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Introduction to Decision Making

Sumitava Mukherjeesumitava.inbox@gmail.com

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Which is the best cell phone according to you?

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Should I marry? (Darwin’s thoughts)

MARRY NOT MARRY

CHILDREN NO CHILDREN

CONSTANT COMPANION FREEDOM

CHARMS OF A FEMALE CHIT-CHAT MEN’S CLUB CONVERSATIONS

TAKE CARE OF HOUSE AND MYSELF NOT FORCED TO VISIT RELATIVES

PICTURE OF NICE EVENING ON A SOFA WORKING TOO MUCH NOT GOOD BUT MORE MONEY FOR BOOKS!

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Press a key..

HHHHHHHHHHNHHHHHHHHHH

Press <- if you see a N in the center and -> if not

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What kind of a face is it?

Press <- if the face was happy and -> if not

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What is more probable?

• If you flip a coin having an equal chance of landing on tails and an equal chance of landing on heads, which is more likely?

[1] H T T H T H[2] H H H T T T[3] H T H T H T [4] H H H H H T

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Q: What is a decision?“A decision is a commitment to a course of action that is intended to produce a satisfying state of affairs”

(Yates et al., 2003)

Q: What is a good decision?•Based on outcome : Good outcome = Good decision•Time to recall: Good decisions slower

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Formal decision theory:The broad framework

• A choice scenario• Set of potential actions• Set of possible (probabilistic) outcomes

• Basic prediction: find an action such that there is a tradeoff between the costs and probabilities of the outcomes vs the preferred outcome

Ex., Neumann & Morgenstern, 1944

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Decision sciences before 1950s: Gambles & Expected value

• Expected value: You win 100Rs if after a coin toss, you get head else you get zero. Expected Utility = 0.5x100 + 0.5x0 = 50 Rs.

• Economists used expected utility to describe how decisions should be made and how “econs” decide.

• What about “humans”?

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Bernoulli’s insight (1738)

• Gustav Fechner: Subjective quantity in mind with objective measurement (Brightness)

• Subjective utility: Psychological value or desirability of money

• Psychological response is inversely related to initial wealth

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Bernoulli : Expected Utility• People’s choices are not based on dollar values but on

psychological values of their outcomes• Utility is a logarithmic function of wealth

• Diminishing marginal value of wealth Wealth: 1,2,3,4,5,6,7,8 Utility units: 10,30,48,60,70,78,84,90

Equal chances of winning 1 million or 8 million Vs winning 4 million for sure?

Expected value vs expected utilityPremium?

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Bernoulli’s Error

• Today Asma and Anjali have 5 lakh. Yesterday Asma had 1 lakh and Anjali had 9 lakh.

Are they equally happy? (Do the sums of money have the same utility).

Bernoulli’s prediction: Yes. Happiness is dependent on the utility of their wealth

Change in wealth matters!

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Bernoulli’s error

• Antony owns 1 million, Betty owns 4 million• Both offered gambles of (a) an equal chance to own

1 million or 4 million vs (b) own 2 million for sure.

• Bernoulli’s prediction: People choose the sure option

• Reference point matters!• Can explain Antony’s risk aversion, but not Betty’s

risk seeking

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Prospect Theory

Not initial wealth but a change in wealthEvaluation is relative to the reference pointPos above ref = gainsNeg below ref = losses

Diminishing sensitivity

Loss AversionProposed by Amos Tversky & Daniel Kahneman -Won 2002 Nobel prize in economics

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Modes of thought

We are not calculators!

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What kind of a face is it?

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What is the value of?

17x24

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Modes of thought Dual systems perspective

SYSTEM 1 (intuition) SYSTEM 2 (Deliberation)

Almost automatically Controlled

No/less effort More effort

Associative Serial

Implicit Explicit

More emotional Calculative

Fast Slower

Stanowich & West, 2000; Kahneman, 2002; 2011

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Heuristics & Biases

• Anchoring & AvailabilityIs the height of the tallest redwood more or less

than 1200 (180) feet?What is your best guess?

System 1 vs System 2S2 works on information cued in memory by S1S2 is biased by anchors induced by S1

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Heuristics & Biases?

• Insensitivity to probability distributions Is it more likely that you shall be killed by falling

airplane pieces or by sharks (if you were in Australia)?

• Diversification heuristics (Simultaneous vs sequential choice of snacks, Simonson, 1990)

• Hindsight (I always knew it!)

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Heuristics and Biases: presentation format

Lindsey, Hertwig & Gigerenzer, 2003

0.0001%

Vs

1 out of 1000000

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Class Q:

Which is more probable?• Ram had one or more heart attacks• Ram is 70 years old and has suffered one or

more heart attacks

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Take homes

• Econs vs Humans• Expected value, expected utility, Bernouli,

Prospect Theory• Modes of thought – System 1 vs System 2• Heuristics and biases is part of life• Too many choices is not always great

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General Readings

• For general topics, see the chapters on thinking, reasoning and problem solving from your textbooks

• A nobel prize in economics goes to a psychologist in decision making – Daniel Kahneman : http://www.forbes.com/2002/11/06/cx_da_1106nobel1.html

• Too many choices in life?: http://www.nytimes.com/2010/02/27/your-money/27shortcuts.html

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Videos

• Are we in control of our decisions? http://www.youtube.com/watch?v=9X68dm92HVI (Dan Ariely)

• Riddle between experience and memory: http://www.youtube.com/watch?v=XgRlrBl-7Yg (Daniel Kahneman)

• Paradox of choice: http://www.youtube.com/watch?v=VO6XEQIsCoM (Barry Schwatrz)

•See http://www.youtube.com/watch?v=VO6XEQIsCoM for paradox of choice and also http://www.youtube.com/watch?v=lDq9-QxvsNU for art of choosing