An Introduction to Decision Theory

This chapter gives an overview of how people actually do make decisions. The headline news is that people frequently act in ways deemed to be irrational by decision theorists. This shows either that people should behave differently, or that there is something wrong with the normative theories discussed in the preceding chapters of this book. After reviewing the empirical findings, both conclusions will be considered.

The interest in descriptive decision theory arose alongside the development of normative theories. Given the enormous influence axiomatic theories had in the academic community in the latter half of the twentieth century, it became natural to test the axioms in empirical studies. Since many decision theorists advocate (some version of) the expected utility principle, it is hardly surprising that the axioms of expected utility theory are the ones most researched. Early studies cast substantial doubt on the expected utility principle as an accurate description of how people actually choose. However, it was not until 1979 and the publication of a famous paper by Kahneman and Tversky that it finally became widely accepted that expected utility theory is a false descriptive hypothesis. Kahneman and Tversky's paper has become one of the most frequently quoted academic publications of all time. (Kahneman was awarded the Nobel Prize in Economics in 2002, but Tversky had died a few years earlier.) In what follows, we will summarize their findings, as well as some later observations.

Observed Violations of the Expected Utility Principle

Kahneman and Tversky asked a group of 72 students to state a preference between prospect A and B below. It turned out that 82% of the participants preferred prospect B to A.

It can be easily verified that the expected monetary value of prospect A is slightly higher than that of prospect B. However, this is of course not sufficient for concluding that the students are irrational. It cannot be excluded that they preferred B to A simply because their marginal utility is decreasing in the interval between $2,400 and $2,500. To make a stronger case against the expected utility principle, Kahneman and Tversky also asked the same group of students to state a preference between prospects C and D below.