HSO 408: Judgement and

Decision Making
Unit 1

Prof. Sathya Narayana Sharma

IIT (ISM) Dhanbad
Theories of decision
● A theory of decision?
● Theories of decision take goals as givens.
● Given a goal, how do people in fact pursue them or should pursue them?
● Descriptive vs Normative theories.
Exercise
Which of the following claims are descriptive and which are normative?

(a) On average, people save less than 10 percent of their income for

retirement.

(b) People do not save as much for retirement as they should.

(c) Very often, people regret not saving more for retirement.
● Theories of rational choice:
○ Specifies what it means to be rational.
○ Every theory of rational decision divides decisions into two classes: rational and irrational
○ A theory of rational choice can be thought of as descriptive or normative (or both).
○ Denote theories that are (or that are thought to be) normatively correct, whether or not they
are simultaneously descriptively adequate.
Neoclassical vs behavioural economics
● Neoclassical economics (standard economic theory)
○ Rational choice theories
○ Assumes people by and large behave rationally, that is in a manner that they should.

● Behavioural economics
○ People do not behave rationally by and large.
○ Such deviations are large, systematic, and predictable.
○ Descriptive theories
The origins of behavioural economics (briefly)
● Early neoclassical economics was built on the foundation of hedonic psychology: an
account of individual behavior according to which individuals seek to maximize
pleasure and minimize pain.
“Pleasure and pain are undoubtedly the ultimate objects of the Calculus of Economics.
To satisfy our wants to the utmost with the least effort … in other words, to maximise
pleasure, is the problem of Economics.” (Stanley Jevons, 1871).
“Nature has placed mankind under the governance of two sovereign masters, pain and
pleasure … They govern us in all we do, in all we say, in all we think.” (Jeremy Bentham,
1780).
● They believed that because people have direct access to their own conscious
experiences, it is evident that individuals seek pleasure and try to avoid pain.
● They didn't rely on external empirical evidence or experimental data; instead,
they argued that introspection alone was enough to support the foundation of
their theory.
● After World War II, many economists were disappointed with the poor results
of early neoclassicism in terms of generating theories with predictive power.
● Instead of taking a theory about pleasure and pain (which must be
experienced) as their foundation, they took a theory of preference (which can
be observed).
● On the assumption that choices reflect personal preferences, we can have
direct observable evidence about what people prefer.
● Postwar neoclassical economists hoped to completely rid economics to its
ties to psychology.
Cognitive revolution (1950s-60s): Researchers in psychology, computer
science, linguistics, anthropology, and elsewhere rejected the demands that
science focus on the observable.

A scientific psychology must refer to things “in the head,” including beliefs and
desires, symbols, rules, and images.

Behavioral economics is a product of the cognitive revolution.

Methods
Hypothetical choice studies

Incentivised lab experiments

Field study and experiments

Process measures (eg. Reaction times, Brain scans, Eyetracking)

Theory of Rational Choice
(under certainty)
Choice under certainty: There is no doubt as to which outcome will result from a
given act.
Preference
● A preference is a relation.

Exercise

Assume that f denotes France and n denotes Norway, and that B means “is bigger than.”

(a) How would you write that France is bigger than Norway? – fBn

(b) How would you write that Norway is bigger than France? – nBf

(c) How would you write that Norway is bigger than Norway? – nBn

● The universe U is the set of all things that can be related to one another; Set of
alternatives.
Weak preference relation
Example:

“coffee is at least as good as tea.”

c ≽Raj t and t ≽Ram c

Exercise

Suppose d denotes “enjoying a cool drink on a hot day” and r denotes “getting
roasted over an open fire.”

(a) How would you state your preference over these two options? – d ≽ r
Consumption bundles
● Consumption bundles: collection of goods.

〈3, 2〉 for threeapples and two bananas

〈6, 3, 9〉 for six apples, three bananas, and nine coconuts
Rational preferences
1. Transitive
○ If x R y, y R z, then x R z.

Transitivity of ≽

● If x ≽ y and y ≽ z, then x ≽ z (for all x, y, z in the U).

● If you prefer coffee to tea, and tea to milk, you must prefer coffee to milk.
2. Complete
○ Either x R y or y R x (or both)

Completeness of ≽

● Either x ≽ y or y ≽ x (or both) (for all x, y)

● If both x ≽ y and y ≽ x, we say that there is a tie.

Completeness implies reflexivity.

Exercise
Assuming the universe is the set of all people – past, present, and future – are the
following relations transitive? Are they complete?
(a) “is the mother of”
(b) “is an ancestor of”
(d) “detests”
(e) “weighs more than”
(f) “has the same first name as”
(g) “is taller than”
Exercise

(a) If the universe is {apple, banana, starvation}, what does the

transitivity of the preference relation entail?

(b) If the universe is {apple, banana}, what does the completeness of the

preference relation entail?

Completeness implies reflexivity. x ≽ x for all x.

Indifference
x ~ y if and only if x ≽ y and y ≽ x

Assuming that the “at least as good as” relation is rational, the indifference relation
is both reflexive (x ~ x; for all x) and transitive.

It is also symmetric: if x is as good as y, then y is as good as x.

Strict Preference
x ≻ y if and only if x ≽ y and it is not the case that y ≽ x

Properties of strict preference

The following conditions hold (assuming that weak preference relation is rational):

(i) x ≻ y & y ≻ z → x ≻ z (for all x, y, z)

(ii) x ≻ y → not y ≻ x (for all x, y)

(iii) not x ≻ x (for all x)

Transitive, anti-symmetric, and irreflexive.

A paradox
Consider 1000 cups of coffee, numbered C0,C1,C2,… up to C999. Cup C0 contains
no sugar, cup C1 one grain of sugar, cup C2 two grains etc. Since one cannot taste the
difference between C999 and C998, one might consider them to be equally good (of
equal value), C999∼C998. For the same reason, we have C998∼C997, etc. all the way to
C1∼C0, but clearly C999≻C0.
Preference orderings
● Rational preference relation allows us to order all alternatives in a list, with the
best at the top and the worst at the bottom.
● Completeness ensures that each person will have exactly one list, because
completeness entails that each element can be compared with all other
elements.
● Transitivity ensures that the list will be linear, because transitivity entails that
the strict preference relation will never have cycles, as when x ≻ y, y ≻ z, and z
≻ x.
● In cases of indifference, the preference ordering will have ties.
Indifference Curves
Preference orderings are frequently represented using indifference curves, also
called indifference maps.

● Suppose that an apple for you is always as good as two bananas.

● Suppose that one apple is always as good, as far as you are concerned, as a
banana.
Convexity of indifference curves
Diminishing marginal rate of substitution: for every additional unit of good 1, the
consumer is willing to give up less and less amount of good 2. This happens due
to the law of diminishing marginal utility and preference for variety.
Choice under certainty
● Choices are revealed preferences.
● To make a choice under certainty is to face a menu.
● A menu is a set of options such that you have to choose exactly one option
from the set.
● Items in the menu are mutually exclusive and exhaustive.
If a restaurant offers two appetizers (soup and salad) and two entrées (chicken
and paneer) and you must choose one appetizer and one entrée, what is your set
of alternatives?

Since there are four possible combinations, your set of alternatives is

{soup-and-chicken, soup-and-paneer, salad-and-chicken, salad-and-paneer}

Budget set
● Budget set: part of the set of alternatives that you can afford given you
budget, that is, your resources at hand.
Exercise
Suppose that your budget is ₹12. Use a graph to answer the following questions:

(a) What is the budget set when apples cost ₹3 and bananas cost ₹4?

(b) What is the budget set when apples cost ₹6 and bananas cost ₹2?
Rational choices
(i) that you have a rational preference ordering

(ii) that whenever you are faced with a menu, you choose the most preferred item
What the theory does not say
● Does not say why people prefer certain things to others.
● Does not say that people prefer apples to bananas because they think that
they will be happier, feel better, or be more satisfied if they get apples than if
they get bananas.
● Says nothing about feelings, emotions, moods, or any other subjectively
experienced state.
● A rational person is self-interested: their choices reflect their own preference
ordering rather than somebody else’s.
● This is not the same as being selfish: the rational individual may, for example,
prefer dying for a just cause over getting rich by defrauding others.
● The theory does not say anything about the things people prefer.
● Rational people cannot have preferences that are intransitive or incomplete,
and they cannot make choices that fail to reflect those preferences.
Utility
How would you represent in numbers how much a
person prefers something?

A utility function associates a number with each

member of the set of alternatives.

u(HB) = 3;

u(C) = u(P) = 2

u(ES) = 1

Every alternative gets exactly one number.

Larger numbers to more preferred alternatives.

Definition of u(·)

A function u(·) from the set of alternatives into the set of real numbers is a utility
function representing the preference relation ≽ just in case x ≽ y ⇔ u(x) ≥ u(y) (for
all x and y).

Utility function is an index/measure of the preference.

x ≻ y ⇔ u(x) > u(y)

x ~ y ⇔ u(x) = u(y)
Indifference curves and utility
Utility and behaviour
● You choose rationally insofar as you choose the most preferred item.
● The most preferred item on the menu will also be the item with the highest
utility.
● So to choose the most preferred item is to choose the item with the highest
utility.
● To maximize utility is to choose rationally.
● Is this theory descriptively true?
● Do people maximise utility in practice?