Lecture 2_Intuition and Framing

IIMC PGPEX 2015-16, Term 5 Intuitive Decision Making, Lecture 2 1

Intuitive Decision Making Intuition, Heuristics & Framing


The intuitive mind is a sacred gift and the rational mind is a faithful servant. We have created a society that honors the servant and has forgotten the gift. - Albert Einstein

•  Firm A is selling a business unit. Firm B wants it. What can break down negotiations? Why?

•  A plant modernisation project has so far exceeded budget ($ 3 Mn) by $ 1 Mn. It has taken 6 months longer. The Plant Manager has made a detailed proposal asking for additional $ 1.35 million and 4 more months. What is the Board likely to do?

•  Workers’ Union and Management of a firm are negotiating wage settlement. Union has asked for a wage increase of 10% over the next two years. Management has offered to increase wages by 13.2% in exchange for elimination of subsidised lunch in the workers’ canteen. 3.2% increase in wages will adequately meet the extra cost of lunch. Will the Union agree?


Consider these situations…


Boundedly rational because…

•  Limited computational power of brain –  Unable to list and evaluate all options –  Inadequate for complex problems involving risk and

uncertainty, especially future events –  Insufficient time

•  Therefore intuitive thinking relies on –  Associative, extensional and extrapolative methods –  Involuntary economic, efficient and quick use of brain –  Spontaneous execution of learned behaviour

Bounded rationality leads to ‘satisficing’ rather than optimising.

System 1 & System 2

•  Intuition: quick, coherence seeking, sense making …. –  Associative,

extensional, extrapolative in nature

–  Hard-wired by evolution

–  Experience based, rules of thumb

•  System 2: the lazy controller –  Frequently endorses

System 1 •  Systematic errors of

judgement •  Illogical conclusions •  Poor risk assessment

–  Can and does validate conclusions



Examples of heuristics?

•  Everyday life…. –  Solving puzzles, crossword…. –  Playing Scrabble, Dumb Charade, Antakshari… –  Matching bolts and nuts…. –  Driving (sections of road) to work/home


Use of intuition at work?


How Senior Managers Use Intuition* •  Using Intuition (System 1)

–  Sensing, finding problems –  Performing certain actions ‘fluently’

–  Synthesise and interpret data –  Use ‘gut feel’ as a check –  Avoid detailed analysis and

quickly come to a solution.

•  Combining Systems 1 & 2 –  Framing –  Prioritising –  Solving –  Validating

* Daniel Isenberg, How Senior Managers Think

Intuition and analytical thinking are complementary.


Is intuition a good thing?


Characteristics of Rational Choice •  Dominance

–  If A>B in one state and =B in all others, A should be chosen always.

•  Invariance –  If A>B then A should be chosen every time regardless of

how the choice is stated. •  Cancellation* •  Transitivity* Dominance and Invariance are necessary conditions for rationality.

*Refer Rational Choice and Framing of Decisions


Our thinking is susceptible to the way we perceive situations, problems.


Problem 1, Group 1 Surgery: Of 100 people having surgery 90 live through the post-operative period, 68 are alive at the end of the first year, and 34 are alive at the end of five years. Radiation therapy: Of 100 people having radiation therapy all live through the treatment, 77 are alive at the end of one year, and 22 alive at the end of five years.

Source: Rational Choice and Framing of Decisions, Tversky & Kahneman

What treatment strategy would you choose?


Problem 1, Group 2 Surgery: Of 100 people having surgery 10 die during surgery or the post-operative period, 32 die by the end of the first year, and 66 die by the end of five years. Radiation therapy: Of 100 people having radiation therapy, none die during treatment, 23 die by the end of one year, and 78 die by the end of five years.


What treatment strategy would you choose?


Problem 1 (survival frame) Surgery: Of 100 people having surgery 90 live through the post-operative period, 68 are alive at the end of the first year, and 34 are alive at the end of five years. Radiation therapy: Of 100 people having radiation therapy all live through the treatment, 77 are alive at the end of one year, and 22 alive at the end of five years. Problem 1 (mortality frame) Surgery: Of 100 people having surgery 10 die during surgery or the post-operative period, 32 die by the end of the first year, and 66 die by the end of five years. Radiation therapy: Of 100 people having radiation therapy, none die during treatment, 23 die by the end of one year, and 78 die by the end of five years.


Majority chose Radiation therapy

Majority chose surgery


Problem 2 Imagine that you face the following pair of concurrent decisions. First examine both decisions, then indicate the options you prefer. Decision 1 Choose between: A. Sure gain of $240 B. 25% chance to gain $1000 and 75% chance to gain nothing. AND Decision 2 Choose between: C. a sure loss of $750 D. 75% chance to lose $1000 and 25% chance to lose nothing


(84%) (16%)

(13%) (87%)


Problem 2 consolidated: Which would you prefer?A & D: 25% chance to win $240 and 75% chance to lose $760 B & C: 25% chance to win $250 and 75% chance to lose $750 Problem 2 Imagine that you face the following pair of concurrent decisions. First examine both decisions, then indicate the options you prefer. Decision 1 Choose between: A. Sure gain of $240 (84%) B. 25% chance to gain $1000 and 75% chance to gain nothing. (16%) AND Decision 2 Choose between: C. a sure loss of $750 (13%) D. 75% chance to lose $1000 and 25% chance to lose nothing (87%)



Framing Effects on Decisions

•  Framing triggers different perceptions of gain / loss and responses to risk

•  Framing affects assessment in chance events •  Frames influence perception of physical stimuli

Framing sometimes results in failure of dominance and invariance.

* Rational Choice and Framing of Decisions, Tversky & Kahneman


Prospect Theory*

•  Perception is reference dependent •  Changes are the bases of reference

–  Changes in (not status of) health, wealth, happiness, emotions

•  Utility (Value) function of choices is based on changes in gains / losses

*Kahneman & Tversky

Choices and decisions

Problem 1: Would you play this gamble? You can say Yes or No. 50% chance to win Rs1200

50% chance to lose Rs1000

Problem 2: Would you gamble if..

You had 50% chance to lose Rs.1000

And 50% chance to win Rs 3000?

Problem 3: Which would you choose?

A. Lose Rs.1000 with certainty, OR

B. 50% chance to win Rs500

50% chance to lose Rs 2000



Source: Kahneman & Tversky

Perceived value

Perception of gain or loss affects the value function.

Risk taking

Risk averse


Prospect Theory in Action 1

•  We drive faster when running late for a flight. –  What are the choices between losses? –  What alternative strategies are available?

•  We stay invested in shares that are declining? •  We enter a bullish market late. Why? •  Why did the software engineer make a hoax bomb call

from his own cell phone?


Prospect Theory in Action 2

•  Promotions are announced as price-offs, or buy one – get one free? Why are prices not reduced by that amount?

•  Endowment effect –  We value something more when we possess it

•  Sunk cost effect –  Project cost over runs….! –  How can you use it as a purchase manager…..? –  How can you exploit it as a sales person?


Decision failures

•  Launch of ‘New Coke’ –  Context of declining market share à perceived

LOSS frame

•  America’s invasion of Afghanistan? •  Failures from framing occur in individual as well

as group decisions! –  Group members tend to align with majority view.

•  Firm A is selling a business unit. Firm B wants it. What can break down negotiations? Why?

•  A plant modernisation project has so far exceeded budget ($ 3 Mn) by $ 1 Mn. It has taken 6 months longer. The Plant Manager has made a detailed proposal asking for additional $ 1.35 million and 4 more months. What is the Board likely to do?

•  Workers’ Union and Management of a firm are negotiating wage settlement. Union has asked for a wage increase of 10% over the next two years. Management has offered to increase wages by 13.2% in exchange for elimination of subsidised lunch in the workers’ canteen. 3.2% increase in wages will adequately meet the extra cost of lunch. Will the Union agree?


Consider these situations…


Rapidly growing unprofitable co. A company has been growing revenue at 15% p.a. (CAGR) for the last 4 years. Market is growing at 10% p.a. Profitability and reserves are very poor, and cash flow tight. The CEO has retired and you have been hired as the new CEO.

After a few months on the job you have come to the conclusion that single-minded pursuit of growth has come at the cost of margins. You believe the Company must forsake high growth for profitability for at least 2-3 years. A lot needs to be put right.

How will you communicate your recommendation to the Board?

Story 1: We have grown but made no money. We can’t continue this way; we must become profitable.

Story 2: Rapid growth of the last few years has cost us € 100 Mn in profits. If we don’t slow down revenue growth, we will lose another 150 Mn in profits and stop growing as well.

Which story(ies) are likely to persuade the Board? Why?

Story 3: Our profitability can be improved substantially if we slow revenue growth from 15% to 10% and retain market share. In the next 2-3 years we can increase our profits from the current Rs. 10 Mn annually to 50 Mn.


- Ramalinga Raju, Jan 7, 2009

Why didn’t Raju stop before ‘it’ became a tiger?


“I think; therefore I am. - Rene Descartes

Documents

Lecture 2_Intuition and Framing