UTorontoX - SP | BE101x-001-Week10303R

Dilip Soman:

This equation that we saw in the last unit is the basis of what is called the expected
utility theory of decision making. This theory relies on five principles, or five axioms,
that underlie rational decision making.
Here are the five axioms. The first one is called completeness. The second one is
transitivity. The third is substitution. The fourth is continuity, and the fifth is
monotonicity. We're going to focus on the first three, because the last two are really
there for mathematical tractability off the model, and they don't have interesting
behavioural insights coming out of those.
Let me start off with completeness. It's a very simple axiom. Completeness says
that when I give a decision maker two options, let's say x and y, the decision maker
should be able to articulate a preference between those two options. In other words,
they should either be able to prefer x over y, or y over x, or they should be able to
say that they're totally indifferent between those two options. What cannot happen is
for the decision maker to say, well, gee, I don't know which one to choose. Now,
we've seen in some of the previous units that in cases where there is too much
information, or when there is overload of data, consumers might actually choose to
not choose, because they're confused, and that would be a violation of this simple
axiom.
Let's go onto to the second axiom, and that's called transitivity. This, again, is a very
simple axiom, and it says the following. Let's imagine a decision maker prefers x
over y, and then chooses y over z. What this axiom says is, in that case, x should be
preferred over z. Now this sounds fairly obvious. If you prefer receiving $100 over
$50, and you prefer receiving $50 over $20, it makes perfect sense that you want to
receive $100 instead of $20. But there are many different domains in which this
particular axiom is violated. And I want to show you one simple example.
Let's imagine that you are looking for a research assistant. You're looking to hire
someone, and you have three applicants, Mr. A, Mr. B, and Mr. C. And for each one

of them, you've got data on two attributes. The first one is their IQ, which is based
on a standardized IQ test. The second one is the number of years of work
experience that these people have. And let's say you've got a very simple rule. You
want to choose the most intelligent person, and if in fact, you have two people of
equal intelligence, then you will choose the one with higher work experience.
If you look at this data, you've got three people. The person with the highest
intelligence score also has the lowest experience. And this is a fairly standard kind
of a set up that you might expect in the real world. Now, here's the interesting part.
We also know from the history of IQ tests that they're not really reliable. They're not
really diagnostic. In other words, a score which is different from 10 points from each
other might not really mean that one person is actually smarter than the other one.
So if I look at these data, 120 is about the same as 110. 110 is about the same as
100.
So if I apply my rule of decision making, here's what it's going to tell me. It's going to
tell me that I will prefer Mr. B over Mr. A, because they're about equally intelligent,
but B has more experience. And likewise, I would prefer C over B. However, if I now
look at the whole picture, I will end up preferring A over C, because now, the
difference between 120 and 100 is significantly large, that by my rule, I end up
picking the more intelligent person.
So this is an example of the violation of the transitivity principle, and it happens in a
number of different domains. Essentially, what's happened here is that the context
has conspired in such a way that the decision maker views the attributes differently
in making choices. So the literature is replete with examples of the violation off this
particular axiom.
Here's the third and more important axiom, and this axiom is called the axiom of
substitution. And it says the following. If I have two options, x and y, and I'm
indifferent between x and y, then I should be indifferent between two lotteries that
have x and y as their price. So for example, if I love an apple as much as I love a
banana, then you come to me and say, well if you're going to toss a coin, in one

case if it's heads, you're going to get an apple. In the other case, if it's heads, you're
going to get a banana. Then I should be indifferent between those two lotteries
because I was indifferent between the two prizes to begin with.
Now, one corollary of this particular axiom is something called the cancellation
principle. And cancellation says that if I've got two options, and I remove something
identical from those two options, I should still now have the same preference
between those two options as I had before. Now it turns out again that this principle,
the principle of cancellation, is often violated in a lot of decisions that we make. And
perhaps the most famous demonstration of the violation of this principle was done
by Maurice Allais in something that is known as the Allais Paradox.
Let's look for a moment at this particular choice. Two options. Option A, I give you a
million dollars, no questions asked. Option B, they're going to play a lottery. In that
lottery, there's a 10% chance that you will win 2.5 million. There's an 89% chance
that you will win one million, and there is a 1% chance that you will win nothing.
In this circumstance, what Maurice Allais found was that most people prefer Option
A. It's a no brainer. It's a million dollars with no strings attached. Makes perfect
sense. Now, let's look at the second problem. Again, if you're choosing here
between two options, we're going to call it A and B. In Option A, we have a lottery in
which there's an 11% chance of winning one million and an 89% chance of winning
nothing. In Option B, we have a second lottery. 10% chance of winning 2.5 million
and a 90% chance of winning nothing.
Now, as you might expect a lot of people prefer Option B. If you think about, the
difference between 10%, 11% isn't very large. The difference between a million and
2.5 million is that much more larger. And so, people tend to pick the Option B, which
gives them a chance of winning the larger price. Here's an interesting thing though.
If I put these two side by side, what you'll notice is that these two options are
essentially identical. These two problems are essentially identical.
What I've done is I've taken away an 89% probability of winning a million dollars
away from both options. And essentially, by doing that, I have now created a

situation in which I can reverse preferences between A and B. And that, again, is a
violation of the axiom.
Now, as we go through this course we'll see a lot of different ways in which
consumers and people in general tend to violate, not only these axioms of choice,
but tend to make inconsistent preferences. And I'd like to leave you with one
thought. We've talked about the four C's of rationality, and we've made the point
that all of these four C's need to happen for people to display rational behavior.
Now, people routinely violate axioms. People routinely do not behave in consistence
with those four C's, but they're just being people. Are they being irrational?
Irrational, I think, has a very strong connotation to it. It suggests that people are
making a mistake. And in my opinion, if you have a theory that doesn't account for
the way in which people make decisions, perhaps that's not the right theory to
explain human behavior. Perhaps it's not people that are being irrational. It is the
theory that is perhaps not rational, and that's why a behavioral approach to
economics tends to be the richer approach.