what are descriptive models?
models of how decision processes operate, irrespective of whether the outcome of the decision is good or bad
what are normative models?
normative models evaluate a decision in terms of the goals of the decision maker where here decisions can be good or bad and if a decision is good it reaches these goals
what does rational choice theory assume about the decision maker?
- assumes the agent has full access to all alternatives
- knows the probability of their outcomes
- knows the value of their outcomes
what is a rational decision according to classical economics?
maximises the expected value = the mathematically best outcome on average
what is bounded rationality?
we have a limited cognitive capacity so limited information on outcomes
what is the formula for expected value under certainty ?
EV = p (outcome) x value
what does rct predict a player should pay in the St Petersburg game?
RCT would suggest that a player should be willing to pay virtually any sum of money since EV is infinite
Why is the St Petersburg example considered a paradox?
Although the expected value of a gamble is infinite the subjective utility is low since the chance to win a high value is quite low
what is marginal declining utility?
each additional unit of wealth is less than the previous one
utility of additional currency units decreases as the number of currency units increase
what is expected utility theory?
it clearly defines what the rational choices are and allows the choice outcome to be situationally dependent
what two rules must a decision satisfy to follow expected utility theory?
weak ordering - we must be able to say we prefer one choice over the other (A is better, B is better, or equal).
transitivity - your preferences must be consistent eg If A > B and B > C, then A > C must also be true).
Who developed Prospect Theory and what type of model is it?
Kahneman and Tversky developed prospect theory as a descriptive model of decision making. Intended to account for deviations from rational choice theory
what are the two main components in prospect theory?
utility and probability
what does the value function X axis represent in prospect theory?
reflects gains to the right and losses to the left instead of total wealth
what does the midpoint represent in the value function graph?
persons current reference point
what is the certainty effect?
for gains people prefer certainty
How are probabilities treated in Prospect Theory?
Probabilities near 0 are overweighted relative to objective probabilities, probabilities near to 1 (but not 1) are underweighted!
People overestimate tiny chances (e.g., thinking they might actually win the lottery)
People underestimate high chances (e.g., thinking 90% success is less certain than it is)
what is a consequence of the Pi function?
very low probabilities tend to be over weighted eg people believe that their chances of winning the lottery are larger than they really are
what is the core assumption of regret theory?
we will regret a decision if an alternative outcome would have led to a higher pay off ( even when the prospect was better)
what is the discounted utility model and who came up with it?
Paul Samuelson (1937, Nobel prize 1970). The normative assumption is that the discount function is an exponential constant rate.
This model says people reduce the value of future rewards just because they’re delayed.
So even though £1000 in 10 years is mathematically better than £500 today, people still choose £500 now — because future gains feel weaker.
What are the 3 properties of exponential discounting?
If there is no delay there is no discounting
As delay increases the present value decreases
As delay approaches infinity the present value approaches zero
What is Hyperbolic Discounting?
The hyperbolic function has the same 3 properties as the exponential function but does accommodate dynamic inconsistencies.
what does Lowenstein (1996) suggest?
that the temporal and physical proximity of options that can reduce aversive states eg hunger leads to a disproportionate increase in the attractiveness of these options
that people with low discount rates, rather than exhibiting self-control, are in fact differing in the way they anticipate the emotional state of the outcome.
what did Ziegler and Tunney find ?
discount rate varied as a function of the coefficient of relatedness (as a measure of social distance) with decisions made for ourselves being more impulsive than decisions made for other people.
