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Heuristics and Biases in Judgment and Decision MakingDr. Xiaoyan Deng1Summary of topicsSystem 1 vs. System 2 ThinkingHeuristics and BiasesContext EffectThe Truth about RelativityThe Fallacy of Supply and DemandProspect TheoryNudging (using decision biases to help people)2Heuristics BiasesHeuristicAny decision rule of thumb or shortcutMake our lives easier!Nothing inherently wrong with them, butBiasUse (or overuse) of a heuristic leads to a poor decisionProblems happen if we OVERAPPLY a heuristic to such an extent that it produces a wrong decision or poor judgment3How do Heuristics lead us astray? System 1 vs. System 2 ThinkingSystem 1: our fast, automatic, intuitive and largely unconscious mode.System 2: our slow, deliberate, analytical and consciously effortful mode of reasoning about the world. System 1 jumps to an intuitive conclusion based on a heuristic an easy but imperfect way of answering hard questions and System 2 lazily endorses this heuristic answer without bothering to scrutinize whether it is logical. 4System 1 and 2 Explained by Daniel KahnemanDaniel Kahneman = the Kahneman of Kahneman and Tversky who created Prospect TheoryFirst psychologist to win Nobel prize in Economics

5Rules of thumbKahneman and Tverskys research is known as the heuristics and biases approach to studying human judgment and decision making (system 1)Three original heuristics identifiedAnchoringAvailabilityRepresentativeness

6Availability HeuristicWhat kills more people: lightning strikes or tornados?Availability HeuristicMaking decisions based on what comes to mind/easy to recallIf something is available to memory/more vivid, its judged to be more likely

7Availability Heuristic ExampleYou are doing consumer research on married couples and how they divide up their lives. You ask them each how much of the housework they do, what percentage of arguments they start, what percentage of gifts they give, and so on.

8Availability Heuristic ExampleYou are feeling guilty about homelessness. Your friend tells you that the primary problem underlying homelessness is that the mentally ill do not have adequate care, and most homeless are mentally ill. You give money to a foundation for mental illness instead of a homeless shelter.

SOURCE: Rational Choice in an Uncertain World, by Robyn Dawes9Availability Heuristic ExampleYou are trying to decide which warranty to buy, one for your dishwasher or one for your vacuum cleaner. Your friends dishwasher recently broke and put huge suds all over the kitchen floor. You decide to buy the warranty for your dishwasher.10Representativeness HeuristicMaking a judgment relating to likelihood, or to cause and effect, by simply comparing a stimulus with the category prototype or exemplarIf it is more representative/similar to the prototype , then it should be more likelyNeglect relevant base rates11Representativeness Heuristic ExampleJohn is a man who wears gothic inspired clothing, has long black hair, and listens to death metal. How likely is it that he is a Christian and how likely is it that he is a Satanist? Underestimate/overestimate the probability of him being a Christian/Satanist. Ignore that the base rate of being a Christian (there are about 2 billion in the world) is vastly higher than that of being a Satanist (estimated to be in the thousands).Even if such clothing choices indicated an order of magnitude jump in probability of being a Satanist, the probability of being a Christian is still much larger.

12Representativeness Heuristic ExampleLinda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

(1 = extremely unlikely; 7 = extremely likely)It is ______ that Linda is a bank teller. It is ______ that Linda is a bank teller and is active in the feminist movement.13Representativeness Heuristic ExampleYour new advertisement for Vitariffic Vitamins is a great success. In the ad, you show three people before they take the vitamins, sluggish and unhappy. Then you show them after taking the vitamins, full of energy, thin, and enjoying an active and varied social life. This ad works much better than the previous one you used in which you gave all of the pre-vitamin and post-vitamin statistics.14Base Rate FallacyBy examining this picture, can we correctly conclude that people from California, Florida, Texas, and New York are more patriotic than people from other states?15Discussion: Should We Be Concerned about the following statistics?Most dog bites (77%) are by dogs known to victimHonda Civics are one of the most commonly stolen carMost car accidents take place within 5 minutes of home16Marketing ImplicationsAvailability HeuristicProvide consumers with positive and vivid product experiencesStimulate positive WOM (e.g., with sneak previews, samples) Representativeness HeuristicPosition brands close to the prototypeShow positive outcomes of using your product!Base Rate FallacyProvide consumers with base-rate information to counteract negative WOMChosen by 4 of 5 consumers17The Truth about RelativityChapter 1 in Predictably Irrational18Decoy effectAbout 10 years ago, when Williams-Sonoma first introduced a home bread bakery machine for $275 most consumers were not interested.How could you use a decoy option to increase sales?19Compromise Effect= Tendency to choose the middle option in a choice setAKA Extremeness AversionWe like to avoid extremesMakes justification of choice easier20Air Conditioners ExampleChoice #1Choice #2PanasonicPanasonic5000 BTU5500 BTUMedium NoiseLow NoiseAdjustable AirflowAdjustable Airflow60 lbs.50 lbs.5 yr. Warranty5 yr. Warranty$350$500How can we increase sales of Choice #2?21Managerial ImplicationsAvoid one-of-a-kind items sitting on shelves isolated from comparable products. Give customers three related choices at three different prices.Especially important for service businesses selling an intangible product that is not easily comparable.

22The role of context and relativity in decision makingContext in which information is encountered/decision takes place influences decisions/how information is interpretedDan Ariely: most people dont know what they want unless they see it in context.

23The Fallacy of Supply and DemandChapter 2 in Predictably Irrational

24Anchoring HeuristicThe common human tendency to rely too heavily on the first piece of information offered (the "anchor") when making decisions.Anchoring-and-adjustingOnce an anchor is set, other judgments are made by adjusting away from that anchor. These adjustments are usually insufficient, giving the initial anchor a great deal of influence over future assessments.Difficulty of avoiding anchoringStudents were asked whether Mahatma Gandhi died before or after age 9, or before or after age 140. Clearly neither of these anchors can be correct, but the two groups still guessed significantly differently (average age of 50 vs. 67).25Anchor pricingWhen we encounter a new product (and new business) we accept the first price we see and from then on that price becomes the anchor for what we are willing to pay for that product.Ariely: once we buy a new product at a particular price, we become anchored to that price.How would you use the concept of anchoring when introducing a new product?26Arbitrary Coherence in Value ConstructionTom Sawyer: Do you call this work?Tom is faced with the unenviable job of whitewashing his aunts fence in full view of his friends who will pass by shortly and whose snickering promises to add insult to injury. When his friends do show up, Tom applies himself to the paintbrush with gusto, presenting the tedious chore as a rare opportunity. Toms friends wind up not only paying for the privilege of taking their turn at the fence, but deriving real pleasure from the task.In Twains words, Tom had discovered a great law of human action, without knowing itnamely, that in order to make a man or a boy covet a thing, it is only necessary to make the thing difficult to attain. Marketing implications?27Value Construction Experiment (Ariely)Would you be willing to pay me $10 for a 10-minute poetry recitation?Participants were willing to pay about one/two/three dollars for the short/medium/long poetry reading.Would you be willing to listen to me recite poetry for 10 minutes if I pay you $10?Participants demanded $1.30/$2.70/$4.80 to listen to the short/medium/long poetry reading.Take an ambiguous experience and arbitrarily make it into a pleasurable or painful experience.The first impression (i.e., the anchor) can be manipulated.28Marketing Implications: The IKEA EffectSo people are irrationalIs this always bad?As a marketer, how do you feel about using this knowledge of how consumers make decisions to sell products? Is it exploitative? Are you tricking the consumer? Or is it just good business?

29Prospect theory30Scenario #1Imagine that the US is preparing for the outbreak of an unusual disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows:If Program A is adopted, 200 people will be savedIf Program B is adopted, there is a 1/3 probability that 600 people will be saved and a 2/3 probability that no people will be saved. __________ A __________ B 31Scenario #2Imagine that the US is preparing for the outbreak of an unusual disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows:If Program A is adopted, 400 people will dieIf Program B is adopted, there is a 1/3 probability that nobody will die and a 2/3 probability that 600 people will die __________ A __________ B 32Framing EffectDecisions are influenced by the way a set of choices is presented.The two scenarios are essentially identical, except that the choices are framed differentlyBut the frame makes a difference in choice72% choose program A in the SAVING frame78% choose program B in the DYING frame33Why Do Framing Effects Exist? Different Sensitivity to Losses versus GainsPeople act differently when something is framed as a loss vs. a gainWhen the choices are perceived as losses (e.g., deaths), people tend to be risk-seeking (willing to take more risk if it means avoiding a sure loss)When the choices are perceived as gains (lives saved), people tend to be risk-averse (more conservative if they can lock in a sure gain)34Loss AversionPeople tend to be more sensitive to losses than to gainsLosses loom larger than gains (have a greater psychological impact)Losing $10 hurts more than finding $10 gratifiesMarch Madness ExampleFouls called but not committed (loss) matter more than fouls committed but not called (gain)Loss aversion in the Moneyball movieI hate losing more than I even wanna win. Oakland Athletics General Manager Billy Beane (or some creative Hollywood writer channeling Billy Beane):

35Prospect Theory (Kahneman & Tversky 1979)People dont follow a traditionally rational theory of choiceProspect theory contrasts with Expected Utility Theory from economics (Van Neumann and Morgenstern 1947)Normative theory how people should make optimal choices)Prospect theory replaces expected utility (objective) with subjective utility (how we see things): incorporates human element of evaluationDescriptive (how people actually make judgments/choices)Studied in Behavioral Decision Theory (BDT)

36Mr. A vs. Mr. BYou are about to see four pairs of scenarios. In each case two events occur in Mr. As life and one event occurs in Mr. Bs life. You are asked to judge whether Mr. A or Mr. B is happier. Would most people rather be Mr. A or Mr. B? If you think the two scenarios are emotionally equivalent, indicate no difference. In all cases the events are intended to be financially equivalent.37Mr. A vs. Mr. BMr. A was given tickets to lotteries involving the World Series. He won $50 in one lottery and $25 in the other.Mr. B was given a ticket to a single, larger World Series lottery. He won $75.

Who was happier?____ Mr. A ____ Mr. B ____ no difference 38Mr. A vs. Mr. BMr. A received a letter from the IRS saying that he made a minor mistake on his tax return and owed $100. He received a similar letter the same day from his state income tax authority saying he owed $50. There were no other repercussions from either mistake.Mr. B received a letter from the IRS saying that he made a minor mistake on his tax return and owed $150. There were no other repercussions from his mistake.

Who was more upset?____ Mr. A ____ Mr. B ____ no difference

39Mr. A vs. Mr. BMr. A bought his first Ohio lottery ticket and won $100. Also, in a freak accident, he damaged the rug in his apartment and had to pay the landlord $80.

Mr. B bought his first Ohio lottery ticket and won $20.

Who is happier?____ Mr. A ____ Mr. B ____ no difference40Mr. A vs. Mr. BMr. As car was damaged in a parking lot. He had to spend $200 to repair the damage. The same day the car was damaged, he won $25 in the office football pool.

Mr. Bs car was damaged in a parking lot. He had to spend $175 to repair the damage.

Who was more upset?____ Mr. A ____ Mr. B ____ no difference41

+$2,000-$2,000Prospect Theory: Key FindingsValue is defined in terms of gains and losses relative to the reference point (judged in relativity)S-shape: concave (convex) for gains (losses) above (below) the reference point (we are more sensitive to changes closer to the reference point)$10 vs. $20 >> $1,010 vs. $1,020Diminishing marginal utilityValue function is steeper for losses than for gains = loss aversionSeparate gainsIntegrate losses

42Implications of Prospect TheorySegregate gainsBut wait, theres more in infomercialsCar descriptions list out attributes separatelyIntegrate lossesCar dealers list price in one lump sumWhy we hate phone bills, itemized tuition bills, TicketmasterWhy we like all inclusive vacationsSilver lining effectSeparate out small gain from big loss$500 cash back when you buy a car, RebatesGifts with purchaseCancel losses against larger gainsPaycheck deductions for insurance or investments43NudgingChanging choice architecture to influence behaviorUsing decision biases to help people44Influencing behaviorWant to do Should do

Suppose you want to get people to choose B instead of AAB45Influencing behavior Strategy 1Eliminate or BanAB46Influencing behavior Strategy 2Incentives Carrots or Sticks!

AB47Influencing behavior Strategy 3Advertise, Persuade, Inform

AB48Influencing behavior Strategy 4Nudge

AB49What Is Nudge?A nudge is any aspect of the choice architecture that alters peoples behavior in a predictable way without forbidding any options or significantly changing their economic consequences. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting fruit at eye level [to attract attention and hence increase likelihood of getting chosen] counts as a nudge. Banning junk food does not.

Status Quo (Default) Bias

= our tendency to take the path of least resistance, to keep doing what we have been doing, or to do what comes automatically.The status quo is taken as a reference point, and any change from that is perceived as a loss.Can be explained by loss aversionCan explain why sometimes people are reluctant to adopt a new product51Make it default52Make it salientGreen footprints led to various garbage bins in the cityHanded out candies to pedestrians. 46% decrease in candy wrappers littering the streets when the green footprints were in use

53Make it fun54Make it easyFAFSA is a long and tedious process Researchers designed software that worked with H&R Blocks tax filing software to extract information from an individuals income tax form and use the information to automatically fill in the FAFSA form Families with high school seniors or recent graduates were 40% more likely to submit an FAFSA application

Make it a normA phone campaign developed to increase voter turnout used two sets of telephone scriptsone emphasizing that voter turnout was expected to be low, and another emphasizing that voter turnout was expected to be high. High turnout-script was more significantly effective than low turnout-script.How to Design a Nudge StrategyMap the decision process (a decision map for retirement savings)Indentify bottlenecks (i.e., paint points)Identify constrains and available resourceDesign nudgesImplement nudges and test for effectiveness