Decision making

Dr Daniel Bennett

PSY3051
Monash University
Week 2, 2023

image credit: James Abbott McNeill Whistler, A Little Red Note Dordrecht (1884) https://asia.si.edu/object/F1908.15a-b/
 Stanislav Petrov makes a Very Good Decision

Ø On September 26, 1983, Stanislav Petrov made a very good decision

Ø If you were born after 1983, you arguably owe your existence to him

Ø Petrov was an officer in the Soviet military, overseeing the early-

warning system for the Soviet nuclear arsenal

Ø His warning systemʼs computer signalled with “high reliability” that

five American nuclear missiles were incoming

Stanislav Petrov (1939-2017)

Ø Petrov was faced with the decision: should he report the missiles to
his superiors?

Ø If yes, it is almost certain that the Soviet military would have launched a retaliatory nuclear strike
Ø If no, no strike would be launched

PSY3051 ‒ Decision making ‒ Daniel Bennett https://www.washingtonpost.com/wp-srv/inatl/longterm/coldwar/shatter021099b.htm

 Stanislav Petrov makes a Very Good Decision https://www.washingtonpost.com/wp-srv/inatl/longterm/coldwar/shatter021099b.htm

Ø Petrov had little time to think, and the stakes were incredibly high
Ø “For 15 seconds, we were in a state of shock”
Ø Petrov made the decision under incredible stress: scanning maps and
computers, another officer screaming at him to ”remain calm and do his job”

Ø Less than 5 minutes after the alert began, Petrov decided that the
launch reports were likely to be false
Ø "I had a funny feeling in my gut. I didn't want to make a mistake. I made a
decision, and that was it."
A ʻMinutemanʼ Intercontinental
Ballistic Missile

Ø Petrov was right: the alert was a false alarm caused by the sunʼs reflection off clouds
Ø It has been suggested that his correct decision saved as many as 2.5 billion lives

PSY3051 ‒ Decision making ‒ Daniel Bennett https://www.washingtonpost.com/wp-srv/inatl/longterm/coldwar/shatter021099b.htm

 Overview of this weekʼs videos

Mini-lecture 1: Decision making and expected utility theory

Mini-lecture 2: Prospect theory and related phenomena

Mini-lecture 3: Emotion and decision making

PSY3051 ‒ Decision making ‒ Daniel Bennett

 Overview of learning outcomes

1. Explain how expected utility theory relates to preference-based

decision making, and define the various components of expected Mini-lecture 1
utility theory ‒ including acts, states, consequences, and utility

2. Define risk aversion, loss aversion, the endowment effect, the framing
effect, and the default-option bias, and describe how each effect can Mini-lecture 2
be explained by Prospect Theory

3. Describe the influence of emotions on decision making in the context Mini-lecture 3

of interpersonal decision making and risky decision making

PSY3051 ‒ Decision making ‒ Daniel Bennett

Mini-lecture 1:
Decision making and expected utility theory

PSY3051
Decision Making
Daniel Bennett
 What is decision making?
Ø Decision making is the set of cognitive processes by
which people choose an action from a set of different
possible alternatives
Ø Some decisions are made on the basis of our preferences
over the consequences of different possible actions
Ø We call this preference-based decision making
Ø Some decisions involve choosing between competing
interpretations of noisy or ambiguous sensory information
Ø We call this perceptual decision making
Ø In this lecture, we will focus on preference-based decisions
PSY3051 ‒ Decision making ‒ Daniel Bennett
Some hypothetical decisions
- Do you want to go to the PSY3051 lecture in
person, or do you want to watch it online?
- Should you take the tollway or the freeway
when you drive to the city?
- Should you go to that house party this
weekend or stay at home studying?
- Was that noise on the roof a possum or a
burglar?
- Does that carton of milk smell like it has
gone off?
- Is that roadworker waving for you to drive
forward or putting their hand up to tell you
to hit the brakes?
 Expected utility theory

Ø Expected utility theory is an economic theory that describes how people make decisions

Ø Expected utility theory proposes that people behave in a way that maximises their expected
utility

Ø Decisions in expected utility theory are analysed in terms of acts, consequences, and states

Ø Acts are the different actions that a decision-maker can take; this is what they are choosing between

Ø Consequences are the different possible results of an act. Can be pleasant, unpleasant, or neutral

Ø States are all the factors that are out of the decision-makerʼs control. The state may determine which
consequences follow an act.

PSY3051 ‒ Decision making ‒ Daniel Bennett

Expected utility theory

Possible acts
- Take the tollway
- Take the freeway

Possible consequences
- Pay no toll and arrive on time
- Pay no toll and arrive late
- Pay a toll and arrive on time
- Pay a toll and arrive late

Possible states
- Roadworks on Dandenong road Should you take the tollway or the freeway
when you drive to the city?
- Car crash on the M1
- Car breaks down
- No toll payment because tollway computer system crashes
- ...
 Expected utility theory

Ø Expected utility theory proposes that people behave in a way that maximises their expected
utility

Ø Utility is defined as the degree to which a given consequence helps an individual to achieve their
goals
Ø Consequences that move us closer to achieving our goals have positive utility; things that move us
further away from achieving our goals have negative utility
Ø In other words: utility measures how good or how bad a given consequence is

Ø Note that utility is subjective: it can differ between different people, and can change over time
for the same person
Ø e.g., ʻsentimental valueʼ: you may not care at all about my childhood photos, but they mean a lot to me!

PSY3051 ‒ Decision making ‒ Daniel Bennett

Expected utility theory

Q: What is the utility of drinking a bottle of water?

A: It depends!

Just drank 20L of water Lost in the desert for a week

Bottle of water has Bottle of water has

negative utility positive utility
Expected utility theory

Possible acts
- Take the tollway
- Take the freeway

Possible consequences
- Pay no toll and arrive on time +10 utility
- Pay no toll and arrive late -5 utility
- Pay a toll and arrive on time +5 utility
- Pay a toll and arrive late -10 utility

Possible states
- Roadworks on Dandenong road Should you take the tollway or the freeway
when you drive to the city?
- Car crash on the M1
- Car breaks down
- No toll payment because tollway computer system crashes
What about the ʻexpectedʼ part?

Ø When we make decisions, we should consider not only the utility of the different possible
consequences, but also the probability of each consequence
Ø By doing this, we can calculate how much utility we expect to get from a particular decision
Ø Then, we should choose the option that has the maximum expected utility
What about the ʻexpectedʼ part?

Consequences
Pay no toll, Pay no toll, Pay a toll, Pay a toll,
arrive on time arrive late arrive on time arrive late
(+10 utility) (-5 utility) (+5 utility) (-10 utility)
Take tollway 1% 0% 75% 24%
Actions
Take freeway 50% 50% 0% 0%

Expected utility of taking tollway = (0.01 x 10) + (0 x -5) + (0.75 x 5) + (0.24 x -10)
= 0.1 + 0 + 3.75 + -2.4
= 1.45

Expected utility of taking freeway = (0.5 x 10) + (0.5 x -5) + (0 x 5) + (0 x -10)

= 5 + -2.5 + 0 + 0
= 2.5
What about the ʻexpectedʼ part?

Ø When we make decisions, we should consider not only the utility of the different possible
consequences, but also the probability of each consequence
Ø By doing this, we can calculate how much utility we expect to get from a particular decision
Ø Then, we should choose the option that has the maximum expected utility

Expected utility: Expected utility:

approx -$0.63 $0
Example: Should I If I donʼt buy a ticket...
If I buy a ticket...
buy a lottery ticket?

I win the lottery I donʼt win the lottery Nothing happens

probability 1 in 45 million, probability 44.999 million probability 100%,

(monetary) utility $30 million in 45 million, no change in
(monetary) utility -$1.30 (monetary) utility
 A note on ʻrationalityʼ

Ø In expected utility theory, people are assumed to be

rational decision makers
Ø Here, rationality is defined as making decisions that
maximise expected utility

Ø So, are people who buy lottery tickets being irrational?

Can we disprove expected utility theory that easily?
Ø Alas, no.

Ø Remember that utility is defined in terms of progress towards a goal. We often make the
simplifying assumption that utility = monetary utility, but this is not necessarily true
Ø The small cost of a lottery ticket may not have much bearing on oneʼs goals, but the large prize
may be very important for oneʼs goals. In that case, buying a ticket would be ʻrationalʼ
Ø To disprove expected utility theory, we would need to observe people taking actions that run
counter to their goals

PSY3051 ‒ Decision making ‒ Daniel Bennett

 Relation to learning outcomes

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A dd d n
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in c lu d c e d e c is i m e
O n ly n g em
s s c ie m a k in
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1. Explain how expected utility theory

relates to preference-based decision
making, and define the various
components of expected utility theory
‒ including acts, states,
consequences, and utility

PSY3051 ‒ Decision making ‒ Daniel Bennett

Mini-lecture 2:
Prospect theory and related phenomena

PSY3051
Decision Making
Daniel Bennett
 Risk aversion

Which option would you choose?

Option A Option B
I flip a coin I give you $500

Heads Tails
I give you $1000 I give you $0

PSY3051 ‒ Decision making ‒ Daniel Bennett

 Risk aversion

Ø Risk aversion is a preference for relatively certain outcomes

over relatively uncertain outcomes
Ø ʻA bird in the hand is worth two in the bushʼ

Ø In this example, risk aversion means preferring the ʻsafeʼ Option B to the ʻriskyʼ Option A
Ø Even though the two options have the same expected monetary utility ($500)
Ø Because people generally prefer Option B in this setting, we would say that they are risk averse on
average

PSY3051 ‒ Decision making ‒ Daniel Bennett

Prospect theory Kahneman & Tversky (1979)

Ø Risk aversion can be explained by an economic theory called prospect theory

Ø The key concept in prospect theory is the utility function, which tells us how the objective
numerical amount of a product relates to subjective utility

Reference point
Prospect theory Kahneman & Tversky (1979)

Ø Risk aversion can be explained by an economic theory called prospect theory

Ø The key concept in prospect theory is the utility function, which tells us how the objective
numerical amount of a product relates to subjective utility

Utility of having 1 additional microwave = +1 This phenomenon is called

Utility of having 2 additional microwaves = +1.5
decreasing marginal utility, and it
Utility of having 3 additional microwaves = +1.8
Utility of having 4 additional microwaves = +2 can explain risk aversion

x
x
x
x
Prospect theory and risk aversion

Ø Because of the curvature of the utility function, every additional dollar is worth slightly less than the dollar
before (just like microwaves!)

Ø Applying expected utility theory to the utility of different monetary amounts can explain risk aversion
Prospect theory and risk aversion

Ø Because of the curvature of the utility function, every additional dollar is worth slightly less than the dollar
before (just like microwaves!)

Ø Applying expected utility theory to the utility of different monetary amounts can explain risk aversion

x
Utility of 0 additional dollars = +0
Utility of 500 additional dollars = +200
x
Utility of 1000 additional dollars = +300

x
Expected utility of A: 0.5 x 300 + 0.5 x 0 = 150

Expected utility of B: 1 x 200 = 200

 Comparing risk aversion across people

Ø Not everybody has the same utility function! Different people have different goals and
preferences, and these differences are expressed in the shape of the utility function

Q: Who is more risk averse, Amy or Bryce?

A: Bryce (greater curvature of utility function)

Amy
Bryce

PSY3051 ‒ Decision making ‒ Daniel Bennett

 Comparing risk aversion across people

Ø Not everybody has the same utility function! Different people have different goals and
preferences, and these differences are expressed in the shape of the utility function
Daniel
Clara

Amy
Bryce

We would say that Clara is risk-neutral,

and Daniel is risk-seeking

PSY3051 ‒ Decision making ‒ Daniel Bennett

 Loss aversion

Which option would you choose?

Option C Option D
I flip a coin No money changes hands

Heads Tails
I give you $1000 You give me $1000

PSY3051 ‒ Decision making ‒ Daniel Bennett

Loss aversion

Ø Loss aversion is a tendency to prefer avoiding losses more strongly than acquiring similar-
sized gains
Ø The negative utility from losing something is stronger than the positive utility of gaining something

Ø In this example, loss aversion would mean that people prefer Option D because the possibility
of losing $1000 outweighs the possibility of winning $1000 in Option C
Ø Even though the two options have the same expected monetary utility ($0)
Ø Because people generally prefer Option D in this setting, we would say that they are loss averse on
average
Prospect theory and loss aversion

Ø Prospect theory can also explain loss aversion

Ø To see how, we need to extend the utility function below the reference point

Reference point

Imagine that to start with

you own six coffee mugs
Prospect theory and loss aversion

Ø Prospect theory can also explain loss aversion

Ø To see how, we need to extend the utility function below the reference point

In the gain domain, the utility

function has its familiar shape,
indicating decreasing marginal
utility of coffee mugs
Prospect theory and loss aversion

Ø Prospect theory can also explain loss aversion

Ø To see how, we need to extend the utility function below the reference point

Things to notice about this plot

- The shape of the utility function in the loss

domain is not a straight line

- Below the reference point, there is x

decreasing marginal disutility x
- The loss domain is not just a mirror reflection
x Utility of losing 1 cup = -1.8
of the gain domain ‒ it is steeper
Utility of 0 cups =0
- The effect of the steeper utility function in Utility of gaining 1 cup = 1.1
the loss domain is that losses loom larger
than gains
Prospect theory and loss aversion

Ø Because the utility function is steeper in the loss domain, losses loom larger than gains

Ø Applying expected utility theory to the utility of different monetary gains and losses can explain loss aversion

Utility of losing $1000 = -700

Utility of gaining $0 =0
x Utility of gaining $1000 = +400

Expected utility of C: 0.5 x -700 + 0.5 x 400 = -150

Expected utility of D: 1 x 0 =0
 Comparing loss aversion across people

Ø Just like with risk aversion, different people can differ in their loss aversion

Q: Who is more loss averse, Eiko or Fiona?

A: Eiko(steeper utility function in loss domain)

Fiona

Eiko

PSY3051 ‒ Decision making ‒ Daniel Bennett

Pause for breath...

2. Define risk aversion, loss aversion, the endowment effect, the

framing effect, and the default-option bias, and describe how each
effect can be explained by Prospect Theory

Kerry Packer
(billionaire/media tycoon/gambler)

text from https://www.casino.org/blog/kerry-packer/

 What is the reference point in prospect theory?

Ø Prospect theory can also explain other patterns of

decision making, not just risk aversion and loss aversion
Ø To understand how, we need to talk more about the
reference point

Ø The reference point is the point that people compare

potential consequences to when they make their decisions
Reference
point
Ø So far, we have assumed that the reference point is the
same thing as the current state
Ø But in fact, the reference point can be anything!
Ø If we can change peopleʼs reference point, we can change the
way they calculate the utility of possible actions

PSY3051 ‒ Decision making ‒ Daniel Bennett

 Illustrating the effects of the reference point

Ø Showing the old price of a sale item is designed to shift your reference point
Ø By emphasising the cheaper price, the seller is trying to emphasise the gain relative to the old price

PSY3051 ‒ Decision making ‒ Daniel Bennett

 Illustrating the effects of the reference point

Ø Showing the old price of a sale item is designed to shift your reference point
Ø By emphasising the cheaper price, the seller is trying to emphasise the gain relative to the old price
Ø By contrast, imagine if your smartphone showed you how your bank balance would decrease after buying a product

Current bank balance: $1646.21 Current bank balance: $942.80

Balance after purchase: $1417.21 Balance after purchase: $566.80
PSY3051 ‒ Decision making ‒ Daniel Bennett
The framing effect based on Tversky & Kahneman (1981)

Ø The framing effect is that people make different decisions in the exact same situation
depending on whether the scenario emphasises potential gains or potential losses

A classic thought experiment involves a disease outbreak in 600 people, with two possible programs of action

Emphasising that some people will certainly

be saved in Program A leads people to
prefer Program A over Program B

Emphasising that some people will certainly

die in Program C leads people to prefer
Program D over Program C

...but Program A is identical to Program C,

and Program B is identical to Program D!
 The endowment effect
Ø The endowment effect is that people tend to over-value things that they already own, and under-
value things that they do not own
Ø In other words, just being ʻendowedʼ with an object seems to change the utility of that object

Ø Thaler (1980): half of participants were given a mug and asked for the
minimum price they would sell it for
Ø The other half of participants were not given a mug and asked for the
maximum price they would buy it for
Ø The average selling price was more than twice the average buying price

Ø Knetsch (1989) gave half of participants a mug and half of participants a chocolate
bar. All participants were asked if they would like to trade one for the other
Ø 90% of participants refused to trade

PSY3051 ‒ Decision making ‒ Daniel Bennett

The default-option bias

Ø If a decision has a default option, people tend to choose it over other options
Ø Even if the default option is not a good one

Ø This bias can help explain why people are more likely to choose an action when they must opt out
of it than when they must opt in to it

In Australia, organ donation is an opt-in procedure.

Some have suggested moving to an opt-out To increase the reach of their marketing, companies make
procedure to increase rates of organ donation post-purchase mailing list subscriptions opt-out
Relation to learning outcomes

2. Define risk aversion, loss aversion, the endowment effect, the

framing effect, and the default-option bias, and describe how each
effect can be explained by Prospect Theory

An endowment effect in dogs

Mini-lecture 3:
Emotion and decision making

PSY3051
Decision Making
Daniel Bennett
 Emotion and decision making

Ø Intuitively, we know that our emotional states can

influence the decisions that we make

Some examples of decisions influenced by emotion

- Driving over the West Gate Bridge by mistake because you

were angry about getting cut off in traffic and missed your turn

- Feeling melancholy and deciding not to attend a party

- Not speaking up in a university tutorial because youʼre afraid

that you will say something stupid

- Feeling great after finishing your last exam, and deciding to

apply for a job you might not be qualified for

Image generated by DALL-E 2 (OpenAI)

Prompt: “emotional emojis” Ø The tools of cognitive psychology can be used to
understand how emotions influence decision making
PSY3051 ‒ Decision making ‒ Daniel Bennett
Effects
The ultimatum
of emotion:
game the ultimatum game
$100 $0
What should people do in this The giver starts the game with a
task if they are trying to
ʻwalletʼ containing $100. The receiver
maximise their money?
starts the game with nothing.

- The receiver should accept any Giver Receiver

offer, since any monetary
amount is better than $0 $100 $0
$20?
- Because of this, the giver should The giver then decides how much of
offer the smallest possible the $100 to offer to the receiver
amount (e.g., $1) and the
receiver should accept it Giver Receiver

- At least according to
neoclassical economics...

$80 $20 $0 $0
If the receiver accepts the If the receiver rejects the
offer, the two players divide offer, both players get
the money as agreed nothing
Giver Receiver Giver Receiver
What
The ultimatum
does the ultimatum
game game tell us? data from Sanfey et al. (2003)

Ø What do people actually do? Giver Identity

Ø Receivers always accepted fair offers, but not

“unfair” offers
Ø People were more likely to accept unfair offers
when they believed the giver was a computer
algorithm

Ø What does this tell us?

Ø Peopleʼs decisions are affected by their emotional
responses (anger at injustice in this case)

Ø Remember that the utility of a consequence is defined in terms of helping to achieve goals
Ø Perhaps emotional states might change decision making by changing peopleʼs goals
Ø Anger might lead to a goal of punishing unfair players that overrides the goal of maximising
monetary gain
 The ʻaffect
ultimatum
heuristicʼ
game Quote from How Emotions are Made by Lisa Feldman Barrett (2017)

Ø The affect heuristic is peopleʼs tendency to make decisions on the basis of their emotional
reactions to different potential consequences
Ø Instead of using the cold calculus implied by expected utility theory and prospect theory

PSY3051 ‒ Decision making ‒ Daniel Bennett

 The ʻaffect
ultimatum
heuristicʼ
game Quote from How Emotions are Made by Lisa Feldman Barrett (2017)

Ø The affect heuristic is peopleʼs tendency to make decisions on the basis of their emotional
reactions to different potential consequences
Ø Instead of using the cold calculus implied by expected utility theory and prospect theory

Ø A related idea is the somatic marker hypothesis of Antonio Damasio, which states that for
complex decisions, people rely on emotional signals generated from their bodies
Ø According to this hypothesis, people literally ʻtrust their gutʼ

PSY3051 ‒ Decision making ‒ Daniel Bennett

 Emotion
The ultimatum
and risk
game
aversion
The DOSPERT questionnaire

Ø The common theme: a risky decision involves taking an action that has unpredictable consequences

Ø Research question: does an individualʼs emotional state change their willingness to make decisions that have
unpredictable consequences?

PSY3051 ‒ Decision making ‒ Daniel Bennett

Mania and risk-taking
(Simplified) DSM-5-TR criteria for a manic episode:

1. A distinct period of abnormally and persistently elevated, expansive, or irritable mood and abnormally and
persistently increased activity or energy
2. During the period of mood disturbance and increased energy and activity, three (or more) of the following
symptoms have persisted and represent a noticeable change from usual behavior:
a) Inflated self-esteem or grandiosity
b) Decreased need for sleep

c) More talkative than usual or pressure to keep talking

d) Flight of ideas or subjective experience that thoughts are racing

e) Distractibility

f) Increase in goal-directed activity or psychomotor agitation

g) Excessive involvement in activities that have a high potential for painful consequences (e.g., engaging in
unrestrained buying sprees, sexual indiscretions, or foolish business investments)
Risk-taking behaviour in manic episodes Fletcher et al. (2013)

Ø Increased likelihood of engaging in behaviours with the potential for negative consequences
 Competing
The ultimatum
theories
gameof emotion and risk aversion

Ø Two influential theories of emotion and risk taking are the

Affect Infusion Model (Forgas, 1995) and the Mood
Maintenance Hypothesis (Isen et al., 1988)

Ø The Affect Infusion Model proposes that emotional information

is incorporated into the appraisal of actions and consequences
Ø Infusion is affect-congruent: positive emotions increase weight on
pleasant information, negative emotions increase weight on
unpleasant information
Ø Predicts that negative emotions will increase risk aversion, and Image generated by DALL-E 2 (OpenAI)
positive emotions will increase risk aversion Prompt: “photograph of a bungy jumper in the
style of Willie Ronis”

Ø The Mood Maintenance Hypothesis states that people in pleasant moods want to maintain their
mood, and that people in unpleasant moods want to improve their mood
Ø Predicts that positive emotions increase risk aversion and negative emotions increase risk seeking
PSY3051 ‒ Decision making ‒ Daniel Bennett
 Competing
The ultimatum
theories
gameof emotion and risk aversion

Ø There is experimental evidence to support both theories!

Ø Predominantly from studies using ʻmood inductionʼ protocols

Ø Schulreich et al. (2014) used a happy/sad/neutral mood

induction interspersed with prospect-theory gamble questions

Image generated by DALL-E 2 (OpenAI)

Prompt: “photograph of a bungy jumper in the
style of Garry Winogrand”

Ø This study showed that participants chose the risky gambles more often after hearing happy
music
Ø In line with the predictions of the Affect Infusion Model
PSY3051 ‒ Decision making ‒ Daniel Bennett
Competing
The ultimatum
theories
gameof emotion and risk aversion

Ø There is experimental evidence to support both theories!

Ø Predominantly from studies using ʻmood inductionʼ protocols

Ø Isen et al. (2014) used a happy mood induction (giving

participants a bag of candy) plus prospect-theory gambles

Image generated by DALL-E 2 (OpenAI)

Prompt: “photograph of a bungy jumper in the
style of Slim Aarons”

Ø This study showed that participants chose the risky gambles less often after receiving the candy
Ø In line with the predictions of the Mood Maintenance Hypothesis
Relation to learning outcomes Comic by Zach Weinersmith, http://smbc-comics.com/comic/2014-10-09

3. Describe the influence

of emotions on decision
making in the context of
interpersonal decision
making and risky
decision making

This weekʼs reading:

Speekenbrink & Shanks, 2013, p. 682-688 and 693-695. A link to the reading is available on Moodle