Lecture 2 - Intuition and Framing

Intuitive Decision
Making
Intuition, Heuristics & Framing
IIMC PGPEX 2015-16, Term 5
Intuitive Decision Making, Lecture 2
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
Consider these situations

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?
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
Intuition and analytical thinking are complementary.

* Daniel Isenberg, How Senior Managers Think
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
10
Our thinking is susceptible to the way we

perceive situations, problems.
11
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.
What treatment strategy would you choose?
Source: Rational Choice and Framing of Decisions, Tversky & Kahneman
12
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?
13
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.
Majority chose Radiation therapy
Problem 1 (mortality frame)

Surgery: Of 100 people having surgery 10 die during surgery or the postoperative period, 32 die by the end of the first year, and 66 die by the
end of five years.
Majority chose surgery
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.
14
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:
(84%)
A. Sure gain of $240
B. 25% chance to gain $1000 and 75% chance to gain nothing. (16%)
AND
(13%)
C. a sure loss of $750
D. 75% chance to lose $1000 and 25% chance to lose nothing
(87%)

15
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.

A. Sure gain of $240 (84%)
B. 25% chance to gain $1000 and 75% chance to gain nothing. (16%)
AND
C. a sure loss of $750 (13%)
D. 75% chance to lose $1000 and 25% chance to lose nothing (87%)
16
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
17
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
18
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
19
Risk averse
Perceived value
Risk taking
Source: Kahneman & Tversky
Perception of gain or loss affects the value function.

20
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?
21
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?
22
Decision failures
Launch of New Coke
Context of declining market share perceived
LOSS frame
Americas invasion of Afghanistan?

Failures from framing occur in individual as well
as group decisions!
Group members tend to align with majority view.
23
Consider these situations

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?
24
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 cant 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 dont slow
down revenue growth, we will lose another 150
Mn in profits and stop growing as well.
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.
Which story(ies) are likely to persuade the Board? Why?

25
- Ramalinga Raju, Jan 7, 2009

Why didnt Raju stop before it became a tiger?
26
I think; therefore I am.

- Rene Descartes
27

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Intuitive Decision

IIMC PGPEX 2015-16, Term 5

Intuitive Decision Making, Lecture 2

The intuitive mind is a sacred gift and the

Intuitive Decision Making, Lecture 2

Consider these situations

Intuitive Decision Making, Lecture 2

Boundedly rational because

Intuitive Decision Making, Lecture 2

System 1 & System 2

System 2: the lazy

Can and does validate

Intuitive Decision Making, Lecture 2

Solving puzzles, crossword.

IIMC PGPEX 2015-16, Term 5

Intuitive Decision Making, Lecture 2

Use of intuition at work?

IIMC PGPEX 2015-16, Term 5

Intuitive Decision Making, Lecture 2

How Senior Managers Use Intuition*

Combining Systems 1 & 2

Intuition and analytical thinking are complementary.

Intuitive Decision Making, Lecture 2

Is intuition a good thing?

IIMC PGPEX 2015-16, Term 5

Intuitive Decision Making, Lecture 2

Characteristics of Rational Choice

Intuitive Decision Making, Lecture 2

Our thinking is susceptible to the way we

IIMC PGPEX 2015-16, Term 5

Intuitive Decision Making, Lecture 2

Intuitive Decision Making, Lecture 2

IIMC PGPEX 2015-16, Term 5

Intuitive Decision Making, Lecture 2

Problem 1 (survival frame)

Majority chose Radiation therapy

Problem 1 (mortality frame)

Majority chose surgery

Radiation therapy: Of 100 people having radiation therapy, none die

Intuitive Decision Making, Lecture 2

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

Intuitive Decision Making, Lecture 2

Problem 2 consolidated: Which would you prefer?

Decision 1 Choose between:

IIMC PGPEX 2015-16, Term 5

Intuitive Decision Making, Lecture 2

Framing Effects on Decisions

Framing sometimes results in failure of dominance and invariance.

Intuitive Decision Making, Lecture 2

Utility (Value) function of choices is based on

Intuitive Decision Making, Lecture 2

Choices and decisions

IIMC PGPEX 2015-16, Term 5

Problem 3: Which would you

Intuitive Decision Making, Lecture 2

Perception of gain or loss affects the value function.

Intuitive Decision Making, Lecture 2

Prospect Theory in Action 1

IIMC PGPEX 2015-16, Term 5

Intuitive Decision Making, Lecture 2

Prospect Theory in Action 2

IIMC PGPEX 2015-16, Term 5

Intuitive Decision Making, Lecture 2