Nova workboard

a blog from young economists at Nova SBE

Decisions, decisions, decisions!

Nothing in life is harder than making decisions. To ponder the different outcomes that one action might have on the rest of your life. Even with a great effort on evaluating and thinking on a specific situation it is impossible to forecast the future (or it is possible, but believing in fortune telling is required!). Life can, therefore, be seen as a pit of unknown futures and a permanent demander of decisions. How do we cope with this? Unfortunately, there is no straight answer. It is a complex issue that can be analyzed in many different ways. Still, I will try to shed some light on some aspects that are usually taken into consideration by us, even if sometimes we do not realize them.

You can know what you don’t know in two distinct ways. The first is that you are unaware of the outcome that something might get but you do know all possible outcomes and what are the chances of each one of them happening. For example if you flip a normal coin you know that either you get tails or heads with half chance of each one of them happening. The second is you simply have no clue of what the possible outcome might be. To the first we call risk, to the second uncertainty.

When you make a decision you do it based on risk. According to prospect theory, you see risk through different perspectives depending on the situation you are facing. On average, people are willing to make a decision that has more risk involved when they are in a bad position than when they are in a good position. However, you will always seek information that might help you decrease the risk of the desired outcome not happening. How much do you value this reduction of risk? I would like to call your attention to the following game. You and your friend decide to play Russian Roulette. You have a six-cylinder gun, you put bullets in it, you spin the cylinder and you fire. Now imagine these two different settings for the game. In the first setting, there is only one bullet in the cylinder, in the second there are 4 bullets in the cylinder. For which of the situations would you pay more to remove one bullet? [This is called the Zeckhauser Russian Roulette]

When making this decision for myself I thought almost immediately that I would pay more to remove the bullet in the first situation where there is only one bullet; I would expect that you had the same intuition. However, I was not allocating the correct value to the reduction of the risk of dying. The two situations had exactly the same amount of risk reduction, i.e. in the first I reduce risk from 1/6 to 0 and in the second I reduce risk from 4/6 to 3/6. Moreover, if I value my life (in order to spend my money) I would have to be willing to pay more money in the second situation than in the first one because in the second there is still a 3/6 possibility of me not being alive. The reason for our initial intuition is that there is a preference for certainty more than a preference for the reduction of risk – also known as zero risk bias defined as the tendency to prefer the complete elimination of a risk even when alternative options produce a greater reduction in risk.

After reading all this, you must be wondering if you really are calculating and processing this much information in your daily life. Well, maybe not, but I can assure you that there is always a way of analyzing and understanding the decisions that you make.

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Author: studentnovasbe

Master student in Nova Sbe

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