Week 2 - Decision Making

• What is decision making? Set of cognitive processes by which people choose an action from a set of different possible alternatives.
• What is preference-based decision making? Decisions made on basis of our preferences over consequences of different possible actions

  e.g.

  • do we want to go to PSY3051 lecture in person or online?
• What is perceptual decision making? Involve choosing between competing interpretations of incoming sensory information

  e.g.

  Does that carton of milk smell like it has gone off?

  • What is the noise on the roof?
• What is expected utility theory? An economic theory that describes how people make decisions. People behave in a way that maximises their expected utility
• What are decisions in expected utility theory based on?

  1.     Acts

  2.     Consequences

  3.     States
• What is an Act? Different actions a decision maker can take, what they are choosing between (within our control)
•  

  What is a Consequence? Different possible outcomes/ results of an act. Can be pleasant, unpleasant or neutral

   

  e.g. if I stay in and study, I consequently get good grades, if I go out and party, I consequently fail
• What is States? All factors outside of a decision-makers control. State may determine which consequences follow an act
• What do people do? Calculate the expected utility of their actions – how good they expect it to be and choose the one with the highest utility
• What is utility? The degree to which a given consequence helps an individual achieve their goals. How good or bad a given consequence is
• When does a consequence have positive utility? Takes you closer to achieving your goal
• When does a consequence have negative utility? Moves us further away from achieving goal
• Is utility subjective? YES, can differ between different people and can change over time

  e.g. childhood photos, have value and sentiment for someone (positive utility) while no sentiment for another (no utility)
• What is the utility of drinking a bottle of water? It DEPENDS on what your goals are
• When does drinking bottle of water have positive utility? Lost in dessert for ages, so drinking water to hydrate has positive utility
• When does drinking bottle of water have negative utility? When you have already drank 20L and are being forced to drink more. This has negative utility. 
• What do we choose according to? The expected utility of ACTS not the utility of consequences
• What is the ‘expected’ part? When we make decision, we should consider not only the utility of different possible consequences but also the probability of each consequence – to calculate how much utility we EXPECT to get from particular ACT

   

  THUS we choose option with maximum expected utility
• What is assumed in decision making? People are assumed to be rational
• What does it mean to be rational? Making decisions that maximise expected utility
• Why can we not prove/disprove rationality in decision making (particularly buying a lottery ticket)? Utility is defined in terms of progress towards a goal

  
  

  THUS  small cost of lottery ticket does not have much affect on one’s goals but large prize may be VERY important for one’s goals. THUS buying lottery ticket would be rational.
• What is Risk Aversion? Preference for relatively certain outcomes over relatively more uncertain outcomes. Preferring the safe option over the risky option.
• What can risk aversion be explained by? Economic theory called Prospect Theory
• What is Prospect Theory? Utility function, which tells us how the objective numerical amount of a product relates to subjective utility
• How does decreasing marginal utility explain risk aversion?

  -       Decreasing curvature of the utility function, every additional dollar is worth slightly less than the dollar before (similar to microwaves)

   

  Applying expected utility theory to utility of different monetary amounts can explain risk aversion

   

   
• Explanation of how decreasing marginal utility explains risk aversion:

  because of decreasing marginal utility, each additional dollar tends to provide less additional satisfaction than the previous one.

  When faced with uncertainty, individuals often exhibit risk-averse Behavior, preferring a certain outcome over a risky one with the same expected value. This Behavior can be explained by the diminishing marginal utility of money. Because each additional dollar provides less satisfaction, individuals are more averse to risking losing money than they are inclined to gain it.
• Why do people have different utility functions?

  Different goals and preferences
• Who is more risk averse? Bryce (his utility function is more curved)

  
• Who is risk neutral? Clara

   

  Who has increasing marginal utility? Daniel (3 microwaves worth more than 2, 5 microwaves worth more than 4)

   

  Who is risk seeking? Daniel

   

  
• What is Loss Aversion? Tendency to prefer avoiding losses more strongly than acquiring similar-sized gains
• Why are people loss averse? Negative utility from losing something (loosing $1000) is stronger than the positive utility of gaining something ($1000)

   

  e.g.

  Option C = 50% chance of losing $1000, 50% chance of gaining $1000

  Option D = no money changes hands

   

  Loss averse people pick option D, as possibility of losing $1000 outweighs possibility of winning $1000

   
• How does Prospect Theory explain loss aversion?

   

  -       Below the reference point (centre), there is a decreasing marginal utility

  -       Losing the first coffee mug stings the most, losing the second one stings less, and the third even less.

  
• -       Below the reference point, the loss domain is steeper than in gain domain

  -       Loss looms larger than gains where it costs more to lose than it does to gain

   

  -       People are loss averse as utility is steeper in loss domain that it is in gain domain

  
• as 0 > -150, the expected utility of Option D is the option to choose.

  *also note the utility of losing $1000 (-700) is far greater than the utility of gaining $1000 (400)

  
• Loss aversion suggests that the pain of losing something (like money or possessions) is psychologically greater than the pleasure of gaining the same amount. This is because losses are evaluated relative to the current state, and losing something means moving away from that reference point, resulting in a decrease in utility.
• Who is more Loss Averse? Eiko (steeper utility function in the loss domain)

  
• What is the reference point in prospect theory?

  -       The point we compare potential consequences to when we make decisions

  -       It can be anything
• Why do stores show you the original price when displaying sale items?

  -       Showing old price of sale item is designed to shift your reference point

  -       By emphasising the cheaper price, the seller is trying to emphasise the gain relative to the old price
• What is the framing effect? People make different decisions in exact same situation depending on whether the scenario emphasises potential gains or losses
• What is the endowment effect? People tend to over-value things they already own and under value things they do not own

  -       They feel endowed with an object which changes utility of that object. Once given an object, the object becomes the reference point thus thought of having the object taken away triggers loss aversion which outweighs gain of the object when it isnt ours.

  e.g.

  50 participants given mugs and asked how much they would sell their mug for

  50 participants were asked how much they would buy a mug for

  Average selling price was more than twice of buying price