I.Chapter 1: Introduction

I.Chapter 1: Introduction

A.Book is about problems in decision making

i.Auditor Examples (page 1)

a)Arthur Anderson

Sued by SEC for Waste Management cover up June 2001

Questions on auditing of Sunbeam & Baptist foundation of Arizona

Enron: March 2002 AA sued for shredding of documents

June 2002 found guilty & collapsed

b)Coopers and Lybrand: Phar-Mor (federal conviction, inventory inflation)

c)Savings & Loan crisis

ii.Why?

a)Very bright people

b)Generally honest even though critics say neglect & corruption

c)Because it is psychologically impossible for auditors to remain completely objective.

d)Unconscious biases

iii. Auditing not the only disaster relating to faulty decision making

a)September 11, 2001

World Trade Center Bombing 1993

1994 Air France hijacking to bomb Eiffel Tower

1997 Al Gore commission report on “Airline Safety”

August 6, 2006 Daily Briefing: “Bin Laden determined to attack U.S.”

iv.Collusion? Between FAA inspectors and Airlines 2008

v.Self-serving bias:

a)“People tend to confuse what is personally beneficial with what is fair or moral”

b)human tendency to maintain positive illusions, to discount evidence & overlook easily available relevant information

c)Book Goal: “to clarify common errors even very bright people make on a regular basis”

B.Anatomy of a Decision (Examples p. 3 + Microsoft-Yahoo 2008)

i.Define the Problem:
“solve the problem not just eliminate its symptoms”

ii.Identify the criteria:

iii.Weight the criteria:

iv.Generate alternatives: continue until search cost > benefits

v.Rate each alternative on each criterion

vi.Compute the optimal decision

C.System 1 & System 2 Thinking (new in 6th edition)

i.System 1

a)intuitive system: fast, automatic, effortless, implicit, emotional

b)most decisions in life made using this method

ii.System 2

a)“rational reasoning”

b)slower, conscious, effortful, explicit, logical

iii.Primary idea;

a)Complete System 2 reasoning not required every time

b)Many System 2 decisions will use System 1 inputs

D.Bounds of Decision Making (Bounds of Rationality in 5th edition)

i.What is rationality

a)how decision should be made rather than how is made

b)Simon: “bounded rationality”

actual rather than normative

lack important information

small amount of information in memory

limitations of intelligence and perceptions

=> Satisficing decisions

c)decision making bounded in 2 ways not precisely captured by bounded rationality

will power is bounded: greater concern for present than long term
(ex: saving for retirement)

self interest is bounded, we do actually care for others

ii.two general models used in decision research

a)prescriptive: methods for making optimal decisions

b)descriptive: bounded ways in which decisions are really made

iii.Bounded ethicality: ethics limited in ways we are not even aware of

iv.Bounded awareness: focusing failure, failure to notice the obvious & important

E.Heuristics

i.Availability heuristic: “what is most available in memory”
ex: emotions or employee in neighboring office review will be more critical

ii.representativeness heuristic: stereotypes
ex: botanist categorizing new plant or new product success
ex: discrimination

iii.Affect (Anchoring and Adjustment in 5th edition):
initial values created by effective or emotional evaluations before cognition
often not conscious but used anyway, especially when people are busy
ex: good meal first time in a restaurant
ex:ice cream overfilled small cup rather than underfilled large cup
ex:stock prices go up on sunny days

F.Overview of book:
“Why should I change? I have always been good at decisions and am successful in my business career.”
Chapters 2 – 4 provide foundation
Chapters 5 – 8 use foundation in decision making lessons
Chapters 9 – 10 use foundation in negotiations
Chapter 11 new research on bounded awareness
Chapter 12 gives strategies on improving judgment

II.Chapter 2: Common Biases
ex1: larger sales in Fortune 500
ex2: student undergrad major

A.Heuristics

i.rules-of-thumb

ii.good “most of time”

iii.really bad sometimes & results in “cognitive bias”

B.Example problems 1 – 11 (all in outline as discussed)

C.Biases from the: Availability Heuristic
“A Lifetime of experience makes us believe that we recall frequent events rather than infrequent events”

i.Ease of Recall -- (p18 Prob 3: causes of death)

a)Many decisions based on vividness of recall

b)Particularly prone to overestimating unlikely events
ex(p18): C.J. spreading AIDS
ex(p19): purchasing agent chose supplier whose name was familar
ex(p19): proximity and employee reviews

ii.Retrievability -- (p19-20 Prob 4a&b: Words in a 2000 page novel)
ex20: store locations

iii.Presumed Associations

a)dichotomous events & decision matrix
ex20: delinquency & marijuana use
ex20: Married under 25 with large family

b)probability of 2 events co-occurring is judged by availability in our minds

D.Biases from the: Representativeness Heuristic

i.Insensitivity to Base Rates
ex22 Prob5: MBA to art or Internet startup

ii.do use base rate info when no other information provided (look at above without personal info
ex22:prenuptial agreement

iii.Insensitivity to sample size
ex 23: 6000 heads out of 10000 or 6 out of 10 or 4 out of 5 dentists

iv.Misconceptions of Chance
ex23 Prob 7: next stock has to be good
ex24: random events must “look” random (coin toss HHHTTT or HTHTHT)
ex: gambler's fallacy
ex24:basketball player makes four shots bound to make 5th one
ex25:”hot hand”
ex25:initial surveys in research

v.Regression to the mean
ex26 Prob8: department store sales prediction
ex24: heredity, student siblings, baseball rookies

a)sometimes do expect regression to the mean, “extreme success cannot last”

vi.Conjunction Fallacy:

a)a combination of two or more descriptors cannot be more probable than any one of the descriptors
ex27 Prob9: Linda's career
ex28: Flood in North America with 1K dead or Earthquake + Flood in CA

E.Biases beyond availability & representativeness (Anchoring and adjustment in 5th )

i.Insufficient anchor adjustment
ex29 Prob10: Stock IPO
ex27: African nations in UN using initial random starting number
ex30: pay increases based on current salary
ex30: Group C children in education
ex30: first impressions
ex31: executive fraud estimate
(before & after Enron)

ii.Conjunctive & Disjunctive Events

a)General bias toward

overestimating conjunctive events

underestimating disjunctive events
ex31 Prob11: red & white marbles
ex32: completing dissertation
ex32: construction projects

b)Complex Systems have lots of conjunctive problems
ex32:human body or nuclear reactor
ex33:morning flights to Chicago

iii.Overconfidence

a)moderate to difficult problems yield most overconfidence

b)How to overcome:

try to find WRONG answers

feedback

communication

ask why might their answers be wrong
ex35:Surgeon
ex35:Lawsuit
ex35:Marketing Plan

iv.Confirmation Trap
ex35: 2-4-5 three ascending numbers

a)people almost almost always look for confirmations

b)should look for dis confirming examples

v.Hindsight & the Curse of Knowledge
ex37:football fan and final play
ex37: driving, make choice get lost -> “I told you so”

a)when assessing others' knowledge people are unable to ignore knowledge that they have that others do not

b)Advantages: a. flattering to believe in own judgment, b. allows us to criticize others

c)Disadvantages: inability to learn from past

ex38: Driving directions
ex38:David & new restaurant

F. Overview & summary on Page 39 – 40

III.Chapter 3: Framing & the Reversal of Preferences
(Judgment under Uncertainty in 5th edition)
“how subtle aspects in the presentation of information, referred to as framing, can significantly impact decision making –particularly when uncertainty is involved”
ex41:Asian disease a)save 200, kill 400 or b)1/3 prob save all 2/3 kill all
ex42:Big positive gamble: a)$10 Mil for sure or b) coin toss and $22M
ex42:Lawsuit:50% chance of loosing %500,000, $240,000 out of court
risk averse (gamble), risk seeking (lawsuit)
ex42: restated Asian disease
People treat risks about gains differently from risks about losses
Framing of choice can dramatically affect choice
Importance of reference points, initial quick evaluation
ex 43: XYZ stock (if $0 will be risk averse, if $20 risk seeking)
When facing a choice identify your reference point & look for other possible ones

A.Framing of Information

i.People evaluate gains and losses relative to a neutral reference point

ii.People tend to be risk averse concerning gains

iii.People tend to be risk seeking concerning losses

iv.People tend to overweight probability of low-probability events and underweight probability of moderate & high probability events

v.Therefore: how the problem is framed (thus setting up the neutral reference point) makes a very large difference

vi.Framing of Choices
ex44-45: sure $240 & 75% $0 or loss of $750 & 75% $1K loss or lose $0

B.Pseudo certainty: “people value the creation of certainty over an equally valued shift in the level of uncertainty”
ex46:full protection against fire or reduced overall protection
ex46:vaccine protecting half or full against 1 of 2 diseases
ex47:sure $30 or 80% chance of $45 vs
two stage 25% chance getting to sage 2 and then sure $30 or 80% 45 vs
25% chance 30 or 20% chance 45
The certainty effect: more likely to reduce likelihood of certain than uncertain

Insurance helps protect against risk AND eliminate worry due to uncertainty

C.Framing & overselling of Insurance

a)Social norms
ex48:insurance & extended warranties on new cars
The word “insurance or warranty” triggers pervasive social norms

b)vividness of costly repair

D.What's it worth (utility)
ex49:cost of beer on beach from fancy hotel or run-down grocery store

a)Acquisition Utility: value on the object (beer in above ex)

b)Transactional Utility: quality of the deal (what “should” it cost)

ex50:high-tech mouse deal versus laptop computer deal
Spend more time on search when $$ at stake are larger

E.Endowment effect: Value placed on what we own because we own it
ex51:selling a painting
ex51:mugs-sellers $7.12, buyers $2.87, choosers $3.12
Ownership makes item much more valuable
Understanding of endowment effect critical to decision making

Mental Accounting
people have a variety of “mental accounts” used to organize info & decisions
ex52:talk & travel in Switzerland vs talk in NY & travel in Switzerland
ex52:cost to drink bottle of 1982 Bordeaux
ex53:two losses of $100 or 1 loss of $200
ex53:”loss fund” setup at beginning of year

F.Do no harm, the omission bias & the status quo
ex54:organ donation (US opt in Others opt out)
either of changes save lives: preferential treatment for donors or opt out
People follow rule of thumb: “Do no harm” action generate more short-term regret than in action, omission produce more regret over long-term
ex55:vaccinations that can harm
Status Quo;
ex55: Trading stock
ex55: pharmaceutical research & new vaccines
ex56: ”by stander laws”

G.Bonus versus Rebate framing
ex56:September 2001 rebate to stimulate growth vs 2008 stimulus $
study 1-56: rebate spent 25% bonus (lowered gov. costs) spent 87%
study 2-56: $50 rebate (spent 10), $50 bonus (spent $22)
study 2-57: $25 rebate($2.43) bonus(11.16)

H.Joint versus separate evaluations
ex57: ice cream cups example from chapter 2 either together or individually
ex57: salary packages
ex57: music dictionaries
want (System 1) in separate evals versus should (System 2) in joint evals

Attributes that are hard to value will be underweighted
--- from 5th edition of Bazerman book ---

I.Avoiding Uncertainty: A common response

i.People tend to “wish away” or ignore uncertainty

ii.Risk is not bad; it is simply unpredictable!
--- imagine life without uncertainty ---

J.A Normative background to Risk

i.Individuals are neither rational nor consistent when making decisions under uncertainty

ii.Thus a normative structure is useful as a guideline

a)Probability:
the likelihood that any particular outcome will occur

b)Expected Value
the weighted sum of all potential outcomes

a simple rule is to select alternative with highest expected value

however....
ex42 from above: coin toss for $0 or $22M or $10M for sure
ex42 from above: Lawsuit out of court settlement

c)Risk Considerations

Certainty equivalent: a decision makers indifference point

Risk Neutral: Certainty Equivalent == Expected Value

Risk Averse: Certainty Equivalent < Expected Value

Risk Seeking: Certainty Equivalent > Expected Value

utility: degree of pleasure or satisfaction with each outcome

iii.Response to loss is more extreme than response to gain

IV.Chapter 4: Motivational Biases
ex61:gained weight at Xmas want to lose it but eat at party

A.When Affect and Cognition Collide (Motivation versus Cognition 5th)
ex62: Ulysses & the Sirens
exs62: Various short ones
ex62: enjoyable low status job versus higher paying one he “should” take
When what we want to do and what we think we should do collide

i.inappropriately high discounting people apply to the future
hyperbolic discounting: view all gains in future as worth less
ex65: value of free soda today, tomorrow, or in 100 days

ii.Multiple selves in general

iii.Planner and the Doer

a)Changing the doers preferences (planner finding exercise doer will like)

b)Monitoring the doers behavior (weekly diet club weighins)

c)Altering incentives (Antabuse for alcoholics)

d)Altering rules (Student forbid use of TV during exam times)

iv.Want versus Should (decision makers overweight proximal (temperal, physical or sensory) attributes)

v.hyperbolic discounting: all future gains worth less than NOW

vi.Should (or Planner) is not always right

a)transient desires are often responsive to the environment

b)at times the planner is too conservative, risk averse, or timid

vii.What to do:

a)Umpire self: Get agreement between planner & doer

b)Questioning both selves to see who is wrong

c)Empower the want or doers

Require both sides to agree

Agreement should be Pareto efficient (no other agreement better)
ex: diet or exercise versus diet & exercise

B.Unrealistic Positive Illusions (enhance & protect self esteem)

i.Constrained by objectivity, credibility, etc

ii.harder when they are “inconsistent with reality”
ex68: easier to believe honest than good tennis player

iii.Unrealistically positive views of the self
we tend to perceive our selves at being better than others
ex66:driving, intelligence, health, skill, etc

iv.unrealistic optimism
believe our future will be brighter than others (p69)
those most incompetent are most deluded (Fig 4.1 on p70 & 4.2 on p71)
ex69: accomplish more in a day than is possible
We seem immune to continual feed back showing “reality”
can lead to turning down best offer for house, best job offer, etc

v.illusion of control
ex: The Matrix :-), or choosing own lottery numbers
ex: Superstitious behaviours
ex: Richard Bach's Illusions & Rhonda Byrne's The Secret

vi.self-serving attributes
We interpret causality in a biased manner
Take a disproportionately large share of credit for success
“Victory has a thousand fathers but defeat is an orphan” JFK

vii.Group Illusions (exs: 72)
We extend self-enhancement to groups we belong to & invert for opponents

viii.Are the illusions good for us?

a)Contribute to psychological well being

b)deal with tragedy

c)employment problems

d)Also a form of emotional procrastination

e)exs74: Irreplaceable employee, high levels of well being → frustration

C.Egocentrism or Self Serving Reasoning
ex74: west blames burning the rain forests, third world blames autos
ex74: legal costs

i.we first determine preference then justify it by changing importance of attributes

ii.Interpret events based on what the want or prefer
ex: percentage work on book or effort in marriage
ex75: football game film, cold war conference in Iceland

D.Affective Influences on Decision Making
Our emotional state can have significant effect on nature of endowment effect
sad people more affected by anchors than neutral people thus worse decisions
people in good moods more optimistic, bad moods more pessimistic
ex77:get to gate at 8:57 what is more aggravating if plane left at 8:30 or at 8:55
ex78:Olympics Silver versus Bronze metal winners
more regret for acts of commission than for omission

i.decision makers distort their decisions to avoid regret

ii.few decision makers list “avoiding regret” as decision criteria

E.Summary
Knowledge of affect of emotions can help limit
“Just like everyone else, I am affected by my emotional state”
Accountability can help
Government “Accountability” Agency ????????

V.Chapter 5: Nonrational Escalation of Commitment
“If at first you don't succeed, try, try again. Then Quit...” W. C. Fields

A.In a series of decisions people are prone to escalate their commitment to their original decision.
Ex81: consulting firm position that does not pay off
ex82: $2 Mil in startup venture, additional $1M or will loose all
ex82: sinking money in old car
Inertia leads to continuing same course. when does this become irrational?

i.sunk costs: evaluate future costs & future benefits ignoring past
reference point should be current state, consider all alternative courses from here
ex83: Quit Doctoral Program?

ii.Need to identify irrational behavior & “unfreeze”

B.Unilateral escalation

i.When outcome previous decision negative decision makers tend to escalate funds

ii.How do you separate rational from non-rational tendency to escalate?
Separate the effect from the person making the decision
ex83: high & low responsibility investment then reinvest 3 years later

iii.One way to eliminate cognitive dissonance is to escalate and attribute problems to temporary factors, success is imminent

iv.Easier to escalate when failure can be easily explained by outside factor: economy

v.groups tend to do this less than individuals, but those that do are worse
ex84: hiring decisions & performance evaluations

vi.Managers should be very aware of these tendencies

C.Competitive Escalation
ex85: company A, B, & C
Most $ benefit from merger mania went to sellers
ex85: Auctioning off $20 bill

i.Strategies to avoid
ex85:organize class to not escalate $20 bill auctioning
ex87:American & United Airlines
Successful decision makers MUST learn to identify traps

ii.the desire to WIN can shift objective from original to beating the other party

D.Why does Escalation Occur
first step is to identify psychological factors

i.Perceptual Biases

a)pay more attention to confirming than disconfirming choices
ex: number sequence

b)Should diligently search for disconfirming evidence

ii.Judgmental Biases

a)any loss from initial investment will distort judgment on continuing
Framing as loss initiates risk seeking behavior
ex82: $2Mil investment being asked for another $1M

b)Decision makers must learn to assess decision from neutral reference point

iii.Impression Management

a)save face

b)initial decision makers look at confirmation not disconfirmation

c)try to appear consistent to others
ex89: Carter & JFK “most difficult decisions President makes is to change course”
How does this compare to President Bush's (W) record of no change no matter what?

d)best decision is to focus on what is best for organization

iv.Competitive Irrationality

a)look very carefully at what looks like opportunity but might be large problem

E.Integration
Be aware of why you are making decisions.
Open our minds to other courses of action
Final caveat: sometimes it is important to consider the other side of the spectrum. It is important to realize that ending a commitment can result in loss of all future benefits and can cause problems, especially in personal realm.