Beyond Rationality

- Dr. Aashita Dawer

Rationality

 Self Interest
 Maximization of Utility
 Transitive and Complete Preferences
 Optimal Choice – Maximization of Utility based on a constraint
 Omniscience - perfect information - know all the utilities and production
possibilities of others in the present domain
 conscious deliberation - individuals are constantly thinking about available
options
 Expected Utility Theory
 Majority Rule
Choice under Uncertainty

 All choices made under some kind of uncertainty.

 Sometimes useful to ignore uncertainty, focus on ultimate choices. Other
times, must model uncertainty explicitly.
 Examples:
 � Insurance markets. � Financial markets. � Game theory.
 You don’t know if it’s going to rain, and you have to decide whether to carry an
umbrella.
 If you carry an umbrella: 10% chance you lose it,
 60% chance you carry it around needlessly,
 30% chance you use it
 If you leave umbrella at home: 0.1% chance you lose it,
 66.6% chance you don’t need it,
 33.3% chance you get wet
 What factors matter in your decision?
 Your decision depends on the probability of each outcome, and on how much
you like/hate each outcome.
Notation and Terminology
 Suppose a situation has n possible and mutually exclusive outcomes,
labeled 1, 2, ..., n.
 Example:
 Lose umbrella (1), carry it needlessly (2), use umbrella (3), don’t carry and
don’t need it (4), get wet (5)
 A lottery [p1, p2, ..., pn] is a list of probabilities, where pi is the probability
that outcome i occurs.
 Example:
 Carrying the umbrella leads to lottery [0.1, 0.6, 0.3, 0, 0],
 not carrying it leads to lottery [0.001, 0, 0, 0.666, 0.333].
 Note: because p1, p2, ..., pn are the probabilities of all possible and
mutually exclusive outcomes, we must have p1 + p2 + ... + pn = 1
Expected Utility

 Suppose outcome 1 gives you utility u1, outcome 2 u2, and so on.
 What is your utility from lottery L = [p1, p2, ..., pn]?
 Natural answer: p1u1 + p2u2 + ... + pnun, which is the L’s (von Neumann-
Morgenstern) expected utility

 EU - under uncertainty, the weighted average of all possible levels of utility

will best represent the utility at any given point in time
 Then the E(U) theory predicts that the individuals’ risk “attitude” for each
lottery may lead to different rankings between lotteries.
 Risk averse - Such a person will need incentives to be willing to play the
game. It could come as a price reduction for playing the lottery, or as a
premium that compensates the individual for risk. - Diminishing MU
 Risk neutral – Constant MU
 Risk seeking (or loving)- Increasing MU
 A Utility Function for a Risk-Neutral
Individual
A Utility Function for a Risk-Seeking
Individual
A Utility Function for a Risk-Averse
Individual
Risk Aversion
 Suppose the person’s current income is Rs. 3,000 and he is offered a fair
gamble in which he has a 50-50 chance of winning or losing Rs. 1,000.
 Thus, the probability of his winning is 1/2 or 0.5. If he wins the game, his
income will rise to Rs. 4,000 and if he loses the gamble, his income will fall to
Rs. 2,000.
 The expected money value of his income in this situation of uncertain
outcome is given by:
 E (V) = 1/2 x 4000 + 1/2 x 2000 = Rs. 3000
 Though the expected value of his uncertain income prospect is equal to his
income with certainty a risk averter will not accept the gamble.
Risk Aversion

 This is because as he acts on the basis of expected utility of his income in the
uncertain situation (that is, Rs. 4,000 if he wins and Rs. 2,000 if he loses) can be
obtained as under:
 Expected Utility (EU) = π U (Rs. 4000) + 1 – π U (Rs. 2000)
 As will be seen from Figure (Risk Averse Individual) the utility of the person from
Rs. 4,000 is 75 (point B on the utility curve and utility from 2000 is 50 (point A in
Figure 17.6), the expected utility from this uncertain prospect will be:
 E (U) = 1/2 (75) + 1/2 (50)
 = 37.5 + 25 = 62.5
 In the N-M utility curve U (I) in Figure 17.6 the expected utility can be found by
joining point A (corresponding to Rs. 2,000) and point B (corresponding to Rs.
4,000) by a straight line segment AB and then reading a point on it
corresponding to the expected value of the gamble Rs. 3,000, the expected
value of the utility is M2D (= 62.5) which is less than M2C or Rs. 70 which is the
utility of income of Rs. 3,000 with certainty.
 Summary of the key assumptions of
expected utility theory:
 1- It is regarded to be rational to be an expected utility maximizer, as this theory is based on
compelling axioms about how people should behave. Expected utility theory posits that
decision makers choose the prospect that maximizes their expected (or average) utility.
 2- Under expected utility, risk preferences are captured by the shape of the utility function.
Decision makers are risk-averse if U(x) is concave, and risk-seeking if U(x) is convex.
 3- based on the tenet that decisions makers are risk-averse.
 4-decision makers are rational.
 5-Expected utility theory assumes that preferences between prospects do not depend on the
manner in which they are described,(invariance assumption).
 6-Expected utility theory assumes that choices only reflect final outcomes. For example, if one
were the beneficiary of a $100 check, but also received a $100 speeding ticket, these two
events would offset one another in monetary terms.

 Risk Aversion vs. Loss Aversion

Beyond Rationality – Behavioral
Economics
 Simon(1947) – Bounded Rationality - decision-making that attempts to
make sense of the world by the way a person takes in information and
processes it to create preferences and choices. - human behavior is limited
by cognition to assess the gains and losses and is accompanied with
emotional motivations towards decision making
 Cognitive Psychologists: Internal Mental Processes: Desires, Imagination,
Mind, Knowledge, Motivation
 Behavioral Decision Research: Compute emotions, thinking and judgment,
Cognition constraint
 Heuristics, Biases and Prospect Theory
Heuristics and Biases

 Tversky and Kanheman - people possess various heuristics and biases which
transforms complex probabilities into simple ones and thus guides their
behavior
 Heuristics are cognitive rules of thumb or hardwired mental shortcuts that
everyone uses every day in routine decision-making and judgment
 Cognitive bias is any inclination toward a particular belief or perspective —
most often one that is ill-supported by reason or evidence.
 Decision-makers use satisficers, to obtain a satisfactory solution rather than
an optimal one.
 The term, “satisficing,” a combination of ‘satisfy and suffice,’ was
introduced by Simon in 1956.
Representative bias

 Refers to determining the probability of occurrence of an event by

incorporating how much is the event representative of the sample it is
drawn from.
 This implies that when a person judges the probability of drawing X from Y
by how much similarity X has to Y, she is said to be displaying representative
heuristic.
 Example - with a sample of 30 lawyers and 10 housewives, with given
description that ‘the variable drawn is very hardworking and busy
throughout a day’, people would end up judging the probability of 0.5
instead of 0.75 and 0.25.
 People tend to ignore the size of the sample and determine the probability
based only on similarity.
Availability bias

 The ease of recalling of an event in a person’s mind. This happens due to

the familiarity or the recency of an event.
 People would predict the probability of a heavy rainfall in near future if
there have been heavy rains in the recent past.
 The frequency of occurrence of an event would be considered highly
probable.
 When certain circumstances are easy to imagine than others, those
circumstances receive higher probability by people using mental
computation.
 Example - destruction by an earthquake is more imaginable than a nuclear
bomb and thus occurrence of earthquake would be considered more
probable.
Anchoring and Adjustment

 Series of mental shortcuts where quick decisions are taken by choosing a

reference point and then adjusting to the reference point till we reach a
suitable decision.
 Example - as the salesman knows that there would definitely be bargaining
by the consumer, he would keep the price higher of the product say $100.
 Now, the consumer would automatically anchor to 100$ and would adjust
the bargaining to probably 70$ and ultimately the equilibrium maybe
reached at $80.
 However, if the shopkeeper would have priced the product at $80 initially,
that may have been sold for around $60. Therefore, when we make
decisions, we first determine an anchor and adjust accordingly.
Reference Point

 Status Quo Bias/Endowment Effect – Preference to Current State of Affairs –

Emotional Bias
 Example - You score 23 out of 25 in mid sem – 23 becomes your reference
point and you will not want to gamble it by giving a remedial exam.
 Aspirations – Preference for a better state of affairs
 Example – You score 10 out of 25 – you will want to give a remedial.
 Prospect Theory

 Expected utility theory suggests that choices are coherently and consistently
made by weighing outcomes (gains or losses) of actions (alternatives) by their
probabilities (with pay- offs assumed to be independent of probabilities). The
alternative which has the maximum utility is selected.
 Prospect theory, on the other hand, provides empirical evidence from "several
classes of choice problems in which preferences violate the axioms of expected
utility theory.
 According to prospect theory, choice is a 3-stage process.
 Framing – taking into account various biases – eg. Initial asset vs. total asset in
Gambling. Risk aversion or Risk seeking based on winning or losing.
 Editing - alternatives are edited and values are attached to outcomes and
weights to probabilities.
 Evaluation - similar to expected utility theory, the edited alternatives are
evaluated.
 Prospect Theory

 Attaches value and measures utility from the gains and losses of wealth.
 According to the theory, the disutility from losing a particular amount of wealth is
more than the utility from the gaining equivalent amount.
 When an option available in a gamble is mixed, then subjects act risk averse.
 However, when all options available are bad, then people behave in a risk
seeking fashion. An example constructed by Kahneman is as follows:
 Consider two problems:
 Problem 1: Which do you choose?
 Get $900 for sure or 90% chance to get $1000
 Problem 2: Which do you choose?
 Lose $900 for sure or 90% chance to lose $1000
Prospect Theory

 Now, in problem 1, options are mixed and subjective value of gain of $900
is more than the gain from 90% chance to get $1000. Thus, subjects to be
risk averse.
 However, when all options are bad as in problem 2, the negative value of
losing $900 for sure is more than the negative value of losing $1000 with 90%
chance, people act as risk seeking agents
 Reference Point - This implies if you have sufficient wealth then your
attitude to a gain or loss of few $100 dollars would not have an effect on
your risk behavior. However, if you are poor then change in your wealth
with a few $100 would affect your risk choice.
Stages

 Framing
 Editing – Involves mental operations by transforming of outcomes and
probabilities.
 Identification of Reference point and framing of outcomes as
deviations of losses or gains from reference point.
 Simplification – Rounding off probabilities
 Evaluation – of edited prospects and selection of highest value as
determined by value of an outcome.
 Weighted value of a prospect V,
V = ∑w(pi)v(xi)
Value Function, v(xi)
Value Function and Weighting
Function
 Value Function[v(xi)] - The psychological value function is S-shaped
representing the diminishing sensitivity both for gains and losses. The slope
of the curve to the right of reference point is different than the slope of the
curve to the left because of loss aversion i.e. the psychological disutility to
the loss is much stronger than psychological utility from the gain in same
amount.
 Weighting Function [w(pi)] – We tend to overestimate small probabilities
and underweight large probabilities. Decision weights are influenced by
ambiguity and uncertainty.