This document discusses key concepts in decision making and cognitive biases. It covers decision theory, prospect theory, bounded rationality, loss aversion, and various heuristics people use like availability, representativeness, and anchoring. Loss aversion refers to the tendency to strongly prefer avoiding losses over acquiring equivalent gains. Heuristics are simple rules people often use in decision making instead of strict logic.

1. Choice and Decision
Greed/fear

2. Class Objective
• To understand nuances of human decision
making

4. Decision Theory
Decision theory is concerned with identifying the
values, uncertainties and other issues relevant in a
given decision, its rationality, and the resulting
optimal decision.
Bounded rationality is the idea that in decision-
making, rationality of individuals is limited by the
information they have, the cognitive limitations of
their minds, and the finite amount of time they
have to make a decision.

5. Choice under uncertainty
• Expected value
– Value X Probability
• Prospect theory states that people make
decisions based on the potential value of
losses and gains rather than the final
outcome, and that people evaluate these
losses and gains using certain heuristics.

6. Choice under uncertainty
• Heuristics: People often make decisions based
on approximate rules of thumb and not strict
logic.
• Framing: The collection of anecdotes and
stereotypes that make up the mental
emotional filters
• Market inefficiencies: These include mis-
pricings, information asymmetry and non-
rational decision making.

7. Preferences
• Get a 100 rupee discount or avoid a 100 rupee
surcharge?
• Mall parking reimbursement or 20 rupee
discount?
• Which has a bigger impact on customer
switching, price increase or discount?

8. Loss aversion
• loss aversion refers to people's tendency to
strongly prefer avoiding losses to acquiring
gains.
• endowment effect—the fact that people place
a higher value on a good that they own than
on an identical good that they do not own

9. • IIMpact ‘merit pay’
• Insurance

10. Ratio of words starting with a K and those
having K later in the word?
• Availability heuristic
The ease with which a particular idea can be
brought to mind

11. • Representativeness
Stereotyping
Brand extensions

12. Conjunction fallacy – a combination of two is
more probable than just one

13. • Is the per capita income of Malaysia more
than $4000?
• How much is it?
• Anchoring and adjustment
• TV infomercials

14. • Heuristics are fast and frugal

15. 1. Ambiguity effect – the tendency to avoid
options for which missing information makes
the probability seem "unknown.
2. Backfire effect – when people react to
disconfirming evidence by strengthening
their beliefs
3. Bandwagon effect – the tendency to do (or
believe) things because many other people
do (or believe) the same

16. 4. Choice-supportive bias – the tendency to
remember one's choices as better than they
actually were.
5. Clustering illusion – the tendency to over-expect
small runs, streaks, or clusters in large samples
of random data
6. False-consensus effect – the tendency of a
person to overestimate how much other people
agree with him or her.
7. Forer effect or Barnum effect (astrology)

17. Summary
• Decision Theory
• Prospect theory
• Bounded rationality
• Loss aversion
• Heuristics
– Availability
– Representativeness
– Anchoring and adjustment

18. Further reading
• Cognitive Bias: Systematic errors in decision
making by Loren Gary, HBR
• Prospect Theory: An Analysis of Decision
under Risk by Daniel Kahneman and Amos
Tversky

19. ?