IEDA 3230

Engineering Economics and Accounting

Behavioral issues

IEDA 3230
Engineering Economics and
Accounting

Behavioral issues

Dr. Jin QI
Department of Industrial Engineering and Decision Analytics
Hong Kong University of Science and Technology
 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Normative vs. Descriptive

• Normative • Descriptive
– Rational decision making – What we are doing
– What we should do – Bounded rationality
• Incomplete information
• Time and cost
constraints
• Limited cognitive abilities

Satisficing: Decision maker explores a limited

number of alternatives and choose an
acceptable decision rather than the optimal one
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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Decision making
• Rational decision making
– All alternatives are known
– DM can determine all the consequences from each
alternative
– DM can calculate the optimal decision
• Bounded rationality
– Incomplete information
– Time and cost constraints
– Limited cognitive abilities
• Daniel Kahneman
– Nobel Memorial Prize in Economic Sciences
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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Origins of Behavior
• Probability matching • Possible evolution
60% H event A 3
a
event B 0 60%: event A happens
40% T
event A 0 40%: event B happens
– Rational: pick H all the b
time event B 3
– Behavioral: randomize
– Individual decision
• choose action a
– Group decision
• randomize
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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Behavioral issues
• Decision Making Biases
– Risk aversion and reference dependent
– Ambiguity averse
– Time inconsistence
– Regret
– Fairness

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Risk aversion
• The St. Petersburg Game
– Game: flip a fair coin until you get the head
– Return
• If you get your first head in the 1st trial: $2
• If you get your first head in the 2nd trial: $4
• …
• If you get your first head in the kth trial: $2k
– Question
• How much are you willing to pay for a chance to play the game?
Risk Aversion
reluctance of a person to accept a bargain with an uncertain payoff rather
than another bargain with a more certain, but possibly lower, expected payoff
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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Expected utility theory

• Utility
– Representation of preferences over some set of goods and
services
– Quantify: assign a value, u(x), for each possible outcome x
• Expected utility
– Given a random outcome X, the expected utility is

p1u(x1)+p2u(x2)+…+pnu(xn)

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Expected utility theory

• Risk aversion
– Concave utility function
• Revisit St. Petersburg Game
– Log utility: u(x)=ln(x)
%
1
! " ln 2* = ln 4
2
"#$
u(x)

x
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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Prospect Theory
• Outcomes judged relative to a reference point
– Risk averse for gain
– Risk seeking for loss

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Framing with gain and loss

• The Asian Disease Problem (A)
– Imagine that the U.S. 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.
• Program A: "200 people will be saved"
• Program B: "there is a one-third probability that 600 people will
be saved, and a two-thirds probability that no people will be
saved"

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Framing with gain and loss

• The Asian Disease Problem (B)
– Imagine that the U.S. 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.
• Program C: "400 people will die"
• Program D: "there is a one-third probability that nobody will die,
and a two-third probability that 600 people will die"

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Ambiguity aware
• Subjective expected utility
– Guess a probability distribution when it’s unknown
• Ellsberg’s Paradox
– Box 1: 50 red balls and 50 blue balls
– Box 2: 100 red and blue balls with unknown
proportions

Payoffs:
Payoffs: US$1000
US$1000 for
for choosing
choosing aa blue ball.
red ball.
Which box will you choose?

Subjected expected utility cannot work

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Long term decisions

• Time is an important dimension
• Approaches for capturing time dimension
– Net present value !" + $!% + $ %!& + $ &!' + ⋯
– Discounted utility ) !" + $) !% + $ %) !& + $ &) !' + ⋯
– Insights: time-independent

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Present-biased preference

$110 in $100 in $110 $100

31 days 30 days tomorrow today
P P

! "# $ 110 > ! "( $(100) !$ 110 < $(100)

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Effort distortion
• Effort is not smoothed over time

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

The role of regret

• Given lottery tickets, students were asked to
exchange their ticket for another plus a small
monetary incentive
– Less than 50% agreed
• Given pens, over 90% agreed to exchange

“ If I exchange and not win, I would be pissed. If I don’t exchange

and don’t win, I’d know that I wouldn’t necessarily have won had I
exchanged

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 IEDA 3230
Engineering Economics and Accounting
Behavioral issues

Fairness
• Distributive Justice
– When the outcome of a decision making process is judged
to be fair
• Equality (shareholders getting same dividend per share)
• Procedural Justice
– When the dynamics of a decision making process are
judged to be fair
Player 1

• Ultimatum game $0
x
$100

Player 2
Accept Reject

$100-x, $x $0, $0
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