How do we maximise expected utility?
- Sum of the outcome of utility multiplied by the probability of the state
- Ai = what you can do
- Sj = possible ways the world can turn out
- Oij: Consequences of act, given a particular state
- e.g A: BBQ indoors/outdoors, S: Sunny vs Rain = 4 outcomes combining S & A
- Then have to assign a utility matrix to each of the combinations e.g bbq and sunny has a 100 utility = subjective numbers
- EU = Sum of (Utility x Probability of it occurring)
What are the four axioms of expected utility theory?
- Cancellation: Sure-Thing principle
- Transitivity
- Dominance
- Invariance
- If a decision maker wants to maximise EU, they MUST obey these axioms otherwise it is not a good decision/EU
What is the Sure thing principle?
- States of the world that give the same outcome regardless of someone’s choice can be eliminated from the choice problem
- Seen through the Allais Paradox as well as the Ellsberg Paradox
- As payout matrixes is the same as some of the outcomes are the same regardless of choice
- All axioms tend to be intuitive and applications of principles are complex
What is transitivity?
- If option A > B, B > C, MEANS A > C
- But our preferences are not always transitive e.g taste = lollipop example
- Often occurs when you compare things on different dimensions
- Can be seen in real life with time lapse
What is Dominance?
- If A is better than B in at least one respect, and at least as good as B in all other respects, A will be preferred to B
- Tend to follow dominance principle when application is apparent but don’t when implications are not immediately obvious
What is invariance?
Preferences should not depend on how the options are described or how the preference is elicited
What is the compatibility principle?
- Putting a price on something increases the saliency of the potential pay off
- Choosing between actions increases the saliency of probabilities
- Choosing 1 out 5 may not yield the same choice as eliminating 4 out of 5
What is Prospect Theory?
- How people assess value and make decisions
- Have objective gains on x axis, and subjective utility/value on y axis
- S-shaped curve: steeper for losses than for gains
- Reference neutral: changes are evaluated not with respect to total wealth but change in wealth
What is the isolation effect?
- People tend to be risk averse for gains, and risk seeking for losses
- Normally, you ignore what you have already and you only evaluate the change
Prospect theory: losses
- Losses loom larger than gains: hurts more to lose £100 than to win it
- Value function is steeper for losses than gains
- Most people would not accept 50:50 gambles with equal prospects
What is the Status-Quo Bias/ Endowment effect?
- Items/prospects are valued higher when owned already and contemplate giving them up e.g lottery tickets
- Valued lower when people contemplate acquiring them
- Seen irl with free trials etc. because you value it higher: no longer thinking do you want to have it but do you want to give it up - hurts more to give it up = more likely to purchase it
What is the pattern of choice behaviour for simple gambles?
- Small probabilities: Gains = risk seeking, Losses = Risk aversive
- Med/Large probabilities: G = Risk aversive, L = Risk seeking
What are decision weights?
- Small probabilities are overweighted e.g choose between losing £5 for sure or have a 0.1% chance of losing £5K
- Med/Large probabilities are underweighted
- Extreme changes when switching to certainty
- Certainty effect - Assurance is worth a lot to us (explains the Allais paradox)
What are Framing effects?
Violation of the invariance effect: conveying EXACT SAME info but in different ways (expressed differently)
What is attribute substitution?
- People sub in a hard question with an easier answer e.g how probable is X = how easily do instances of X come to mind?
- Must be related to target attribute and is a natural assessment = automatic cog procedure
What is ambiguity aversion?
- Decision makers have aversion to uncertainty
- Or that people are reluctant to choose options they are ignorant about
- People bet in situations where they think they are competent BUT also bet on chance events rather than probability where they thought they had little competence
What are the negatives of prospect theory?
- Describes but there is no psychological explanation for the processes
- It does not include factors that have a strong influence on decision making e.g emotion or regret
What is decision by sampling?
- Addresses people’s value and decision weighting functions
- People do not possess stable internal scales to represent subjective value or probability, the subjective value of an attribute corresponds to its rank position in a sample of attributes
- People’s valuations of attributes will depend on the samples used to generate their rank orderings
What is the evaluability hypothesis?
Some attributes of a choice option may be harder to evaluate in isolation than others
What are context effects?
Consists of similarity and attraction effects: changes in the balance of preference between two options as a result of introducing a third decoy alternative = changing the context between choice
