Session 12

Framing and Decision Making

Asian Disease Problem

Program A:  If Program A is adopted, 200 people will be saved.

Program B:  If Program B is adopted, there is 1/3 probability that 600 people will be saved, and 2/3 probability that no people will be saved.

Which of the two programs would you favor?

Imagine that the US is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people.  Two alternative programs to combat the disease have been proposed.  Assume that the exact scientific estimates of the consequences of the programs are as follows.

Program A:  If Program A is adopted, 400 people will die.

Program B:  If Program B is adopted, there is 1/3 probability that 1/3 probability that nobody will die, and 2/3 probability that 600 people will die.

Which of the two programs would you favor?

Ticket versus Lottery

Ticket $100 for traffic ticket and be done with it, or

challenge it, and take a 50-50 chance of getting it dismissed or paying double the ticket value (for court fee).

Lottery Two stage game in which, at end of Stage 1, you

have won $100. Now you choice is to take your cash and leave or go to Stage 2, taking a 50-50 chance of making an additional $100 or losing $100.

Framing and Risk Preference Tendency to choose riskier options under loss frames

rather than gain frames. A pure framing effect (Asian Disease Problem) A genuine reflection effect (Ticket/Lottery)

Has to do with shape and curvature of the utility functions in the domain of losses and gains.

This is described in Prospect Theory (Kahneman and Tversky, 1979).

Violates the general assumption of economic behavior that people should respond to absolute outcomes not relative outcomes.

Prospect Theory

Over weighting of certain outcomes Certain losses are more aversive, certain gains

are more attractive.

Value-function Concave in gains Convex and steeper in losses

Decreasing marginal utility and disutility

The psychological intensity of outcomes of increasing magnitude is progressively smaller.

V(Risky)

V(Risky)

V(Risk-free)

Prospect Theory and Reflection Effect

V(Risk-free)

50 90-50-90

Value of Outcome

Magnitude of Outcome10

-10

Why then…?

Do people buy lotteries?

Do people buy insurance?

Limitations of Prospect Theory Holds better in low involvement decisions Holds better when outcomes are amenable to

mathematical computation

S-P/A Theory

Security-Potential Security orientation leads to risk aversion Potential orientation leads to risk seeking A personality trait

Aspiration Level The minimum payoff/maximum loss rules the risky

option in or out

No clear predictions under losses and gains

Where’s the Fat?

Package A states that product contains 75% fat.

Package B states that product is 25% fat free.

Which would be preferred more?

Attribute Framing

Varying the description of the option by framing the attribute of the option.

Specifically, focusing on presence of undesirable versus desirable attributes, or absence of desirable versus undesirable attributes.

Positive attribute framing results in higher persuasion compared to negative attribute framing.

Works by trigger differential elaboration. Positive frames cause contemplation of positive states of

affairs relative to negative frames.

Skin Exam

By taking the skin exam now, you will give yourself an opportunity to detect and treat any problems. Positive goal frame or outcome frame

By not taking the skin exam now, you give up an opportunity to detect and treat any problems. Negative goal or outcome frame.

Loss Aversion Explanation for Goal Framing Effects

Everything else being equal, people are more averse to losing than they are attracted toward gains of equal magnitude.

Hence, greater motivation to avoid losses.

Value of Outcome

Magnitude of Outcome

Choosing versus Rejecting

What if we asked people to add options to a base computer versus remove options from a fully loaded computer.

Principle of task invariance suggests, nothing should change.

People should wind up with very identical final configurations.

Study: Simulated computer purchase scenario. Online study Subjects randomly assigned to choose/reject task

Effect on Size of Final Option Set Rejecting (paring

down) results in a significantly larger option set compared to choosing (building up).

Y-axis = Number of options.

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Reject Choose

Effect on Value of Choice Set

Rejecting results in significantly higher value of final option set than choosing.

Y-axis = dollar value of the options in final set.

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Reject Choose

Biases in Decision Making

Enhance Production Capacity? 9 months back your team decided to go ahead with

major modification to your production facilities. The budget was $10m. The project is on time, and scheduled to be completed

next month. The project is on budget, and you have invested $9m to

date. You are now informed that a major shift in the market

place will put your product on a downward path to extinction, and there is nothing you can do about it.

The question before you is, should you invest the remaining $1m and complete the planned plant modification, and continue or should you abandon?

Results

A significant majority said, invest.

You are not alone. Many examples

Vietnam Concorde Hubble

And this is called, sunk cost fallacy.

Why does this happen?

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Abandon Continue

The Source of Sunk Cost Fallacy

A cost is sunk if it is irretrievable, and has no effects on future payoffs.

•This is a prospect theory account•Incremental losses look smaller in comparison

with the potential gain.

•As you invest more, it looks like a bigger waste if you abandon, and incremental investment looks miniscule in comparison with the increasingly remote gain.

•The killer is that the decision-maker starts abandoning the probability that modifies the gain.

Investment at T1

Investment at T2

Investment at T3

Investment at T4

Alternate Explanation for Sunk Cost Fallacy

Cognitive Dissonance What is it?

Tendency to engage in revisionist history while looking back at decision.

Engage in behavior, especially information search that: Strengthens the reasons in favor of decision Weakens reasons against.

More on Sunk Cost Fallacy

Reverse of ‘Hindsight Bias’? Also known as ‘irrational escalation of

commitment’. Many anecdotes, somewhat weak

evidence. Bought two tickets for Shows A and B worth $50

and $100, and prefers Show A, but finds out that they are for the same day/time, and people choose to go to Show B.

Shuttle mission justified on investments and lives lost.

Source: Friedman et al (2003), preliminary version of manuscript

Trading Scenario Let us say, a slightly intoxicated fellow with plenty of money

shows up in class and says “I am feel like giving stuff away”. I tell him, do the following:

Give half of this class $2.00 Give the other half, a lottery ticket worth some unspecified

amount Randomly decide who belongs in which half.

He does just that. But then, the Donor thinks a bit and says, “Hey this is good

only for those whose preferences for the lottery/money matches what they got…what if they don’t like what they got?”

To which, I say, “Okay, give them an opportunity to switch to the other gift”.

What do you think happened?

Endowment Effect

Mere possession of an object causes it to be over valued.

Result, very few people traded. Replicated in trades involving coffee mugs for $6.00. Replicated in trades involving coffee mugs for

chocolate, 89% and 90% respectively chose to retain what was given to them.

People are willing to pay less than what they would expect others’ to pay.

Cannot be attributed to a simple economic market rationality. The dropping of the atomic bomb was justified by the $2b spent

on the Manhattan Project.

Indifference Curves

Indifferences curves represent the points in satisfaction space that are equivalent for two combinations of items/attributes of value.

For example, a person might have in indifference curve between engine power and upholstery. Equally satisfied with a car with a powerful engine with cloth interior as with a care with a

less powerful engine but a leather interior. Indifference curves are not supposed to intersect, regardless of whether you start

with high interiors and trade down to get more power, or start with high power and trade down to get a better interior.

Desirable Attribute B

Desirable Attribute A

Trade down Attribute A

Trade down Attribute B

More on Endowment Effect

Endowment effect occurs because indifference curves intersect.

It affects inexperienced traders more than it does experienced traders. As experience accumulates and trading

intensity picks up, endowment effects gives way.

Can be thought of as behavioral inertia.