THE OPTIMIZING MODEL OF DECISION MAKING: A RATIONAL ECONOMIC "MAN" MODEL"

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Judgment and Decision Making The capacity of
the human mind for formulating and solving
complex problems is very small compared with the
size of the problems whose solution is required
for objectively rational behavior in the real
world.
Herbert Simon (Nobel Laureate in Economics)
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TWO MODELS OF DECISION MAKING

• So called Optimizing or Rational-Economic
  Man Model of Decision Making
• prescriptive
• Behavioral Model of Decision Making
• descriptive

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THE OPTIMIZING MODEL OFDECISION MAKING A
RATIONAL -ECONOMIC MAN MODEL
Steps in the Process

• Identify a decision point or issue.
• Identify the decision criteria.
• Allocate weights to the different criteria.
• Develop a list of possible alternatives.
• Select the best alternative (e.g., the
  alternative that maximizes utility).

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ASSUMPTIONS OF THE OPTIMIZING MODEL

• There is no conflict about the goal.
• All options are known or knowable.
• Your preferences are known to you and clear.
• Preferences are constant.
• The final choice will maximize outcomes of value.
• THERE IS LITTLE OR NO UNCERTAINTY (e.g. you are
  certain about how to evaluate options on the
  criteria you have established.

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BEHAVIORAL MODEL OF DECISION MAKING
Basic premise People intend to be rational but
are only boundedly so.
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BEHAVIORAL MODEL OF DECISION MAKING

• FOUR KEY FEATURES OF BOUNDED RATIONALITY
• 1) People satisfice when searching for
  alternative solutions to a problem.
• (satisficing sequential and limited as opposed
  to simultaneous and complete search for
  information)

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BEHAVIORAL MODEL OF DECISION MAKING

• FOUR KEY FEATURES OF BOUNDED RATIONALITY
  (contd)
• 2) People resort to the use of certain
  simplifying heuristics or rules of thumb that
  often serve them well in making decisions but
  that often get them into trouble because they
  misapply these rules of thumb.

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Examples of Heuristics people use when making
decisions AVAILABILITY BIAS

• Peoples probability estimates are biased by
  things like vividness and ease of
  retrievability of examples from memory.

REPRESENTATIVENESS HEURISTIC

• Patterns of resemblance bias estimation

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Availability Bias

• Which of the following causes more deaths in the
  United States each year?
• A.. Stomach Cancer
• B. Motor Vehicle accidents
• What percentage of women in the U.S. keep their
  maiden name after marriage?

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Representativeness Bias

• Mark finished his MBA at a prestigious
  university. He is very interested in the arts
  and at one time considered a career as a
  musician. Where is Mark more likely to take a
  job
• In the management of the arts
• With a management consulting firm?

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OTHER SPECIFIC EXAMPLES OF DECISION MAKING
HEURISTICS

• Insensitivity to effect of sample sizes (Question
  2)
• In the extreme, called the vividness effect.
• Difficulty estimating probabilities of compound
  events (question 3)
• Gamblers Fallacy (Question 6)
• Hindsight bias
• Overconfidence (Question 8)

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The Reference Point Problem in Gambling

• You are spending the afternoon at the racetrack.
  You have lost 90 and are considering a 20 bet
  on a 151 long shot in the last race. Are you
  going to place the bet or not?
• You were given 100 shares of XYZ company. At the
  time you received them, they were valued at
  80/share. They are now valued at 20. The
  company is currently drilling for oil -- if they
  hit oil, the stock could go up to 25 or more,
  if they dont, it is likely to be worthless. Do
  you hang on to the stock?

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BEHAVIORAL MODEL OF DECISION MAKING
FOUR KEY FEATURES OF BOUNDED RATIONALITY
(contd) 3) Peoples preferences appear to be
influenced by how decision situations are framed
-- causing them to be inconsistent in their
preferences across contexts.
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Prospect Theory Decision 1. Choose
between _______ a. Sure win of
3,000. _________ b. A 75 chance of winning
4,500 and a 25 chance of winning nothing.
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Prospect Theory Decision 2. Choose
between _________ a. A sure loss of
3,000. _________ b. A 75 chance of losing
4,500 and a 25 chance of losing nothing.
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• You are the manager of a large manufacturing
  plant in a Fortune 100 company. At the present
  time, you are in the midst of a year-long plan to
  cut costs in your unit. Your goal for this
  quarter is to
• Do your best vs. save 250,000
• At present, you are considering two plans
• Plan M will save 95,000
• Plan N has an 80 chance of saving 50,000 and a
  20 chance of saving 250,000.
• Which do you choose?

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Prospect Theory Peoples decision making
behavior suggests a pattern of being risk seeking
in choices between alternative forms of losses
and risk averse in choices involving
gains. Implication People do not choose so as
to maximize gains and minimize losses.
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BEHAVIORAL MODEL OF DECISION MAKING

• FOUR KEY FEATURES OF BOUNDED RATIONALITY
  (contd)
• 4) People often become psychologically invested
  in their decisions which influences how they
  respond in decision making situations.
• Escalation of Commitment phenomenon
• Confirmation bias
• Motivation Need for Consistency to avoid
  dissonance attributional biases

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ESCALATION OF COMMITMENT
Individuals will invest more and more heavily in
an apparently losing course of action than in a
winning one in order to justify their earlier
decisions.
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CONFIRMATION BIAS
Individuals tend to seek confirmatory evidence
and exclude the search for disconfirming
information from our decision process.
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Attributional Biases

• Fundamental Attribution Error
• Tendency to underestimate the influence of
  external factors and overestimate the influence
  of internal factors when making judgments about
  others behavior
• Self-Serving Bias
• Tendency to attribute ones own successes to
  internal factors and ones failures to external
  factors