SUMMARY -1

Class started with a simple question like, what cause more deaths potholes or terror attack? Most of
the people answered terror attacks, which was incorrect. The experiment identifies one of the biases
of brain i.e. availability heuristic, mental shortcut used by brain in which brain disregard all the
information which it does not have, in this example we do not know how many people died because
of potholes and assumed that terror attack causes more death. Next, we did survey on good and bad
decision, rate your good and bad decision and why was that decision good or bad, most of the
people rate good decision a high rating while bad decision had a low rating. But when we were asked
about why it was good/bad, most people answered because of outcomes were good/bad. This was
due to decision bias, Brain deviates from rational judgement/optimal decision because of external
factor, emotion and etc.

Expected value, summation of product of probability of the event and its reward. it indicates the
anticipated value of an investment in the future. This led to expected value theory, it is used to
quantify outcomes for formal decision-making approach.

Diamond Water Paradox, what should have more value diamond or water, although diamond has no
use as such other than collectable but its price is much higher than the water which is very important
for our survival, this was a dilemma for economist for many years.

St Petersburg Paradox, it is a classic problem in economics and probability theory that highlights a
contradiction between expected value theory and human decision-making. It was introduced by
Daniel Bernoulli in the 18th century. People were asked pay certain amount to play a game in which
a coin was tossed until it lands on tail and each time the coin was tossed reward was increased to 2n ,
where n is the number of flips. Expected value of the game was infinite but people were not willing
to pay large amount of money on it, this paradox was solved using Expected Utility Theory, according
to the theory as amount of goods increases, total utility (overall satisfaction for consuming a goods)
increases very little i.e. marginal utility decreases (additional satisfaction achieved after consuming
one more unit of goods).
Diamond water paradox was solved using marginal utility, as water is abundant its marginal utility is
low and diamond is scarce so its utility is less on other hand if we are in desert where water is less
then it could be different.

Different kind of Decision-Making Models:

process (How they came to conclusion). Maximizing expected utility model is considered a
normative, “as-if” model.
Process model: - Describe actual mental process used to take decision, focuses on steps and
computation involved.
Axioms of expected utility theory:
Sure-thing: - decision will be same in every scenario i.e. Once you prefer outcome, it will be same in
every scenario.
Transitivity: - if A > B, B > C, then A > C (if you prefer A over B and B over C, then you will prefer A
over C).
Dominance: - If two options are same in every aspect, but one is better than other in one, then all
other aspects will be not considered and will be made choosing that one aspect.
Invariance: - A person’s preference between options should not be affected by the order of option,
choice should be same (end value is same).

Allias Paradox, experiment presents two decision problems, Problem 1: Choose between A (a
guaranteed $1 million) and B (a 10% chance of $2.5 million, 89% chance of $1 million, 1% chance of
$0).Problem 2: Choose between C (an 11% chance of $1 million, 89% chance of $0) and D (a 10%
chance of $2.5 million, 90% chance of $0).Most people choose A in Problem 1 and D in Problem 2,
showing preference inconsistency and violating the Expected Utility Theory. this was explained by
Certainty effect and probability scaling which are the part of prospect theory.

Prospect theory (1979), One of the most dominant accounts of decision making, descriptive
framework of decision making by Amos Tversky and Daniel Kahneman.

Risk aversion: - People are generally risk averse, they will be happy to take a sure thing rather than
getting more by taking chance, even if both have equal utility value.

Reference point: - People do not evaluate outcome of a gamble in terms of overall status of wealth,
rather gains or loses relative to neutral reference point, although risk seeking is relative, but loses
have more value than gains i.e. we feel the value of loss more than the gains even if the both have
same magnitude, this was explained using the value graph which has S shape which was more sharp
in loss area as compared to gain area.

Loss aversion: - Loses loom larger than the gains, this can be understood by value graph, where
function is steeper in loss side as compared to gains for same unit. This concept is supported by
Endowment effect (1980) by Richard Thaler, which suggest people increase perceived value of things
that they own, so when they lose that, value of loss is also more as compared to gains.

Probability scaling: - People assign subjective weights to probability instead of actual values, very
low probabilities are overweighted while medium and large are underweighted, this factor is
exploited by lottery firms by making people buy the lottery tickets even though they have very low
probabilities to win because the overweigh it.

Framing effect: - people’s decisions are influenced by how information or choices are presented (the
"frame"), rather than the content itself. It demonstrates that the way a decision is framed as a gain or
a loss can significantly impact choices, even if the outcomes are logically equivalent.

ambiguity aversion: - people prefer options with known probabilities over those with unknown or
uncertain probabilities, even when the expected outcomes are identical. This behaviour highlights a
discomfort with ambiguity or uncertainty.
The Ellsberg Paradox illustrates ambiguity aversion, given an urn with 30 red balls and 60
black/yellow balls in unknown proportions, people are more likely to bet on outcomes involving the
red balls with known probabilities rather than the black/yellow combination with unknown
probabilities. This behaviour violates Expected Utility Theory, showing how ambiguity influences
decision-making.