Chapter 5

Framing and the Reversal

of Preferences
Big Positive Gamble
You can (a) receive $10 million for sure (expected
value = $10 million) or (b) flip a coin and receive $22
million for heads but nothing for tails (expected value
= $11 million). An expected-value decision rule would
require you to pick (b).
What would you do?
Lawsuit
You are being sued for $500,000 and estimate that
you have a 50 percent chance of losing the case in
court (expected value = –$250,000). However, the
other side is willing to accept an out-of-court
settlement of $240,000 (expected value = –
$240,000). An expected-value decision rule would
lead you to settle out of court.
Ignoring attorney’s fees, court costs, aggravation, and
so on, would you (a) fight the case, or (b) settle out
of court?
Departing from Expected Value
• Why most of the people do not pick the option with
highest expected value?
• Risk preferences
• Risk averse for a gain
• Risk seeking for a loss

• Expected utility concept (Daniel Bernoulli)

• Each outcome is associated with an expected utility or
pleasure
• Declining marginal utility of gains
Expected Utility Theory
Wealth 1 2 3 4 5 6 7 8 9 10
(millions)
0 30 48 60 70 78 84 90 96 100
Utility units
Prospect theory
• You are offered a gamble on the toss of a coin
• If the coin shows tail you lose $100
• If the coin shows head you win $100
• Your response…..
• Lets look at another set of options, will you accept this offer
• If the coin shows tail you lose $100
• If the coin shows head you win $150
• Your response…..
• Lets look at another set of options, will you accept this offer
• If the coin shows tail you lose $100
• If the coin shows head you win $250
Prospect theory
Framing
Framing and the Irrationality of the sum of our choices
Framing and the Irrationality of
the Sum of Our Choices
Imagine that you face the following pair of concurrent decisions. First, examine
both decisions, and then indicate the options you prefer.  

Decision A
Choose between:
a. a sure gain of $240
b. a 25 percent chance to gain $1,000 and a 75 percent chance to gain nothing
 
Decision B
Choose between:
c. a sure loss of $750
d. a 75 percent chance to lose $1,000 and a 25 percent chance to lose nothing
 What Do People Choose?

Decision
90 A Decision
100 B
80 90
70 80
Percent Choosing Option

60 70
60
50
50
40
40
30 30
20 20
10 10
0 0
Framing and the Irrationality of
the Sum of Our Choices
Choose between:
e. a 25 percent chance to win $240 and a 75 percent
chance to lose $760
f. a 25 percent chance to win $250 and a 75 percent
chance to lose $750
E = A + D (the preferred choices in previous example)
F = B + C (the choices not preferred)

Implication: Managers go with their departmental

perspective while making decisions, but when viewed as a
whole are suboptimal
Framing
We like certainty, even pseudocertainty
Certainty
Version 1 described a disease that was expected to
afflict 20 percent of the population. Research
participants in this condition were asked if they would
receive a vaccine that protected half of the individuals
vaccinated
Version 2 described two mutually exclusive and
equally probable strains of the disease, each of which
was expected to afflict 10 percent of the population.
In this case, vaccination was said to give complete
protection (certainty) against one strain and no
protection against the other
Certainty
• Humans have a tendency to underweight high
probability event,
• But appropriately weight events that are certain
- This is because we place a much higher value on
reducing the probability of harm to zero relative to
reducing the probability of harm to a nonzero sum.
- We place a high overall value on the creation of
certainty.
Pseudocertainty
• Pseudo-certainty and insurance framing
• Full protection vs reduction in overall probability of
loss
Framing
Transactional utility and Acquisition utility
What’s it Worth to You?
• Buying a cold drink at a high end restaurant
• How much do we pay?
• Would you pay the same amount while buying a cold
drink from PDC?
• Is that behavior logical? Does the cold drink at a
fancy restaurant taste different?
• ………..May be for some….. But actually it doesn’t if
the source is an original bottler.
What’s it Worth to You?
• The concept of Acquisition utility and Transaction
utility
What’s it Worth to You?
Imagine that you are about to
purchase a high-tech mouse for
$50. The computer salesperson
informs you that the mouse you
wish to buy is on sale at the store’s
other branch, located a 20-minute
drive away. You have decided to
buy the mouse today, and will
either buy it at the cur­rent store or
drive 20 minutes to the other store.
What is the highest price that the
mouse could cost at the other store
such that you would be willing to
travel there for the discount?
Imagine that you are about to
purchase a laptop computer for
$2,000. The computer salesperson
informs you that this computer is
on sale at the store’s other branch,
located a 20-minute drive from
where you are now. You have
decided to buy the computer today,
and will either buy it at the current
store or drive to the store a 20-
minute drive away.
What is the highest price that you
would be willing to pay at the other
store to make the discount worth
the trip?
What’s it Worth to You?
• Let’s say you find out that the mouse is available for $20
at the other store?
• Your reaction……
• How would you decide
• What if a similar ($30) discount is available on the
laptop…..what will you do
• How should you decide
• Prescriptive vs descriptive models….
• One should simply compare the savings with the value
of the time spent
Framing
Endowment Effect
Endowment Effect
• It is the value we place on what we own
• Logically speaking the just-acceptable selling price
and the just-acceptable buying price should be
identical
• You buy a pair of branded shoe, for how much you
would trade that pair
• If you can get a similar pair at same price anytime
• If you have bought it during your international trip and
that is not available locally
Endowment Effect
• What about a ticket to a concert
• You have been lucky to buy a ticket for Rs 5000 to a concert
of a world famous singer and you do not expect that singer
to ever perform here again. All tickets are sold, would you
trade that ticket for money? If yes, for how much? For
5000?....
• Now consider that you have not been able to get the ticket,
and there are some tickets which are available on black, how
much you will be willing to pay? 15000?...
• We generally tend to hold on long after it makes sense
to give it up for a great price
• Endowment effect is for things not regularly traded
Framing
Mental Accounting
Mental Accounting
• A shopping coupon
• Suppose you are handed over a shopping coupon of Rs
1000 when you visit your grocery store Should that
affect the amount you will spend at the store?
Mental Accounting
Suppose that you bought a case of a good 1982 Bordeaux in the
futures market for $20 a bottle. The wine now sells at auction
for about $75 per bottle. You have decided to drink a bottle.
Which of the following best captures your sense of the cost of
your drinking this bottle?
a. $0
b. $20
c. $20 plus interest
d. $75
e. –$55 (you’re drinking a $75 bottle for which you paid only
$20)
 Mental Accounting
35

30

25
Percentage of People

20

15

10

0
a b c d e
Mental Accounting
You receive a letter from You receive a letter from
the IRS saying that you the IRS saying that you
made a minor arithmetic made a minor arith­metic
mistake in your tax return mistake in your tax return
and must send them $100. and must send them
You receive a similar letter
the same day from your
$200. There are no other
state tax authority saying repercussions from the
you owe them $100 for a mistake.
similar mistake. There are
no other repercussions
from either mistake.
Framing
Rebate vs Bonus
Rebate/Bonus Framing
• Imagine that at the of semester the university
hands back certain amount of money to
you…….what will be your response
• Federal stimulus spending
Framing
Joint Versus Separate Preference Reversals
Joint Versus Separate Preference
Reversals
Payout Package A Payout Package B
$27,000 Year 1 $23,000 Year 1
$26,000 Year 2 $24,000 Year 2
$25,000 Year 3 $25,000 Year 3
$24,000 Year 4 $26,000 Year 4
Joint Versus Separate Preference
Reversals
• Separate evaluation promotes emotional responses
• Polling practices
• “Want/should” explanation
• “Evaluability” explanation