1 Business System Analysis & Decision Making - Lecture 4 Zhangxi Lin ISQS 5340 July 2006

2 Chapter 3: Framing and Reversal of Preferences Expected utility Risk attitude: aversion, neutral, and seeking Reference point The effect of problem framing Preference reversals focuses: How framing can lead to a portfolio of framing that few of us would want but like to choose. How the perception of “pseudocertainty” can affect judgment How framing causes us to purchase more insurance How we evaluate the quality of a transaction How ownership creates a different frame for evaluation How our mental accounts affect how we frame decisions How we overvalue acts of commission vs. acts of omission The differences between calling a “bonus” vs. a “rebate” Whether we evaluate options separately or simultaneously

3 Framing and the Irrationality of the Sum of Our Choices Question 4 Our tendency to be risk averse concerning gains: a > b Our tendency to be risk seeking concerning losses and negatively framed questions: d > c Combining the choices of Question 4: a, b, c, and d, we have Question 5. However, f > e, where e = a + d, f = b + c. There is a contradict. Suggestion by Kahneman and Lovallo (1993): we would be generally better off following an expected- value rule for most decisions.

4 We Like Certainty, Even Pseudocertainty People underweight high-probability events but appropriately weight events that are certain. The perception of certainty can be easily manipulated. Pseudocertainty: Problem 7.

5 The Framing and the Overselling of Insurance Sure loss (insurance premium) vs. risky option: Called insurance premium - preferred Called certain loss – less preferred Discussion on extended warranty Electronics Car

6 What’s It Worth to You? Example: Buying a bottle of beer at a resort shop Acquisition utility: the value you place on a commodity. Transactional utility: the quality of the deal that you receive, evaluated in reference to “what the item should cost.”

7 The Value We Place on What We Own Experiment of “selling mugs” Values: $7.12 (seller), $2.87 (buyer), $3.12 (chooser)

8 Mental Accounting Problem: The cost of a bottle of 1982 Bordeaux wine? Bought for $20/bottle, now worth of $75 in the market How much does it cost you if you drink one bottle: $0, $20, $20+, $75, or -$55? Good idea or not? Fund raisers frequently call your home for donations. Typically, you got 20 calls in a year just for $10-15 each call. You decide to make a budget of $300 each year to cope with these calls and make fund raisers happy. Is this a good idea? Why or why not?

9 Do no Harm, the Omission Bias, and the Status Quo Omission bias usually supports the status quo Problem 14: heart donation Problem 15: Stock switching Most people think that George will feel much worse than Paul.

10 Rebate/Bonus Framing In 2001 the US paid $38 billion to tax-payers as rebates, but research suggested that this would be better to be called bonuses. Bonuses would have caused citizens to immediately consume the money. “Rebate” participants: “Proponents of this tax cut argued that the government collected more tax revenue that was needed to cover its expenses, resulting a tax surplus”, so it is “withheld income”. – 25% spending “Bonus” participants: “proponents of this tax cut argued that the costs of running the government were lower that expected, resulting in a budget surplus,” so it is “bonus income”. – 87% spending

11 Joint vs. Separate Preference Reversals Outcomes could be reversed between separate evaluation and paired evaluation.