Part 1: Review each situation (there are FIVE scenarios within the activity) and identify the applicable decision concept (you may select from any theory, principle, model, etc. from our learning in Unit 2) that you believe to be present. Make sure you also explain (for each concept identified) “how” and “why” you arrived at your conclusion. In other words; what information helped you select each concept for each situation? Be sure you separate your findings and support for each of the different scenarios (don’t put all your findings & support in a single block paragraph).

Part 2: Look at the different decision concepts you identified in part 1. What do you think those different concepts imply about how people make decisions?

Part 3: Do the decisions we make always need to be rational? Under what circumstances are we (decision makers) likely to make irrational choices?
Activity #1

If you were given a choice, which of the following gambles would you prefer?

$1,000,000 for certain
A 10 percent chance of getting $2,500,000, an 89 percent chance of getting $1,000,000, and a 1 percent chance of getting $0.
Answer:

Most people choose the sure outcome, but the alternative choice has an expected value greater than $1,000,000. The alternative expected value once calculated is as follows: EV = (.10)($2,500,000) + (.89)($1,000,00) + (.01)($0) = $1, 140,000 compared to the certain $1,000,000 in selection A.

If you were given a choice, which of the following gambles would you prefer?

An 11 percent chance of getting $1,000,000 and an 89 percent chance of getting $0.
A 10 percent chance of getting $2,500,000 and 90 percent chance of getting $0.
Answer:

Most people select Alternative B reasoning that there is little difference between a 10 or 11 percent chance of winning, but there is large difference in expected value. The problem is this: If you chose A in the first scenario you should also select A here. Likewise if you selected B in the first scenario, you should also select B here. The two choice situations offer the identical alternatives except for the addition of an 89 percent chance of winning $1,000,000. How did you do?

Activity #2:

Suppose you consider the possibility of insuring some property against damage (e.g. fire or theft). After examining the risks and the premium you find that you have no clear preference between the options of purchasing insurance or leaving the property uninsured.

It is then called to your attention that the insurance company offers a new program called probabilistic insurance. In this program you pay half of the regular premium. In case of damage, there is a 50 percent chance that you pay the other half of the premium and the insurance company covers all of the losses; and there is a 50 percent chance that you get back your insurance payment and suffer all of the losses.

For example, if an accident occurs on an odd day of the month, you pay the other half of the regular premium and your losses are covered; but if the accident occurs on an even day of the month, your insurance payment is refunded and your losses are not covered.

Recall that the premium for full coverage is such that you find this insurance barely worth its cost. Under these circumstances, would you purchase probabilistic insurance?

Answer:

80 percent of students that responded to this item in a study conducted by Kahneman and Tversky indicated that they would not purchase probabilistic insurance. People apparently would rather eliminate risk than merely reduce it, even if the probability of a catastrophe is diminished by an equal amount in both cases (as is the case here).

Activity #3:

How much money would you pay to play a game in which an unbiased coin is tossed until it lands on Tails, and at the end of the game you are paid ($2.00)k where k equals the number of tosses until Tails appears? In other words, you would be paid $2.00 if Tails comes up on the first toss, $4.00 if Tails comes up on the second toss, $8.00 if Tails comes up on the third toss, and in general:

Tosses Until Tails 1 2 3 4 5 … K
Payoff in Dollars 2 4 8 16 32 … 2K

Answer:

The expected value of this game (the average payoff you would expect if the game were played an endless number of times) is infinite, yet very few people are willing to pay large sums of money to play. Mathematician Daniel Bernoulli arrived at a solution to this paradox, however, by reasoning that the value, or utility,. of money declines with the amount won (or already possessed). Specifically, he argued that a gain of one thousand ducats is more significant to a pauper than to a rich person though both gain the same amount. By assuming that the value of additional money declined with wealth, Bernoulli was able to show that the expected utility of this game is not infinite after all.

Activity #4

If you were given a choice which of the following would you prefer?

A 1 in 1000 chance of winning $5000.00
A sure gain of $5.00.
Answer:

Of the 72 respondents that originally made this choice, nearly three in four chose the first alternative. Thousands of people make much the same choice each day when they purchase lottery tickets.

If you were given a choice which of the following would you prefer?

A 1 in 1000 chance of losing $5000.00.
A sure loss of $5.00
Answer:

Of the 72 respondents that originally made this choice more than four out of five preferred the sure loss. Researchers Kahneman and Tversky explained this almost overwhelming preference in terms of a tendency of most people to overweight the chances of a large loss – a tendency that greatly benefits the insurance industry.

Activity #5:

You are the chair of a faculty search committee consisting of five other members: Ann; Bob; Cindy; Dan; and Ellen. Your task is to hire a new professor and the top three preferences have already been determined to be Joe Schmoe, Jane Doe, and Al Einstein. Suppose you know everyone else's preferences, as shown in the table, and you want to control the balloting so that Al Einstein is chosen.



Ann Bob Cindy Dan Ellen
Joe Schmoe 1 1 2 3 3
Jane Doe 2 3 3 1 1
Al Einstein 3 2 1 2 2

What should you do?
Call for a direct vote between Schmoe and Einstein followed by a direct vote between Einstein and Doe
Call for a direct vote between Schmoe and Doe followed by a direct vote between Schmoe and Einstein
Call for a direct vote between Einstein and Schmoe followed by a direct vote between Doe and Einstein
Why can the person setting the agenda have complete control over the outcome?
Answer to question A:

If you selected #1 you are incorrect. This would serve to get Jane Doe hired. Reexamine the committee members’ preferences and use a strategy that avoids direct votes between Al Einstein and Jane Doe.

If you selected #2 you are correct. This strategy avoids direct votes between Einstein and Jane Doe and would effectively serve to get Al Einstein selected.

If you selected #3 you are incorrect. This would serve to get Jane Doe hired. Reexamine the committee members' preferences and use a strategy that avoids direct votes between Al Einstein and Jane Doe.

Answer to Question B:

Because the committee's preferences are intransitive with a majority rule based on pairwise comparisons, the person setting the agenda has complete control over the outcome.


Questions and Answers

Question #1
What is Expected Utility Theory?


Classical expected utility theory was not intended to describe actual human behavior. Expected utility theory is, instead, a normative theory that suggests how you will likely behave if you follow the requirements of rational decision making. What does that mean to you? It means that there are some guidelines you could use when making a decision and when you are trying to understand how other people make decisions.

Let’s examine these principles by using everyday examples of rational decision making in action.

You are shopping for an automobile. You have three children so it must be large enough for the entire family. Even if you saw a small car you liked, it would not be practical. Ordering of alternatives says that you will compare alternatives such as large and small; that auto size will be very high in the order of your alternatives; and that you will not consider a more attractive small car.
A rational, reasonable person will never make a decision that is dominated by other strategies.
When faced with a decision between two or more items; if all the items have some common characteristic such as convenience, price, or color, that common characteristic is cancelled out. If you love three cars and they are all red, then you will have to base your decision on which one to buy on something other than color, because they all have the same color, thus, negating that characteristic as a deciding variable.
An example of transitivity would be as follows: You and your friends go out to eat together after work. You all like hamburgers better than pizza, so, even though there is an Italian restaurant closer, you will drive past it to find hamburgers.
Continuity says that you would prefer to risk making a choice between an excellent outcome to your decision or a horrible outcome, rather than having a guaranteed outcome that was neither excellent nor horrible but somewhere in between.
The rule of invariance suggests that you would not be affected by the way your options are presented to you.
It is important to remember that expected utility theory has been altered and extended by later scholars. Thus, even though expected utility theory is often discussed as a monolithic theory of rational decision making, it is more aptly described as a family of theoretical suppositions.


Question #2
Am I a rational decision maker? How do I know? Is it important?


To be truly considered a rational decision maker, you would need to select the decision that would give you the best results after having made the decision. To know if you have made a rational decision can take time. You might not know right away if you made the best choice. It is also possible that you believe, at first, that you have made the right decision, only to discover weeks later that not only it was not the best decision, but worse, it was the wrong decision.

Why would you make an irrational decision? If you did, it would probably only be because you did not realize it was irrational at the time you made the decision. You might have made an irrational decision because:

You assumed certain things to be true that were not true, or assumed certain things to be false that were not false. (The product warranty was only 60 days, not the one year that you expected.)
You might not have had adequate, complete or accurate information upon which to base your decision. (You had to choose between a concert and a sports event to attend with your friends, but you didn’t realize that the tickets are sold out for the concert.)
Your perception could have been highly selective (I don't like that color of blue on a car; that restaurant always puts too much salt on their food)
You did not know everything that would happen to you after making each decision.
Is it important to be a rational decision maker? That depends on numerous factors such as how rationality and logic are culturally defined, the importance of the decision, and the context in which the choice was made. What to eat for lunch probably does not deserve extensive research and study to avoid undesirable consequences. Choosing the right education and career for your future happiness, however, is likely to yield more significant consequences and deserves more time and attention than the former.


Question #3
Why are models based on rationality problematic?


As sensible as the principles of rational based models sound (in particular, expected utility theory); there are many cases in which decision makers violate those principles. In fact, decisions that cannot be defended as logical may nevertheless be rational if, over the long run, it provides a quick and easy approximation to normative strategies that maximize utility. Simply put, the pillars of cancellation, transitivity, invariance, and dominance were not consistently supported by continuing research. In fact, actors made seemingly choices that could still easily be seen as rational acts. As a result, expected utility theory operated better as a normative theory, how people might act than as a descriptive theory, how people do act.


Question #4
How can the endowment effect influence my decisions?


The endowment effect is a result of loss aversion in which the value of a good increases when it becomes part of a person’s endowment. In other words, you are likely to name a selling price for something you own that is higher than what you, yourself, would be willing to pay for the same item. Richard Thaler and his colleagues suggest that the reason for this effect is that losses are felt more strongly than equivalent gains.


Question #5
What are noncompensatory strategies?


When people are confronted with complex choices among a number of alternatives, they typically use noncompensatory strategies. In contrast to compensatory strategies, these strategies do not allow trade-offs. Four well-known examples of noncompensatory strategies are the conjunctive rule, the disjunctive rule, the lexicographic strategy, and elimination-by-aspects.

Conjunctive rule: Decision makers using the conjunctive rule eliminate any alternatives that fall outside certain predefined boundaries. In other words, it is an example of satisficing, not optimizing.
Disjunctive rule: According to the disjunctive rule, each alternative is evaluated in terms of its best attribute, regardless of how poor other aspects of the alternative may be.
Lexicographic strategy: A decision maker using this strategy begins by identifying the most important dimension for comparison and choosing the most desirable alternative or alternatives on this dimension. If more than one alternative remains, the alternatives are compared on the next most important dimension, and then next, and so on until only alternative remains.
Elimination-by-aspects: The elimination-by-aspects strategy is essentially a probabilistic lexicographic strategy. Each aspect of comparison is selected with a probability proportional to its importance. The alternatives are first compared with respect to a selected aspect, inferior alternatives are then eliminated, another aspect of comparison is selected, additional alternatives are eliminated, and so forth, until only one alternative remains within the field of choice.

Question #6
What is counterfactual reasoning?


As prospect theory makes clear, decision makers evaluate their alternatives relative to a reference point. The status quo is probably the most common reference point, but in some cases, people compare the quality of their decisions to what might have happened if they had made a different choice. This comparison of imaginary outcomes is sometimes referred to as counterfactual reasoning because it relies on hypothetical events.


Question #7
What is satisficing?


Actually, one the earliest alternatives to expected utility theory was Herbert Simon's notion of satisficing.Simon contended that people rather than optimize when they make decisions.To satisfice is to choose a path that satisfies your most important needs, even though the choice may not be ideal or optimal.