Lecture Notes: Cognitive Biases and Decision Making

Introduction to Kahneman and Tversky

• Founders: Daniel Kahneman and Amos Tversky, psychologists from Israel.
• Contributions:
  • Revolutionized psychology and economics by changing perspectives on human behavior.
  • Developed a theory explaining systematic decision-making biases.
• Nobel Prize: Daniel Kahneman awarded the Nobel Prize in Economics in 2002. Amos Tversky was ineligible due to posthumous rule.

Key Findings in Decision-Making Biases

1. Loss Aversion:

   • People prefer avoiding loss over acquiring gains.
   • More effort is often put into preventing a $100 loss than earning an extra $100.

2. Reference Dependence:

   • Decisions influenced by framing as losses or gains.
   • Example: Framing effects impact decisions based on presentation.

3. Probability Weighting:

   • Small probabilities are overweighted; large probabilities are underweighted.
   • Example: A 10% chance is often perceived as 0%; a 90% chance is seen as certain.

4. Diminishing Sensitivity:

   • Marginal utility for gains/losses decreases as they increase.
   • Illustrated with a graph showing loss aversion and framing effects.

Examples and Implications

• Diminishing Sensitivity Example:

  • Pen Purchase: $15 pen vs. $8 at another store; likely to switch stores.
  • Camera Purchase: $1015 camera vs. $1008 at another store; unlikely to switch.
  • Rationality: Both scenarios involve saving $7, but perceived differently due to reference dependency.

• Implication: Large purchases (houses, cars) show insensitivity to price changes relative to total price.

Why Do We Make Systematic Errors?

• Bounded Rationality: Economic assumption of rational behavior is limited.

Kahneman's Two Systems of Thinking

1. System 1:

   • Fast, automatic, emotional, subconscious.
   • Uses heuristics for quick, often correct decisions but poor in unique situations.
   • Economical in terms of resources.

2. System 2:

   • Slow, effortful, logical, conscious.
   • Requires full focus and energy.
   • Useful in recognizing errors and logical inconsistencies.

• Application: Quizzes/exams often use System 1, but System 2 is encouraged for accuracy.

Conclusion

• Cognitive Biases: Understanding these frameworks helps identify biases.
• Decision-Making: Recognizing when to switch from System 1 to System 2 can improve decision quality.