Business Decisions

SOC 138/ECO 148

Professor: Carter T. Butts

Time: M/W/F 11:00-11:50
URL: https://canvas.eee.uci.edu/courses/40401

1
 Decisions Matter
■ Betting on a "Sure Thing"

Bernard Madoff, former NASDAQ
chairman and respected
financier and philanthropist,
claimed to offer clients modest
but surprisingly steady returns
➔
Attractive to many, especially
non-profit organizations

In 2009, admitted that his entire
business was a scam
➔
Wall Street Journal estimated
total loss of over $26 billion
dollars to hundreds of clients
➔
Scam was a "classic," but went
uncaught for almost 20 years 2
 Decisions Matter
■ Extreme Management

In late 1911, Robert F. Scott leads a
five person expedition to the south
pole (racing against Roald
Amundsen)

Numerous questionable command
decisions by Scott
➔
Reliance on ponies and experimental
motorized sledges
➔
Disdain of dogs (thought unreliable and
“ignoble”)
➔
Substantially insufficient food/resources
➔
Unwillingness to listen to others

All five men perished. A supply depot
was 11 miles away. 3
 The COVID-19 Pandemic
■ Weighing the odds

COVID-19 pandemic forced businesses
and governments around the world to
weigh the risks of infection against the
costs of shutting down businesses
➔
Unstopped, could have resulted in apx
3 million deaths in US (based on
Thomas et al., 2020, Verity et al., 2020),
large numbers w/chronic injuries;
deaths alone imply economic cost of
over $21 trillion (@$7 million per, Cutler
and Summers (2020))
➔
US economic costs from shutdowns/interventions (not all
policy-driven) estimated at $3-5 trillion (Walmsley et al., 2020)

■ Potential savings from intervention are huge - but

so are costs; uncertainties are large, but little room
for making a bad call....and decisions can't wait for a
final analysis 4
 A Normative Lesson: The Price of Human Folly

■ Poor
decision making costs time,
money, jobs, and even lives
■ In
business contexts, decisions can
make the difference between
success and failure
■ Doingthings “right” means knowing
how – and why – we so often do
things “wrong”
5
 A Descriptive Lesson: Predicting Decisions

■ Decision making as a behavioral

model
■ Understanding decision processes
facilitates prediction of individual,
group outcomes
■ Humans do not always do what
would seem “rational” or “intuitive”
to an outside observer
6
 What Is a Decision?
■ Decision Maker

Beliefs

Values
■ Context

Choice Set A B

States of the 50% 50% 90% 10%
World

1 4 3 2
7
 Example: Value at Risk and Bank Capital Requirements
■ In making lending decisions, banks must weigh value of
interest against risk carried

Beliefs: estimates of default probability, opportunity costs, future
capital availability, estimates of capital demand

Values: risk/return trade-off, discount rate

Choice set: loan terms (exposure, maturity, interest rate, etc.)

States of the world: possible income streams (including potential
for firm failure)
■ Likewise, those investing in banks must consider
exposure
■ Regulating exposure: capital requirements and the Basel
Accords

Agreements determine how risk is assessed, communicated

Rules for rating risks set context for future investment decisions
8
 Domains in the Study of Decision Making

■ Judgment

What we believe, how we learn?
■ Choice

What do we value, how to we choose?
■ Strategic Behavior

How do we respond to other decision
makers?

9
 Decisions in Business Contexts
■ Accounting/forecasting

■ Consumer behavior
■ Human resources
■ Task performance
■ Managerial decision making/strategy

10
 Class Overview
■ Three Components:

Part 1: Models of Rational and
Irrational Decision Making Behavior

Part 2: Pathologies in Individual
Decision Making

Part 3: Decision Making in Social
Contexts
■ Approximately
nine lectures, one
exam per component
11
 Requirements and Grading
■ Assignments

Lecture

Reading

Discussion sections
■ Evaluation

Three exams [3x30% = 90%]

Decision making exercises [4x2.5% =
10%]
■ See syllabus and web site for timing
information and related policies 12
 Discussion Sections
■ TAs

Iuliia Puchko Wilson (ipuchkow@uci.edu)

Alexander Murray-Watters (amurrayw@uci.edu)

Camille Samuels (csamuel1@uci.edu

Roscigno Saverio (sroscign@uci.edu)

Activities

Review/discuss lecture and readings

Answer additional questions from lecture

Prepare for exams
13
 Final Notes
■ Remember to check the web site for
syllabus and updates
(https://canvas.eee.uci.edu/courses/40401)

■ Use business.decisions.logistics
@gmail.com if you encounter technical
issues
■ Discussion sections start in week 2

Sections are held in person at their assigned
times and rooms

Contact your TA if you have section-related
questions 14
Rational Decision Making: Myths
and Confusions

Business Decisions
SOC 138/ECO 148

1
 Back to Decisions
■ Decision Maker

Beliefs

Values
■ Context

Choice Set A B

States of the 50
%
50
%
90
%
10
%
World

1 4 3 2
2
 What Do We Mean by a “Rational” Decision?

■A quick and dirty approximation:


One which considers the probable states of
the world associated with each potential
option;

Weights states of the world based on
probability and personal values in a logically
consistent manner; and

Selects the option which puts the most
weight on the most desirable states.
■ Choiceconsistent with our values
and beliefs
3
 Modern Rational Choice Theory
■ Providesa precise, minimal
implementation of consistent
reasoning

Future oriented

Avoids pathological behavior

Builds on probability theory, logic

Concerned only with consistency, not
with content of values or beliefs
■ (We’ll
see this in more detail in the
next several lectures)
4
 “Pseudo-irrationality”
■ Mythsand confusions abound
regarding “rational” behavior

What seems rational may not be – and
what seems irrational may be rational!

Must turn to the theory, rather than
intuition
■ Beforediscussing what the theory
says, we consider some things it
does not say

5
 Myth: Rationality is “Cold” or “Emotionless”

■ Rational behavior depends on

values

The content of these values is not in
question – only their consistency
➔
There is no “rule” against “sentimental values”

Ignoring one’s values is not rational
■ Emotion per se is neither rational
nor irrational

Rationality involves decisions, not feelings;
it neither predicts nor prescribes emotional
states
6
 Myth: Rationality Is Inherently Egoistic

■ Rational behavior is assessed in

terms of the decision maker’s
values…
■ …thus, if the decision maker’s
values are altruistic, it is rational for
him or her to behave altruistically.

Altruistic behavior can satisfy the axioms of
rational choice

Egoism is sometimes assumed but not
required
7
 Myth: Rational Players Always Win
■ Actors are constrained by the choice set

The action chosen will be the best available,
but may not be the best conceivable
➔
Popularity is not always a signal of desirability

Strategic factors may make some choices
ineffectual
➔
Dilemma games
■ Actors also face limited information

We can’t choose options if we don’t know
about them!

Incorrect beliefs may be rational if derived
from faulty information
8
 Myth: “Weird” Things are “Beyond” Rationality

■ Rational choice requires action which is

consistent with our beliefs

Even if we are dealing with a strange or far-fetched
notion, we can (and must) consider it
■ Rational judgment as scientific skepticism

Update prior beliefs based on the weight of
evidence

That which is logically consistent is not ruled out
(although it may be extremely improbable)

The same rules of judgment apply to all claims

9
 From Myth to Reality
■ Rational
decision making stresses
consistency with values and beliefs
■ All
decisions or questions of
judgment are “fair game”
■ Context, subject matter, or
emotional states do not render
decisions intrinsically rational or
irrational

10
 Confusion: Normative and Descriptive Models

■ Descriptive Models – What is


Rational behavior as a predictive device

Empirical – it works or it doesn’t
■ Normative Models – What “ought” to be

Rational behavior as a prescription for making
decisions

Evaluative – we accept it or we don’t
■ The same concepts can be used for both
purposes, but the purposes are not the same!

11
 Example: Planning, Policy, Measurement, and Forecasting

■ Normative or Descriptive?

Basel Capital Accord

Annual sales forecast

S&P 500 index

Mission statement

Investment plan

Sharpe ratio
■ How could each of these be used in
an alternate role?
12
 Avoiding Confusion
■ Determine if a given use if normative
or descriptive

Are we making prescriptions, or
predictions?
■ Keeping our “is” out of our “ought”

We do not have to view real behavior
as optimal or desirable

Our ideas of optimal or desirable
behavior do not have to reflect
common practice
13
 Summary and Prospect
■ Folk notions of "rational" behavior differ
from modern rational choice theory
■ Principles of rational decision making can
be used either descriptively or
prescriptively

Both are important, but shouldn't be confused!
■ Up next: the theory itself (in three parts)

Axioms of rational choice

Principles of rational judgment

Game theory
14
The Axioms of Rational Choice

Business Decisions
SOC 138/ECO 148

1
 Reminder: Goals of a Rational Decision System

■ A quick and dirty approximation:


One which considers the probable states of the
world associated with each potential option;

Weights states of the world based on probability
and personal values in a logically consistent
manner; and

Selects the option which puts the most weight on
the most desirable states.
■ Choice consistent with our values and
beliefs

2
 An Axiomatic Development
■ “Axiom”: a property or constraint which must
be satisfied
■ Axiomatic development (indirect definition)

Pick constraints (axioms) which are necessary
conditions for rational behavior

Find a system which satisfies those constraints (if
any)

Behavior generated by such a system will then
satisfy the initial constraints – it implements the
axioms
■ Applied to choice by Von Neumann and
Morganstern, Savage, and others

3
 Notation and Basic Concepts
■ Alternatives

S signifies the set of alternatives, with outcomes A,
B, etc.
■ The preference relation

AB signifies “A is preferred or indifferent to B,” or
“B is not preferred to A”

A=B signifies indifference between A and B
■ The lottery

(ApB) signifies a gamble (or “lottery”) in which A
occurs with probability p, and B occurs with
probability 1-p

p ? 1-p
(ApB) A B 4
 Axiom 1: Comparability
■ Given alternatives A and B, either AB, AB, or
both, in which case A=B
■ Interpretation: All pairs of options can be
compared; you either prefer one to the other,
or else you are indifferent between them
■ Pathology avoided: Inability to make a
prediction or judgment of any kind (even of
indifference) for some sets

5
 Axiom 2: Transitivity
■ If AB and BC, then AC
■ Interpretation: Preferences can’t have
“loops”; values must form a hierarchy
■ Pathology avoided: The “money pump”;
also, manipulation via agenda setting
(the Condorcet problem)

6
 The "Money Pump": A How-To
Imagine that "Bob" has preferences A>B, B>C, but C>A...
Here's how to take all of his money:

1. Give him A (you have B and C).

2. Offer to trade him C for A (and a small fee).
3. Now that he has C, offer to exchange his C for a
B (again, for a fee).
4. Finally, offer him the A (that you got from him in
step 2) in exchange for his B (and a fee).
5. Go back to step (2) and take more of his money!
Repeat as needed.

(Transitivity: it keeps you from losing your shirt.)

7
 Axiom 3: Closure
■ If A and B are in S, then (ApB) is in S as well
■ Interpretation: If I can compare A and B, then I
can also compare lotteries over A and B
■ Pathology avoided: Inability to make a
prediction or judgment for choice under risk

8
 Axiom 4: Distribution of Probability Across Alternatives
(Frame Invariance)

■ (ApB)qB = (ApqB)
■ Interpretation: Only the “final” probability
distribution over states of the world matters –
re-expressing a choice in terms of compound
lotteries will not change your decision
■ Pathology avoided: Manipulation by framing
effects
q 1-q

=
pq 1-pq
p 1-p

A B B A B
pq 1-pq pq 1-pq 9
 Axiom 5: Independence
■ For options A,B,C, AB if and only if (ApC)(BpC)
■ Interpretation: Adding an equal chance of getting
an irrelevant third outcome instead of either A and
B shouldn’t change your decision
■ Pathology avoided: Manipulation by framing effects
(e.g., pseudocertainty), “(weak) stochastic money
pump”

10
 Taking More of "Bob's" Money
Imagine that "Bob" has preferences (ApC)>(BpC), but B>A...
Here's how to take more of his money:

1. Sell him (BpC) for R (his reservation price).

2. Offer to trade him (ApC) for (BpC) (and a fee)
before the lottery is held.
3. Let the lottery resolve. You either both win C (in
which case stop) or you win B and he wins A.
4. If you won B in (3), trade it to him for his A (plus
a small fee).

Ultimately, "Bob's" outcomes are the same as (BpC), but

he pays more than his reservation price!
(This is like the earlier money pump, but can only be run once ("weak")
and relies on randomness ("stochastic"); also called a "Dutch Book")
11
 Axiom 6: Consistency
■ AB if and only if A(ApB)B
■ Interpretation: Preferring A to B implies that
you should be at least indifferent to having
some chance of getting A instead of B (and,
similarly, that you don’t strictly prefer some
chance of getting B instead of A to getting A for
sure)
■ Pathology Avoided: Violation of the “sure
thing” principle; “(strong) stochastic money
pump”

12
 Yet More Money from "Bob"
Imagine that "Bob" has preferences (ApB)>A>B...
Here's how to take whatever money "Bob"
has left after the previous axioms:
1. Give him A (you have B).
2. Offer to give him a chance to win B from you
(i.e., (ApB)) in exchange for A and a small fee.
3. Let the lottery resolve; if he ends up with A (you
have B), return to (2).
4. If instead he ends up with B (you have A), offer
to trade it for your A and a small fee.
5. Go back to step (2) and take more of his money!
Repeat as needed.

(This is like the first money pump, but it uses a random ("stochastic")
process; we call it "strong" because it can be repeated.)
13
 Axiom 7: Solvability
■ If ABC, there exists a probability p such that
B=(ApC)
■ Interpretation: If you prefer A to B to C, there is
some lottery over A and C which is equivalent
to B
■ Pathology avoided: “Obsession with the
infinitely improbable”; indirect violation of
completeness (e.g., if two alternatives are
unbounded)

14
 The Form of Expected Utility Theory
■ A model which satisfies the axioms: Subjective
Expected Utility Theory (or just EUT)
■ Model structure

Utility function: an abstract numerical measure of
preference

Subjective probabilities: beliefs about states of the
world, given choices
■ Decision procedure

For each option, take the (probability) weighted
average of outcome utilities

Choose the option with the highest expected (I.e.,
weighted mean) utility

15
 Example of EUT in Action

Hypothetical utility for money: u ( x)  x

A B
60% 40% 40% 20%

40%

$15 $10 $40 $5 $0

E  u  A   =0.6 u  15 0.4 u  10  E  u  B   =0.4 u  40 0.4 u  5  0.2 u  0 

=0.6  150.4  10 =0.4  400.4  50.2  0
≈0.63.8730.4 3.162 ≈0.4 6.3250.4 2.2360.2 0
≈3.589 ≈3.424

16
 A Geometric View of Risk Aversion

7
6
5
u(x) 4
3
2
1
0
$0 $5 $10 $15 $20 $25 $30 $35 $40
x

17
 Another Example – the WhirliLoop Dilemma
Invest in new infrastructure, or not?
• Current facility results in $200,000 profit per quarter
• New facility costs $100,000
• If demand for WhirliLoops spikes (30% chance), new facility would
allow for estimated quarterly profit of $600,000
• Without new facility, could only obtain $300,000
• Only interested in next quarter (you plan on retiring!)

Maintain Invest
30% 70% 30% 70%

$300k $200k $500k $100k

E u=0.3 u $300k 0.7 u $200k  E u=0.3 u $500k 0.7 u $100k 
=0.3  3000000.7  200000 =0.3  5000000.7  100000
≈477 ≈433

18
 Generality of the Framework
■ A surprising result: any model satisfying the
axioms will be equivalent to EUT

In fact, only transitivity, completeness, continuity,
and independence are required

Further, the utility function itself can be specified up
to a positive affine transformation
■ Implications:

EUT can be considered a “generic” or canonical
model of rational choice (as defined by the axioms)

Any alternative model must lead to one or more
pathologies of choice

19
 Still Ahead….
■ The judgment side: probability, and
rational judgment
■ Strategic decision making
■ Descriptive models

20
Rational Judgment

Business Decisions
SOC 138/ECO 148

1
 Manifesto for Rational Judgment
■ Judgments must be logically
consistent
■ If a conclusion can be reached in
more than one way, then every
possible way must lead to the same
result
■ We must always take into account all
of the evidence at our disposal
■ The same evidence must always
lead to the same judgment
2
 Reasoning About Uncertainty
■ Long understood to be of importance

“Probability is the very guide to life.” –J. Butler,
1896
■ Deeply connected with “common
sense”…

“Probability theory is nothing but common
sense reduced to calculation.” --P. Laplace,
1819
■ …but, as we shall see, Monsieur Laplace
exaggerates

3
 From Mystery to Probability
■ Rules of evidence

Roman and Talmudic witness laws

Medieval “half-proof”
■ Early insurance pricing

Athenian “Maritime Loans”, c340BCE

Ulpian’s annuity tables
■ Games of chance

Geralamo Cardano (1540s) – inveterate
gambler

Le Chevalier de Mere (1650s) – first
mathematical theory of dice (followed by
Fermat, Pascal, and others)
4
 What is Probability?
■ Probability
is a mathematical
representation of uncertainty

Probability theory is a formal system
for reasoning about uncertainty
■ Various interpretations

Classical

Frequentist

Subjective

5
 Basic Concepts and Notation
■ The“universe of possibilities”
(denoted S)

Events (denoted A, B, C, etc.)

Negation (denoted A)

The null event (= S)

Conjunction (AB) and disjunction (A or
B)

Conditioning (A|B)
■ The probability measure (denoted p)

p(A) is the probability of A

6
 The “Rules” of Probability
■ 0p(A)1 for all events A in S

Probabilities are real numbers between 0
and 1
■ p(S)=1, p()=0

Something must happen, and nothing can’t
happen
■ p(AB)=0 iff p(A or B)=p(A)+p(B)

If A and B are mutually exclusive, the
probability that at least one happens is the
sum of their probabilities

7
 More “Rules”
■ p(A)+p(A)=1

Something either happens, or it
doesn’t

(Can derive from previous rules)
■ p(AB)=p(A|B)p(B)

The probability of A and B is the same
as the probability of B times the
probability of A given B

8
 Bayes’ Theorem
■ The most important result in the
theory of inference!
■ p(B|A)=p(A|B)p(B)/p(A)

The probability of B given A is “share”
of the probability of A taken up by the
probability of A and B together

9
 Why the Excitement?
■ Bayes’ Theorem allows us to derive
probabilities of hypotheses given
data from probabilities of data given
hypotheses
■ For hypothesis, H, and data, D:

p  D∣H  p H 
p H∣D=
p D∣H  p  H  p  D∣¬H  p¬H 

10
 Interpreting the Theorem
■ Each component of Bayes’ Theorem
has a specific meaning:
Probability of Probability of
data given H H before data

p  D∣H  p H 
p H∣D=
p D∣H  p  H  p  D∣¬H  p¬H 

Probability of Probability of NOT

H after data Probability of
data given H before data
NOT H
11
 Some More Terminology
■ Useful jargon:

“Prior” probability – p(H) before data

“Likelihood” – p(D|H) and p(D|H)

“Posterior” probability – p(H|D) after
data
■ Analogies

“Prior” – experience

“Likelihood” – evidence

“Posterior” – conclusion

12
 Example #1: Detecting a Cheat
■ Problem: p(Coin is two-headed)

Assume fair/2H are equiprobable

Three flips yield 3 heads in a row
■ Solution:

p H H H∣CpC
p C∣H H H =
p H H H∣Cp Cp  H H H∣¬Cp ¬C
10.5
=
10.50.1250.5
≈88.9%

13
 Example #2: Bankruptcy
■ Problem: p(Mr. X defaults)

Assume a base default rate of 0.01

Mr. X is observed to have a monthly obligation of $X

60% of defaulters have a monthly obligation of $X,
versus only 10% of non-defaulters
■ Solution:
pO X∣D pD
pD∣OX =
pOX∣DpDpO X∣¬D p¬D
0.60.01
=
0.60.010.10.99
≈5.7%

14
 Summary
■ Probability theory supplies a basis for rational
judgment
■ Bayes’ Theorem tells us how to combine past
experience (priors) and new evidence
(likelihood) to reach conclusions (posteriors)

Recite it to yourself every day; it builds character

■ Next time: the theory of strategic behavior

15
Decision Making in Strategic
Contexts
Business Decisions
SOC 138/ECO 148

1
 Life is But a Game....
■ Thus far, we have been concerned with choices
and judgments

“Decision” as central concept
■ “Games”: formal models of strategic situations

Basic Elements
➔
Players
➔
Actions
➔
Strategies
➔
Payoffs/outcomes

Complications
➔
“Chance” as a player
➔
Information sets
2
 Game Theory and Strategic Decision Making

■ Game theory – a body of normative

work on rational strategic behavior
■ Builds on “classical” rational choice
theory

Multiple decision makers

“Dynamic” versus “static” orientation
■ Providesformal guidelines for
optimal play

“With many calculations, one can win;
with a few, one cannot” –Sun Tzu
3
 Sequential Games
■ Games in which
players can observe I.
and respond to Cheat Not
previous actions

Represented in
II. II.
extensive form
■ Subgame perfection Report Not Report Not

Look forward in tree

Find path such that
every step is payoff- -9 9 -1 0
maximizing 1 0 -1 0

4
 Simultaneous Games
■ Games in which
players choose
without observing I.
others’ choices Cheat Not

Not observing others
doesn’t mean ignoring -9 -1
them, however Report

Represented in matrix 1 -1
form II.
9 0
■ Various solution
Not
concepts

Dominant strategies
0 0

Nash equilibrium
5
 Dominant Strategies
■ Strategies which are at least as good as
any other strategy, no matter what one’s
opponents do

Weakly dominant: at least as good

Strongly dominant: strictly better
■ Should always be used, where possible

Where available, can ignore opponent’s
choices

Dominant strategies do not always exist

Procedure: deletion of dominated strategies

6
Example – Overzealous Enforcement

I.
Cheat Not

-9 -1
Report
5 1
II.
9 0
Not
0 0

7
 Best Responses
■ Given opponents’ strategy choices, the
best response is one which maximizes
expected payoff

Contingent on opponents’ strategies

Dominant strategies are best responses, if they exist
■ Best response may be a mixed strategy

Do one thing sometimes, sometimes another

Choose randomly, given optimal weights

“Clamor in the East, attack in the West” –Stratagem 6

8
 Example – Adoption of New Technologies

DevelCo
C++ Java

1 -1
C++
1 -1
SupportCo
-1 2
Java
-1 2

9
 Equilibria
■ Multiple decision makers create the
problem of strategic reasoning

My behavior depends on your behavior which
depends on my behavior which depends on your behavior which depends on my behavior………..

➔
“In war, the will is directed at an animate object
that reacts” -Clausewitz

Seek sets of strategies which are “stable”
➔
Infinite regress should not change behavior
➔
Rational players should not have incentives to
deviate
■ Strategy sets which are stable in this way
are called “equilibria”

Many kinds – we consider only two here
10
 Equilibrium in Dominant Strategies
■ Where dominant strategies exist, they
should be used…
■ …so, if each player has a dominant
strategy, this provides a stable strategy set
■ Equilibrium in dominant strategies

Usually unique, but may not be (if multiple weakly
dominant strategies exist)

Not often found

Very stable – not easily perturbed

Always subgame perfect

11
 Hypothetical Example - OPEC
■ Cartel problem
Kuwaiti

Increased production Prod.
decreases price/barrel

Temptation to expand
1 2
■ Dominant strategies 3 5

Kuwait: produce more
8
Saudi 24 20

SA: produce less
Prod.
■ Result: Kuwait 2.5 4.4
expands, SA holds 9
back 22.5 19.8

Why? SA has larger
share!
(Production in mB/d, Payoffs in 10m$/d)

12
 Nash Equilibrium
■ Where equilibria in dominant strategies
fail, what other options are there?

Look for sets of mutual best responses
■ Nash equilibrium

Many may exist

May be in pure or mixed strategies

Can be unstable – problem of equilibrium
selection

Dominant and subgame perfect equilibria are
Nash, but the reverse is not always true

13
 Hypothetical Example – Tobacco Advertising

■ Advertising problem

Advertising is
expensive Philip Morris Adv.

Can draw customers L H
from a competitor
■ Nash equilibria 1.2 1.4

One stands firm, one L
yields Ligget 0.8 0.7

Mixing it up Adv.
■ Result: unstable 1.1 0.9
situation H

Multiple equilibria 1 0.6

Expect frequent
changes in strategy (Payoffs in 1b$/y)
choice
14
 A Heuristic Summary
■ Assess the game

Determine players, actions, payoffs

Determine form (sequential or simultaneous)
■ D&N’s Heuristics

“Look forward, reason backward”

“If you’ve got a dominant strategy, use it”

“Eliminate dominated strategies from consideration”

“Look for an equilibrium”
■ Final inspiration

“Study strategy over the years and achieve the spirit
of the warrior. Today is victory over yourself of
yesterday; tomorrow is your victory over lesser men.”
–Musashi
15
Bounded Rationality, Search,
and Satisficing
Business Decisions
SOC 138/ECO 148

1
 The Frailty of the Flesh
■ Rational choice implies substantial cognitive
capacity

Must consider all possible options

Must consider all possible outcomes

Must weight probabilities/values perfectly for all of
the above

In strategic contexts, must model opponents’
behavior, too!
■ Perhaps we ask too much?

Limits on memory, cognitive processing capacity

Cannot conceive of all possibilities, must less
compare them optimally

2
 Bounded Rationality
■ An alternative to perfect rationality:
assume decision makers are rational
within specified limits

Primarily descriptive, although some
normative uses
■ Many kinds of limits can be considered

Memory

Forward-thinking (myopia)

Strategic thinking

3
 Heuristics
■ Heuristic: a general guideline or “rule of
thumb” which usually works well (but
which is not optimal)
■ How well each rule works depends on the
environment

Particular heuristics are better for particular situations

Can be especially bad in the wrong context

4
 Examples
■ Measuring length via thumb, forearm,
paces
■ Avoiding odd-looking people in dark
alleys
■ Buying from established firms (branding)
■ Hiring based on recommendation
■ “Folk” diversification rules (e.g., always
have 5 stocks, half stock/half bond mix)
■ Investing based on personal experience
5
 Heuristic Search
■ A metaphor: “All the world’s
a supermarket”

Many options, with multiple
features of interest
➔
“Search space”

Can only see a few at a time

Must search through the
options for the one which is
most preferred
➔
“Search strategies”
■ Want to understand the
implications of different
search strategies for choice
6
 The Conjunctive Rule
■ Procedure:

Choose a set of requirements each option must meet

Reject any option which fails one or more requirements

Pick (possibly randomly) from the remainder
■ Properties:

Close to optimal if filtering conditions are stringent
enough

Not very useful if conditions are too loose

Can get “stuck” if no option satisfies conditions

Related to the principle of satisficing (which we will see
presently)

7
 The Disjunctive Rule
■ Procedure:

Choose a set of requirements each option must
meet

Reject any option which fails all of the requirements

Pick (possibly randomly) from the remainder
■ Properties:

Close to optimal if options are similar except for one
feature (and filter is tough enough)

Often over-inclusive

Can easily lead to acceptance of skewed options

8
 Lexicographic Search/Elimination by Aspects

■ Procedure:

Rate aspects by importance

Compare/eliminate options by most important
aspect (for EBA, pick aspect semi-randomly)

If still not through, go to the next aspect
■ Properties:

Close to optimal if one aspect is vastly more
important than all others

Can get into trouble if strong trade-offs exist

9
 Example – Portfolio Selection
Portfolio A Portfolio B Portfolio C
Expected Return: $1500 Expected Return: $900 Expected Return: $3500
Sharpe Ratio: 1.5 Sharpe Ratio: 3 Sharpe Ratio: 0.75
Social: 2 out of 5 Social: 4 out of 5 Social: 1 out of 5

Conjunctive: Return >$1000, Sharpe >1, Social>1

Disjunctive: Return > $1000, Sharpe >1, Social>1

Lexicographic: Return > Sharpe > Social

(FYI, Sharpe Ratio is excess return/risk.)

10
 Satisficing
■ Very general heuristic: search until you find
something which is “good enough,” then stop
■ Strength – relatively undemanding

Need definition of “good enough,” ability to check
options against the definition
■ Weakness – you may miss out on a good thing
■ Close to optimal when search costs are high,
and/or when most “acceptable” options are of
similar value

11
 Example – Hiring by Interview

1 2 3 4 5 6

1yr 2yr 6yr 3yr 10yr 4yr

Observed Not Observed

Wanted: As experienced as possible

Criteria: 5yrs experience

12
 Win-Stay Lose-Shift
■ A simple satisficing heuristic for strategic play

When you are winning, keep the same strategy

When you are losing, try something else
■ Requires minimal processing power, works
moderately well in many situations

Don’t tend to keep doing things which don’t work, tend
to spend most of your time with strategies which (more
or less work)

In long run, will avoid dominated strategies, seek
dominant ones

Not so good where “clever” behavior (like mixing) is
required

13
Example – Good/Bad Traders

14
 Summary
■ Bounded rationality: a compromise
between genius and stupidity

Heuristics instead of optimal procedures

Search metaphor
■ Different heuristics have different
strengths/weaknesses

Some aren’t bad, but they must be matched
to the environment

Can result in systematic distortion (e.g., eye-
level bias)

15
Loss Aversion and Framing
Effects
Business Decisions
SOC 138/ECO 148

1
 A Less Rational Decision Theory
■ With bounded rationality, persons
were taken to be rational within
limits
■ The problem runs deeper, alas

Empirical studies by Allais, Ellsberg,
Kahneman, Tversky, and many others
suggested that people choose in
fundamentally irrational ways
■A new imperative: can we model this
behavior?

2
 A Detour Through Psychophysics
■ Study of human response to
physical stimuli

Perception of color,
light/darkness, sound, etc.
■ Stylized fact – perceptions
occur in terms of changes,
rather than absolute values
■ Weber-Fechner law

The “just-noticeable”
difference in any stimulus is
proportional to the magnitude
of the stimulus 3
 Example: Noise Levels

Increase for
Same Perceived

2
Volume
1 Change

Base Level

4
 Reference Values
■ Psychophysical principle for decision making:
values are assessed in terms of changes,
rather than absolute states of the world
■ Each person has a reference value for their
current state

Decisions are evaluated based on changes from the
reference point

Contrast with EUT, which focuses only on end
states

Results in irrational behavior, as we shall see

5
 Diminishing Sensitivity to Gains/Losses
■ Application of Weber-
Fechner law Value

Sensitivity to
gains/losses diminishes
as gain/loss grows

Requires “S-shaped”
value curve Payoff
■ Implies proportional
pricing effects

Example 1: would drive
across town to save $20
on a vacuum cleaner, but
not on a car

Example 2: difference
between losing nothing
and $10 greater than
between losing $10,000
and $10,010
6
 Gain/Loss Frames
■ A problem: we can change gains into losses by
changing the problem frame!

The same choice between states of the world can be
put in terms of what you could lose (assuming the
gains) or what you could gain (assuming the losses)

Violates the principle of frame invariance
■ S-curve implication: risk averse when framed
as gain, risk-loving for loss

Sure gain of $240 vs 25% chance of gaining $1000

Sure loss of $750 vs 75% chance of losing $1000

46% chose A,B (about twice as many as the next
most popular option), 59% inconsistent

7
 Example – The Layoff Problem
"Due to a revenue shortfall, a CEO faces a dilemma. Firm
analysis say that required plant closings will force the
layoff of 600 workers for certain, unless one of two plans is
chosen. If the CEO chooses the first plan, 200 workers’
jobs can be saved [400 workers’ jobs will be lost]. If the
CEO chooses the second plan, there’s a one-third chance
that 600 workers’ jobs will be saved [no jobs will be lost],
and a two-thirds chance that none will be saved [600
workers’ jobs will be lost]. Which plan do you think the
CEO should choose?"

First (safe) plan: 84% [52%] Second (risky) plan: 16% [48%]

(Loss frame increased rate of choosing risky option by

about 30%....)
8
 Loss Aversion
■ Gain/loss response is
Value
asymmetric

Losses felt more keenly
than corresponding
gains
Payoff

Linkage with biological
theory, e.g., loser effect
■ Don’t confuse with
risk aversion!

One can be loss averse
and risk loving!

9
 Implication: Honoring Sunk Costs
■ When we fail to update our reference values,
we may think of resources already spent as
still being “ours to lose”

Violates future orientation
■ “Completing Tennessee-Tombigbee is not a
waste of taxpayers’ dollars. Terminating the
project at this late stage of development would,
however, represent a serious waste of funds
already invested.” –Sen James Sasser, Nov.
1984

(Too bad the project was estimated to be worth less
than the cost of completion!)

10
 Implication: The Endowment Effect
■ Once we are “endowed” with an object, we
update our reference value

Giving it up is now a loss – and the object is now
worth more than it was before!

Kahneman, Knetch, and Thaler’s magically more
marvelous mugs
■ Evidence suggests that the effect grows with
time

No clear endpoint

May explain obsession with old trinkets

11
 Example – Negotiations
■ Consider negotiations between Mr. X and Ms. Y

Mr. X has apples, Ms. Y has oranges
■ An obstacle to trade: the endowment effect

That which you trade away is a loss – and hence
more valuable

That which you receive is a gain – and hence
(relatively) less valuable

But this is true for both parties!
■ What can be done?

Distance both sides from their endowments; “put
everything on the table”

Discuss dividing the resources, not direct exchange

Frame the breakdown of talks as a loss

12
 Tying it All Together: Prospect Theory
■ Descriptive model Value

Choice among
prospects
 [(x1,p1),(x2,p2),...,(xn,pn)]  Payoff

■ Three elements

Reference value

Loss averse value
function (v(x))

Probability weighting 1
function ((p))

Decision Weight
■ Choose prospect
which maximizes
n

∑ v x i  pi  0
i=1
0 Probability 1
13
 Prospect Theory vs. EUT
■ EUT looks to the end state, PT thinks about the
present

Gains and losses may lead to the same place, but
PT cares about how we get there
■ EUT is frame-invariant, unlike PT

Can lead to transitivity, comparability violations
■ PT differentially weights probabilities

Can lead to independence violations

Overweights certain small probabilities,
underweights moderate ones
■ EUT has a normative foundation, PT is
intended to describe real behavior

14
 Coming Soon…
■ More on the weighting function

Censoring effects
■ Forecasting and scenario thinking
■ Risk perception
■ And, finally, the dread exam

Advice from prospect theory: endow
yourself with a good grade, and then
consider the chance of losing it!

15
 Censoring Effects,
Forecasting, and Scenario
Thinking
Business Decisions
SOC 138/ECO 148

1
 Prospect Theory, Redux
■ Descriptive model Value

Choice among
prospects
 [(x1,p1),(x2,p2),...,(xn,pn)]  Payoff

■ Three elements

Reference value

Loss averse value
function (v(x))

Probability weighting 1
function ((p))

Decision Weight
■ Choose prospect
which maximizes
n

∑ v x i  pi  0
i=1
0 Probability 1
2
 Prospect Theory and the Decision Weighting Function

■ In EUT, outcomes 1
are weighted by p; in
PT, (p) fills that
role

Decision Weight
■ Some features:

Underweighting of
moderate/large
probabilities

Overweighting of 0
small probabilities
0 Probability 1

Censoring of
extremes

3
 Censoring the Extremes
■ For probabilities very 0.2
close to 0/1, weights
are treated as 0/1

Decision Weight
■ Intuition: we cannot
conceive of extremes,
“round” them to
nearest whole number
■ Problem: where
extremes matter, 0

judgment may be 0 Probability 0.2

impaired

4
 Conjunction Conundrum
■ The intersection (conjunction) of many highly
probable events is difficult to evaluate

For probabilities close to 1, PT rounds up

Even below this point, hard to calculate intuitively
■ Problem: many scenarios involve conjunctions

Plans with multiple elements

Strategic contingencies

Mechanisms with many parts

5
 Example – Uptime Problem
"A machine is composed of seven parts. Suppose each part in the
machine works 90% of the time. If the machine works as long as
all seven parts are working, what percent of the time will the
machine be working?"

Correct answer:

p works= p  part 1 works×⋯

× p part 7 works
7
= ∏ p  part i works
i=1
7
=0.9
≈48 %

6
 The Difficulties of Disjunction
■ The probability of an event happening at least
once (disjunction) is hard, too

Disjunction = conjunction of non-events

For probabilities close to 0, PT rounds down

Same problem of intuitive calculation
■ Problem: risk evaluation often involves
disjunction

Chance of event happening within time span

Chance of at least one failure occurring

7
 Example – Bankruptcy Risk
"Assume that a firm, StableCo, faces a 0.4% chance of filing for
bankruptcy per month. Over the course of 25 years, what is the
probability that StableCo will file for bankruptcy?"

Correct answer:
p  BR in 25y =1− p ¬BR in 25y 
25 12 ?!?
=1− ∏ ∏ p ¬BR in 1mo
i =1 j =1
25 12
=1− ∏ ∏  1− p BR in 1mo 
i =1 j =1

=1−1−0.004300
=1−0.996 300
≈70 %

8
 Thinking with Stories
■ In considering complex situations, we fall
back on causal narratives (“stories”)

Reflect mental models of phenomenon at
hand
■ Elements of a story

Actors

Events

“Reasons”
■ Stories without these elements typically
seem less plausible

9
 The “Plausibility” Bias
■ Flashback from probability: p(AB)≤p(A)

Thus, adding elements to a story cannot make it more
probable (conjunctive fallacy)
■ Thinking with “reasons” and “explanations”

More reasons/explanations provide a clearer picture
of how the story might come about

Conjunctive reasoning is difficult, makes complex
stories seem more probable
■ “Plausibility” bias

Stories with more elements (particularly elements
which are individually probable) are seen as more
probable

10
 Example – PittSteel
"PittSteel is a rust-belt steel company which has fallen on hard times. 87%
of similar firms in the region have filed for bankruptcy in the last five years,
and two of the firm's five largest customers have recently shifted to
alternative suppliers. After a recent earnings report, PittSteel's credit was
downgraded, and its stock price has fallen by more than 40% over the past
three months."

Which of these scenarios seems more likely to you:

• PittSteel will post record profits within the next four

quarters. [8%]

• PittSteel will implement massive job cuts within the next four
quarters, leading temporarily to record profits, but will be forced
into Chapter 11 bankruptcy protection when revenues continue
to slump. [92%]
(p(profits)≥p(profits AND job cuts AND bankruptcy), but it doesn't
always seem that way....)
11
 Further Problems from Hindsight
■ Coherent stories are easier to remember
than complex collections of events

An incoherent set of circumstances may be
forgotten; cases which fit our sense of
“plausibility” more likely to be remembered

“Profusion of special cases”
➔
Each previous account seems to be unique,
generalization difficult
■ “Creeping determinism”

Memory biased in direction of current knowledge

Past events seem more certain in retrospect

12
 Implications for Forecasting
■ Systematic biases in scenario evaluation

Risks of event occurrence will be underestimated

Probability of plan success will be overestimated

Scenarios which make “good stories” will be seen
as more probable (even when they aren’t)
■ Difficulties in learning

Past uncertainties will seem reduced

Present knowledge will color recollection

The “this time will be different” effect

13
 Putting it All Together
■ Reasoning about “chains” of events is hard

Censoring of extremes

Difficulty of intuiting px
■ Instead, we think with stories

Elements linked by “explanations”

Plausibility related to the strength, number of causal
explanations
■ Produces problems for realistic forecasting
■ Next time: risk perception

14
Risk Perception

Business Decisions
SOC 138/ECO 148

1
 What is “Risk”?
■ Conventionally: a chance of a negative
outcome

I am “at risk” if something bad might happen to me
■ More formally: uncertainty in payoffs

I am “at risk” if I’m not sure what will happen to me
■ Contrast the notions by considering sure
losses and unsure gains

Sure losses are “risky” by lay usage, and unsure
gains are not

Sure losses have no risk in the formal sense, and
unsure gains are risky

2
 Objective Factors
■ For a rational decision maker, risk is a function
of payoff uncertainty
■ While uncertainty is “subjective” in a strict
sense, it depends upon objective information

Set of potential outcomes

Base rates in the relevant population

Supplemental knowledge regarding problem
■ Rational perception of risk must also follow
rules of rational judgment, EUT

Update probabilities using Bayes’ Theorem

Weight outcomes by the axioms

3
 Example – Portfolio Selection
■ Standard financial risk measure: standard
deviation
n
StdDev  x=
1
∑
n−1 i=1
 x x
i 
−
2

■ Common measure of risk efficiency in financial

settings: Sharpe ratio

(Portfolio Return-Risk Free Rate)/Portfolio Standard
Deviation

How many units of return do you get for every unit
of risk?
■ Would calculate from historical data, statistical
models, etc.

4
 Risk Perception
■ Risk as a lay concept

Not simply variance in payoffs
■ Affected by cognitive, environmental
factors

Differential reporting of certain events

Differential saliency, ability to recall from
memory

Loss aversion

Decision weights and censoring

5
 Example: Perceived Death Rates
■ Death rates provide a basic background set
of risks for a population
■ It is difficult to weight risks appropriately if
you do not even know the rates
■ Knowledge of death rates heavily skewed

Differential media coverage (“newsworthy” death)

Differential visibility (“silent” death)

Differential saliency (“representative” death)
➔
Coherent causal accounts, low variability in details

Confusion of morbidity with mortality (“non”
death)

6
7
8
 The Slovic et al. Three Factor Model
■ An alternative to variance: descriptive model of
risk perception based on event features

Subjects rate risks

Ratings analyzed using factor analysis
■ Risk perception of non-experts employs three
distinct concepts

Not simply an approximation to variance

Combination of factor scores determines overall
perceived risk

9
 Factor 1: “Dread”
■ Most powerful latent dimension: “dread risk”

“Perceived lack of control, dread, catastrophic
potential, fatal consequences, and the inequitable
distribution of risks and benefits” (Slovic)
■ Events which are dramatic, and which we
cannot control, are seen as riskier

Airplane crashes, terrorism, food poisoning
■ “Mundane” events are less likely to generate
dread, even if they kill more people
불안감, 공포


Tobacco, car wrecks, falls and other household
accidents

10
 Factor 2: “Knowability”
■ Next latent dimension: “unknowable risk:

“Judged to be unobservable, unknown, new, and
delayed in their manifestation of harm” (Slovic)
■ Events which are thought to be poorly
understood are seen as riskier

Carcinogen scares, “psycho kids” and spree
shooters, genetic engineering
■ Events which are seen as well-known seem
safer

Coal plants, x-rays

11
 Factor 3: “Scale”
■ Third dimension: scale or exposure

Total number of persons affected by or exposed to
the risk
■ Something which affects only a small minority
is perceived as less risky

AIDS during the early/mid 1980s
■ Threats which are omnipresent are seen as
more hazardous

Radon, alar scares

12
 Examples
■ Nuclear power: rated high dread,
unknowable/controllable, potentially affects
many people
■ Tobacco: rated low dread, easily controllable,
potentially affects many people

Compare concern over second-hand smoke with
first-hand smoke
■ X-rays: rated low dread, unknown, affects few
people

13
More Examples

(Figures from Slovic, 1987)

14
Interpreting Events – Preexisting Views and Risk Updating

■ What happens when we observe a near-miss?


Could be a sign of increased risk (“this was almost
a disaster”)

Could be a sign of increased safety (“see, nothing
went wrong”)
■ Assessments are made based on existing
mental models

Make sense out of ambiguity by relating it to prior
beliefs

Reinterpreted event taken as evidence that prior
beliefs were right all along (circular reasoning)

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 Example
■ Plous showed various (real) near-misses to
subjects with established pro/anti military leanings

US nuclear missile launch initiated by accident

Russian missile accidentally re-targeted to Alaska

Phony US Coast Guard advisory claiming that WWIII had
been declared

Russian naval alert falsely claiming war with the US
■ Elicited interpretations, implications
■ Responses followed preexisting biases

Pro-military subjects felt reassured, saw cases as
proving that the system worked

Anti-military subjects felt alarmed, saw cases as proving
that the system is prone to failure

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 Summary
■ Normatively, risk is a shorthand for payoff uncertainty
■ Perceptions of risk do not follow normative models

We fear the catastrophic, the mysterious, and the omnipresent
■ Understanding of objective factors relating to risk is
also distorted

Biased information leads to biased estimation
■ Our interpretation of risk-related events depends on
our base risk perception

Tend to interpret in a based on initial beliefs

Circularly use interpretation as evidence
■ Speaking of risk…Exam 1 approaches! Don’t dread it!

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