Psychologists Amos Tversky and Daniel Kahneman conducted much of the research contributing to the current state of our knowledge about decision-making biases. Tversky and Kahneman tested tendencies in people’s real-life choices by presenting experimental subjects with laboratory-simulated decision-making situations. From the results they developed a set of principles called prospect theory to explain why people tend to be nonrational in making economic decisions.

Tversky and Kahneman’s most important finding was that an individual’s perception of gain or loss in a situation is more important than an objective measure of gain or loss. In this respect, they’re being nonrational—that is, they aren’t making decisions based purely on rational criteria. Similarly, they found that different people think differently about gains and losses—a phenomenon they call framing. Not surprisingly, people also tend to allow their perceptions to be skewed (positively or negatively) by the information they receive about a situation. Unfortunately, when new information later becomes available, they have a hard time letting go of their initial perceptions, even if the new information contradicts their original impressions. Tversky and Kahneman refer to this process as anchoring and adjustment. 

In this exercise, we’re going to ask you to answer a few questions. To answer them, however, you must know how to calculate an expected value. To do this, you multiply each possible outcome value of a situation by the probability of its occurrence and then sum all the results. Here’s a simple example: Let’s say you have a 50 percent chance of earning 80 points on an exam and a 50 percent chance of earning 70 points. You can calculate the expected value as (.5^❄80) + (.5^❄70) = 75. In other words, a .5 chance of 80 points equals 40 points and a .5 chance of 70 points equals 35 points. Therefore, the expected value of your exam is 40 + 35 = 75 points.

Exercise Task 

1. Respond to the list of brief questions that your professor provides to you. Remember: No answer is correct or incorrect; simply choose your most likely response. Then, when your instructor tells you to, share your answers with the class. 

2. Discuss the answers given by the class. Why do students’ answers differ? 

3. What have you learned from this exercise about decision-making biases and risk propensity?