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A first lecture in basics of human decision making
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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