Two Ways to Study Decision Making

• Rational Choice Theory

– Articulated by economists, philosophers and mathematicians

– A normative approach: it prescribes how people ideally should make decisions

• Behaviorial Decision Theory

– Developed by psychologists and cognitive scientists

– A descriptive approach - it generalizes about how people actually make decisions

Sample Claims within Rational Choice Theory

• If you believe the Hoosiers have a 75% chance of winning their next game, then you must also believe that they have a 25% chance of losing it.

• If you prefer world music to rap and prefer jazz to world music, then you must prefer jazz to rap.

Sample Findings of Behavioral Decision Theory

• Jones may believe that:

– the Hoosiers have a 75% chance of winning tonight

– although if the game goes into overtime, they have only a 25% chance of winning

– but, luckily, there is only a 50% chance of the game going into overtime

Violation of the Probability Calculus

Another Example:

• Jones is the commander of 600 soldiers caught in an ambush. An aide describes two possible escape routes:

– If they take route A, 200 hundred soldiers are likely to die.

– If they take route B, 400 are likely to survive.

• “The choice is obvious”, says Jones. “Clearly route B is the best. Let’s get these guys out of here.”

Framing Effects

• Jones’ mistake was to be misled by how the decision was framed.

• Investors in the stock market exhibit lots of subtle framing effects.

• In their book Why Smart People Make Big Money Mistakes, Gary Belsky & Thomas Gilovich call such cases examples where “When six of one isn’t half a dozen of the other”.

Overall Plan of this Course

• We will begin with a unit on Rational Choice theory. Here we will supplement the textbook with chapters from other books posted on the web site.

• Our text will provide most of the readings for a unit on Behavioral Decision Theory.

• We will then juxtapose the two approaches and look at some criticisms of each.

Terminological Equivalents

• Although the content of Rational Choice Theory is quite stable, different writers use different terms for basic concepts. Here are some synonyms:

– We must {decide, choose} from a set of {options, actions}

– The anticipated {outcomes, consequences, states of affairs} resulting from our {decision, choice} often depend on

- {contingencies, conditions, states of the world} over which we have no control.

Talking the Talk

• Jones’ aide presented two {options, possible actions}, route A and route B.

• The {outcomes, consequences, final state of affairs) as described by the aide were identical.

• The outcome of a bet on the ballgame may well depend on {contingencies,conditions, states of the world} such as whether it went into overtime.

Swim Ticket Decision

• A ticket allowing the bearer to use a certain beach all weekend costs $3 if purchased during the week, while a single day’s admission costs $2 if paid on the day.

• Here is a matrix showing possible purchasing actions, various weather conditions, and the consequences of combinations of purchases and weather.

Matrix for Swim Ticket Problem

Which Swim Ticket Option Is Best?

• To decide between the options we would ideally like to have a weather forecast that would tell us {the probability of, how likely} each possible outcome is.

• We also need to assign a {value, desirability, utility} to each outcome.

• Here are some plausible assignment of probabilities and relative values to the outcomes.

Assigning Probabilities

• From the weather forecast Jones surmises that there is roughly a 50% chance of having exactly 1 day of good weather, 25% of the weather being good all weekend long and 25% chance that it will be bad both days.

• Jones also assumes that the weather is independent of whether he buys a weekend ticket or not!

Assigning Value Numbers

• In evaluating each outcome, Jones has to look at both the cost of the ticket and the benefit of getting to swim.

• For the moment, let’s assume that each day of actual swimming is worth $5 to Jones.

• In this case the overall value of each outcome can be represented as follows:

Matrix of Values