In this mindware strategy tutorial you will learn about:
- Components of a rational decision
- How to compute expected utilities to make rational decisions
- How to identify cognitive biases in decision making
Basics of rational decision making
Cognitive scientists and economists have a ‘conceptual framework’ for understanding how to make good decisions. Here are some of the basics of this framework:
Actions or Options
To make a decision requires a choice, and different choices depend on different actions or options: marry or not marry, book an activity holiday in South Africa or a beach holiday in Cyprus, start making a coconut curry or – alternatively – a spaghetti bolognaise, take this bet or that bet.
Outcomes
Second, the action/option chosen in making a decision results in an outcome. If we choose one job over another (decide to accept job X rather than job Y), the action of signing a contract has real consequences in terms of income, location, career development, and so on. There is usually some uncertainty in the outcomes.
Risk and uncertainty
Decisions typically occur in conditions of uncertainty – where the outcomes are not entirely predictable, and where an action/option taken may involve risk – the chance of loss. It is not usual that the outcomes of decisions are entirely certain and it’s important to factor in this uncertainty when you make your decisions.
Gains vs losses – utilities
There are gains and costs associated with the outcomes of decisions you make called the utility of the outcomes. Gains are what you desire or value, costs the opposite. Gains include fun or pleasure, monetary or material gains, rewarding relationships, recognition, status, achievement, new skills and so on. Costs include physical pain, loss of face, financial hardship, stress, unwanted effort or time.
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Expected Utility Theory
According to expected utility theory, to choose optimally you must multiply the potential utilities (gains or losses) of different courses of action with the probabilities that the actions will lead to these utilities. By doing this we can calculate the ‘expected utilities’ of different actions or options.
Which bet do you choose?
A. A 10% chance of winning $1000.
B. A 50% chance of winning $50.
C. Either A or B – both are as good as each other.
To calculate the expected utility of A we multiply .10 x $1000 = $100.
To calculate the expected utility of B we multiply .50 x $50 = $25.
So, the rational answer is A! Your System 1 (intuitive) thinking might not agree with this, but objectively, this is the better decision.
How about? –
Which bet do you choose?
A. A 10% chance of winning $500.
B. A 50% chance of winning $100.
C. Either A or B – both are as good as each other.
0.10 x $500 = $50
0.50 x $100 = $50
So the rational answer is C! Both bets have the same utility – whatever your ‘System 1’ intuitive thinking tells you.
And how about? –
I would rather be given $100 for sure than a 50% chance of getting $500 and a 50% chance of getting nothing.
The expected utility of the first option is 1.0 (certainty) x $100 = $100.
The expected utility of the second option is more tricky. It is the ADDITION of the expected utilities of the two possible outcomes – i.e. (.50 x $500 = $250) + (.50 x $0 = $0) =$250.
So your answer should be NO!
Mindware strategy tip: the ‘maximum utility’ decision rule
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