pay for that product) and the price.
In the case of advance purchases people are more willing to still attend the event in the case of bad
weather, because not attending the game is being seen as having to close a mental account that is
negative. The concept of payment depreciation is the process of prior expenditures gradually
stopping to influence decision making processes.
For consumers the concept of payment decoupling is desired, meaning that it is desirable to be able
to mentally decouple the costs of an item from the item itself. This makes a flat rate for a dinner
experience more desirable than a pay per piece policy because the costs of every piece would then
be very salient to the customer.
Budgeting: in the case of budgeting money is categorized mentally into different categories, namely:
Expenditures are grouped into budgets (e.g. food and housing)
Wealth is allocated into accounts (e.g. pension, ‘rainy day’)
Income is divided into categories (e.g. regular or windfall)
This categorization of spending serves the purposes of facilitating rational trade-offs between
competing uses for funds and it can act as a self-control device.
For the process of tracking expenses against their budgets two steps need to be taken, firstly the
expense must be noticed and secondly they must be assigned to their proper accounts. Many very
, small expenses are not even booked into categories (making the ‘it’s just 47 cents a day’ strategy
effective).
According to the account money is stored in it can be less or more tempting to spend. For example,
money in ‘current assets’ will be more tempting to spend than money in ‘current wealth’ which is
seen as savings.
Violations of fungibility are caused by:
The budgeting process
The locations of funds
The source of income: the sources of income can dictate spending because they seem
‘linked’ together e.g. spending on children’s clothing typically decreases after child
allowance gets cut.
Choice bracketing: the integration of multiple decisions into groups. This can be done, for example,
by integrating all decisions of the same day into one group, whereby all these decisions affect one
another.
A prior gain can stimulate risk-seeking in the same account, this is called the house money effect.
Also, a prior loss in the same account can stimulate risk-seeking in the same account, but only if
there is a chance to break-even.
The diversification heuristic is the tendency of people to diversify their outcomes when asked to
make several choices at the same time.
Maps of bounded rationality: psychology for behavioral economics (Kahneman 2002)
Doel: This article attempts to obtain a map (overview) of the concept of bounded rationality, by
studying the systematic biases that lead people to systematically make sub-optimal choices.
The paper discusses scientific work relating to three main lines of research, namely:
1. Heuristics and biases in various tasks of judgement under uncertainty.
2. Prospect theory, a model of choice under risk.
3. Framing effects and their implications for rational-agent models.
System 1 (roughly intuition) processing is: fast, parallel, automatic, effortless, associative, slow-
learning and emotional.
System 2 (roughly reasoning) processing is: slow, serial, controlled, effortful, rule-governed, flexible
and neutral.
Accessibility: the technical term for the ease with which certain mental concepts come to mind.
Perception is reference-dependent, this means that perceived attributes of a focal stimulus reflect
the contrast between that stimulus and a context of prior and concurrent stimuli.
Prospect theory proposes a reference point that is used for decision-making and the idea of loss
aversion (change in utility of an X win is not the same as an X loss). It deals in changes of wealth
(gains and losses, respective of the reference point) not in absolute states of wealth (such as the
expected utility theory does). Mainly it states also that in the domain of losses people favor risk-
seeking and in the domain of gains people favor risk-aversion. This theory also explains the
