People are faced with declining marginal utility gains. The more we get of something, the less pleasure it provides us. For example: winning half a million is nice, winning one million is nicer but winning one million is not twice as nice as winning half a million. We are also making risk averse choices giving up expected value to reduce risk. In contrast, risk seeking choice involves a lower expected value and higher risk.
Expected utility refers to maximisation of the arithmetic average rather than simply maximisation go the arithmetic average of possible course of action. Decision researchers view the logic of expected utility as rational behaviour.
In practice, individuals treat risk concerning perceived gains differently from risk concerning perceived losses. Introduced by Kahneman and Tversky (1979) prospect theory explains how perceived differences based on a change in the “framing” of choices (e.g. losses and gains) can dramatically affect how people make decisions.
Framing is defined as alternative wording of the same objective information that significantly alters the decisions that people make, even though differences between frames should have no effect on rational decisions.
A disease is expected to kill 600 people. Two programmes are suggested to solve this problem.
a) 200 people will be saved (most choose)
b) There is a 1/3 probability 600 people will be saved and 2/3 probability no people will be saved
c) 400 will die
d) There is a 1/3 probability no one will die and 2/3 probability 600 people will die (most choose)
Nevertheless the choices between programmes are identical, changing the description of outcomes from lives saved to lives lost, it sufficiently shifts prototypic choice from risk averse to risk seeking.
In programmes 1 and 2, key framing manipulation involves the implicit reference point against which outcomes are supposed to be evaluated. However, one should remember that two programmes are objectively the same.
Programme 1 is frames in terms of saving lives. Implied reference point is a worst outcome of 600 deaths. When we make decisions about gains, we are risk averse.
Programme 2 is framed in terms of losses. Implicit reference point is the best outcome of no deaths. When we make decisions about losses, we are risk seeking.
It is possible to take the same objective problem, change the frame and get a predictably different results.
Rational decision makers should be immune to the framing of choices. Yet, frames strongly affect our decisions and produce profound effects. In other words: errors and inconsistencies in human judgement.
Irrationality of the sum of choices
Framing of the combined problem in two parts may result in a reversal of preferences. Managers face many inter collected decisions such as portfolio selection, budgeting and funding for new projects. They can occur one decision at a time or in groups of decisions.
Sequential nature of the decision making process in organisations is likely to enhance the potential for inconsistency and non-rational choice. Managers may go along making individual decisions that each seem sensible, but when viewed as a whole are obviously suboptimal. For instance: sales department is encouraged to think in terms of acquisition of corporate gains and credit offices are encouraged to frame decisions in terms of avoiding corporate losses.
To arrive at a coherent strategy for making judgements under uncertainty, individuals and organisations need to become more aware of this bias and develop procedures to identify and integrate risky decisions across organisations.
Risk averse at some point and risk seeking at the other times we are likely to adopt an inferior decision portfolio. We would be generally better off following an expected value rule for most decisions.
We should try to follow the same strategy across all decisions. Risk aversion is likely to temp us to down each individual opportunity for gains. Aggregated risk of all of positive-expected gambles would become infinitesimal and potential profit large. As a basis for decision making, it is better to use expected value model.
Bazerman, M.H. and Moore, D.A., 1994. Judgment in managerial decision making (p. 226). New York: Wiley.