1. Framing and Decision Making
Session 12
Framing and Decision Making

2. Asian Disease Problem
Imagine that the US is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people.  Two alternative programs to combat the disease have been proposed.  Assume that the exact scientific estimates of the consequences of the programs are as follows.
Program A:  If Program A is adopted, 200 people will be saved.
Program B:  If Program B is adopted, there is 1/3 probability that 600 people will be saved, and 2/3 probability that no people will be saved.
Which of the two programs would you favor?
Program A:  If Program A is adopted, 400 people will die.
Program B:  If Program B is adopted, there is 1/3 probability that 1/3 probability that nobody will die, and 2/3 probability that 600 people will die.
Which of the two programs would you favor?

3. Ticket versus Lottery Ticket Lottery
$100 for traffic ticket and be done with it, or challenge it, and take a chance of getting it dismissed or paying double the ticket value (for court fee).
Lottery
Two stage game in which, at end of Stage 1, you have won $100. Now you choice is to take your cash and leave or go to Stage 2, taking a chance of making an additional $100 or losing $100.

4. Framing and Risk Preference
Tendency to choose riskier options under loss frames rather than gain frames.
A pure framing effect (Asian Disease Problem)
A genuine reflection effect (Ticket/Lottery)
Has to do with shape and curvature of the utility functions in the domain of losses and gains.
This is described in Prospect Theory (Kahneman and Tversky, 1979).
Violates the general assumption of economic behavior that people should respond to absolute outcomes not relative outcomes.

5. Prospect Theory Over weighting of certain outcomes Value-function
Certain losses are more aversive, certain gains are more attractive.
Value-function
Concave in gains
Convex and steeper in losses
Decreasing marginal utility and disutility
The psychological intensity of outcomes of increasing magnitude is progressively smaller.

6. Prospect Theory and Reflection Effect50 90
-50
-90
Value of Outcome
Magnitude of Outcome 10
-10
V(Risk-free)
V(Risky)
V(Risk-free)
V(Risky)

7. Why then…? Do people buy lotteries? Do people buy insurance?
Limitations of Prospect Theory
Holds better in low involvement decisions
Holds better when outcomes are amenable to mathematical computation

8. S-P/A Theory Security-Potential Aspiration Level
Security orientation leads to risk aversion
Potential orientation leads to risk seeking
A personality trait
Aspiration Level
The minimum payoff/maximum loss rules the risky option in or out
No clear predictions under losses and gains

9. Where’s the Fat? Package A states that product contains 75% fat.
Package B states that product is 25% fat free.
Which would be preferred more?

10. Attribute Framing
Varying the description of the option by framing the attribute of the option.
Specifically, focusing on presence of undesirable versus desirable attributes, or absence of desirable versus undesirable attributes.
Positive attribute framing results in higher persuasion compared to negative attribute framing.
Works by trigger differential elaboration.
Positive frames cause contemplation of positive states of affairs relative to negative frames.

11. Skin Exam
By taking the skin exam now, you will give yourself an opportunity to detect and treat any problems.
Positive goal frame or outcome frame
By not taking the skin exam now, you give up an opportunity to detect and treat any problems.
Negative goal or outcome frame.

12. Loss Aversion Explanation for Goal Framing Effects
Everything else being equal, people are more averse to losing than they are attracted toward gains of equal magnitude.
Hence, greater motivation to avoid losses.
Value of Outcome
Magnitude of Outcome

13. Choosing versus Rejecting
What if we asked people to add options to a base computer versus remove options from a fully loaded computer.
Principle of task invariance suggests, nothing should change.
People should wind up with very identical final configurations.
Study:
Simulated computer purchase scenario.
Online study
Subjects randomly assigned to choose/reject task

14. Effect on Size of Final Option Set
Rejecting (paring down) results in a significantly larger option set compared to choosing (building up).
Y-axis = Number of options.

15. Effect on Value of Choice Set
Rejecting results in significantly higher value of final option set than choosing.
Y-axis = dollar value of the options in final set.

16. Biases in Decision Making

17. Enhance Production Capacity?
9 months back your team decided to go ahead with major modification to your production facilities.
The budget was $10m.
The project is on time, and scheduled to be completed next month.
The project is on budget, and you have invested $9m to date.
You are now informed that a major shift in the market place will put your product on a downward path to extinction, and there is nothing you can do about it.
The question before you is, should you invest the remaining $1m and complete the planned plant modification, and continue or should you abandon?

18. Results A significant majority said, invest. You are not alone.
Many examples
Vietnam
Concorde
Hubble
And this is called, sunk cost fallacy.
Why does this happen?

19. The Source of Sunk Cost Fallacy
Investment at T1
This is a prospect theory account
Incremental losses look smaller in comparison with the potential gain.
As you invest more, it looks like a bigger waste if you abandon, and incremental investment looks miniscule in comparison with the increasingly remote gain.
The killer is that the decision-maker starts abandoning the probability that modifies the gain.
Investment at T2
Investment at T3
Investment at T4
A cost is sunk if it is irretrievable, and has no effects on future payoffs.

20. Alternate Explanation for Sunk Cost Fallacy
Cognitive Dissonance
What is it?
Tendency to engage in revisionist history while looking back at decision.
Engage in behavior, especially information search that:
Strengthens the reasons in favor of decision
Weakens reasons against.

21. More on Sunk Cost Fallacy
Reverse of ‘Hindsight Bias’?
Also known as ‘irrational escalation of commitment’.
Many anecdotes, somewhat weak evidence.
Bought two tickets for Shows A and B worth $50 and $100, and prefers Show A, but finds out that they are for the same day/time, and people choose to go to Show B.
Shuttle mission justified on investments and lives lost.
Source: Friedman et al (2003), preliminary version of manuscript

22. Trading Scenario
Let us say, a slightly intoxicated fellow with plenty of money shows up in class and says “I am feel like giving stuff away”.
I tell him, do the following:
Give half of this class $2.00
Give the other half, a lottery ticket worth some unspecified amount
Randomly decide who belongs in which half.
He does just that.
But then, the Donor thinks a bit and says, “Hey this is good only for those whose preferences for the lottery/money matches what they got…what if they don’t like what they got?”
To which, I say, “Okay, give them an opportunity to switch to the other gift”.
What do you think happened?

23. Endowment Effect
Mere possession of an object causes it to be over valued.
Result, very few people traded.
Replicated in trades involving coffee mugs for $6.00.
Replicated in trades involving coffee mugs for chocolate, 89% and 90% respectively chose to retain what was given to them.
People are willing to pay less than what they would expect others’ to pay.
Cannot be attributed to a simple economic market rationality.
The dropping of the atomic bomb was justified by the $2b spent on the Manhattan Project.

24. Indifference Curves
Desirable Attribute A
Trade down Attribute A
Trade down Attribute B
Desirable Attribute B
Indifferences curves represent the points in satisfaction space that are equivalent for two combinations of items/attributes of value.
For example, a person might have in indifference curve between engine power and upholstery.
Equally satisfied with a car with a powerful engine with cloth interior as with a care with a less powerful engine but a leather interior.
Indifference curves are not supposed to intersect, regardless of whether you start with high interiors and trade down to get more power, or start with high power and trade down to get a better interior.

25. More on Endowment Effect
Endowment effect occurs because indifference curves intersect.
It affects inexperienced traders more than it does experienced traders.
As experience accumulates and trading intensity picks up, endowment effects gives way.
Can be thought of as behavioral inertia.