Behavioral Decision Making 90L – 6 ECTS Credits First spring semester 2014 Instructor: Outi Somervuori, Jyrki Wallenius Mondays 13-16, Tuesdays 13-16

2 Outline Overview of the course  Introduction  Contents  Evaluation and Grading  Objectives Introduction to the analysis of decisions Behavioral decision making research Reference: Baird, B. F.: Managerial Decisions Under Uncertainty: An Introduction to the Analysis of Decision Making, Wiley, 1989 (textbook) – or other introductory texts

3 Objectives, overview of the course The purpose of this course is, within risky and riskless choice to: provide an overview of behavioral decision research understand the anomalies within classical decision theories utilize the basic (descriptive) decision models in practice differentiate between descriptive and normative theories of decision making provide an idea how to improve decision making relate the theories to the domains of financial decision making and consumer decision making

4 Objectives, overview of the course --- much of the course is a criticism and extension of the classical expected utility model Readings: many classic papers (Herbert Simon, Amos Tversky, Daniel Kahneman, James March, Howard Raiffa, Antonio Damasio, Antoine Bechara) Can you conduct behavioral decision research after the course? … Can lead to it …

5 Contents of the course  Introduction to the analysis of decisions (Expected Monetary Value, Expected Utility)  The subjective components of decision making  Utility  Subjective probabilities  Limited rationality (Herbert Simon)  Axioms, limitations and anomalies in EU model  Probabilistic reasoning: heuristics and biases  Theory of choice: Tversky-Kahneman prospect theory, evidence from the field

6 Contents of the course … continued  Role of Framing and Context  The role of emotions in decision making Psychophysiological and neurological methods in decision- making  Motivational factors in decision theories Atkinson’s motivational determinants of risk-taking Regret theory  Improving decisions Even Swaps  Organizational decisions

7 Grading policy – multiple components  Final exam 40% (First exam , second )  2 sets of homework problems (total 20%) – note due dates  Essay questions (total 20%) – largely not covered in class – note due date  Class presentation 10% ( me your pp slides)  Mandatory readings, class participation 10 % Note: Need to have a passing grade from each component Course: Combination of lectures, student presentations, class discussions, “small-scale” experiments, readings, essays, homeworks Readings: Where to get copies? Articles? Book chapters? When to read?

8 Grading policy … continued Essay questions  Generally topics not covered in class, broaden your perspective on behavioral decision research  2 essays, 2 papers each Student presentations: show slides  Agree on who presents what when  Agree on the format, length etc (30-45 min including discussions, pp slides) Homework problems: 2 sets hand out, will be posted on website, note due dates

INTRODUCTION TO THE ANALYSIS OF DECISIONS

10 Introduction to the analysis of decisions: descriptive vs normative Positive (descriptive) versus normative (prescriptive): fundamental difference Descriptive: How are decisions made? Prescriptive: How should decisions be made? What decisions should we make?  80% descriptive, 20% normative in the course  Sometimes same decision model is used for both purposes  Descriptive = behavioral decision theory … but also interested in improving decisions  Prescriptive = decision analysis, management science (“the science for better”)

11 Introduction to the analysis of decisions … examples Examples of decision problems (personal, corporate)  Choice of consumer durables  Company recruiting decision  Buying a home  Choice of a location for a commercial airport  Whom to vote in presidential elections  Pricing alcoholic beverages  Deciding about the rate at which random sampling of the production line is to take place Uncertainty, multiple conflicting objectives (attributes, dimensions) – either or both; small versus large number of alternatives

12 Introduction to analysis of decisions: combining objective and subjective Decision making has two important subjective elements:  Quantification of uncertainty (probabilities)  Quantification of preferences using utilities/values You can choose to ignore probabilities and utilities/values – and just make choices … but they are embedded in your choices, in other words your choices reflect your utilities/values and your perception of the likelihood what will happen Decision theorists have developed theories of choice (normative and descriptive) that are often based on these concepts

13 Introduction to the analysis of decisions … framework Theorists conveniently distinguish 4 steps in decision making:  Structuring the problem  Generating alternative courses of action  Specification of possible consequences for each alternative  Indicating the chronology of the problem (what happens when), including options for collecting information  Describing likelihoods of the possible consequences of each alternative (often subjective)  Assigning utilities (values) to the possible consequences (subjective)  Synthesizing the information to explain why a particular alternative is chosen or should be chosen (theory of choice)

What else influences decision making?

Source: Johnson & Goldstein, 2003, Science.

Madonnan CD (Hsee & Rottenstreich, 2004) How much would you be willing to pay for Madonna’s CD (5 CD or 10 CD)? Group 1: valuation by calculation 5 CD, average 15,10 USD 10 CD, average 28,81 USD Group 2: valuation by emotion 5 CD, average 22,64 10 CD, average 19,77

Information processing A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost? –Intuitive answer: 10 cents –Correct answer: 5 cents

Information processing = 18 x 27 =

Can there ever be too many options? (Iyengar & Lepper, 2000) Two conditions: small assortment 6 jams x large assortment 24 jams Every consumer who approached the table received a coupon to get $1 off the purchase of any jam of that brand. Results –more consumers approached the tasting table when it displayed 24 jams –30% of all consumers who saw the small assortment of six jams at the tasting display actually bought one of the jams (with the coupon), whereas in the large assortment case, only 3% of the people redeemed the coupon for a jam Too many options decreased the motivation to make a choice

What else influences decision making? E.g. Framing Emotions Intuition Information overload  Often people make systematic and predictable errors in decision-making.  These features may help or hurt decision making.