INTRODUCTION

All judgments and decisions are made in one (or some combination) of two basic modes: joint and separate. In the joint evaluation (JE) mode, people are exposed to multiple objects simultaneously and evaluate these objects comparatively. In the separate or single evaluation (SE) mode, people are exposed to only one object and evaluate it in isolation. For example, when shopping for a piano at a music instrument store, we are usually in the joint evaluation (JE) mode because there are typically many pianos for us to compare.

The theory of rational choice assumes that preference between options does not depend on the presence or absence of other options. This principle, called independence of irrelevant alternatives, is essentially equivalent to the assumption that the decision maker has a complete preference order of all options, and that -given an offered set - the decision maker always selects the option that is highest in that order. Despite its simplicity and intuitive appeal, experimental evidence indicates that this principle is often violated (see Huber et al. 1982, Simonson and Tversky 1992).

INTRODUCTION

The idea that the legal system should not move wealth from one person to another pervades common law doctrine and reasoning. As Oliver Wendell Holmes stated, “The general principle of our law is that loss from accident must lie where it falls.” Common explanations of that position focus on the political power and class bias of those who make legal decisions and create legal rules.

The term money illusion refers to a tendency to be influenced by nominal as well as real monetary values in one's thinking about, and the conduct of, economic transactions. Money illusion has significant implications for economic theory, yet it implies a lack of rationality that is alien to economists.

INTRODUCTION

Theories of labor supply predict how the number of hours people work will change when their hourly wage or income changes. The standard economic prediction is that a temporary increase in wages should cause people to work longer hours. This prediction is based on the assumption that workers substitute labor and leisure intertemporally, working more when wages are high and consuming more leisure when its price - the forgone wage - is low (e.g., Lucas and Rapping 1969). This straightforward prediction has proven difficult to verify. Studies of many types often find little evidence of intertemporal substitution (e.g., Laisney, Pohlmeier, and Staat 1996). However, the studies are ambiguous because when wages change, the changes are usually not clearly temporary (as the theory requires). The studies also test intertemporal substitution jointly along with auxiliary assumptions about persistence of wage shocks, formation of wage expectations, separability of utility in different time periods, and so forth.

An ideal test of labor supply responses to temporary wage increases requires a setting in which wages are relatively constant within a day but uncorrelated across days, and hours vary every day. In such a situation, all dynamic optimization models predict a positive relationship between wages and hours (e.g., MaCurdy, 1981, p. 1074).

Many different disciplines deal with the resolution of conflict. Even within the single discipline of psychology, conflict can be approached from different perspectives. For example, there is an emotional aspect to interpersonal conflict, and a comprehensive psychological treatment of conflict should address the role of resentment, anger, and revenge. In addition, conflict resolution and negotiation are processes that generally extend over time, and no treatment that ignores their dynamics can be complete. In this chapter we do not attempt to develop, or even sketch, a comprehensive psychological analysis of conflict resolution. Instead, we explore some implications for conflict resolution of a particular cognitive analysis of individual decision making. We focus on three relevant phenomena: optimistic overconfidence, the certainty effect, and loss aversion. Optimistic overconfidence refers to the common tendency of people to overestimate their ability to predict and control future outcomes; the certainty effect refers to the common tendency to overweight outcomes that are certain relative to outcomes that are merely probable; and loss aversion refers to the asymmetry in the evaluation of positive and negative outcomes, in which losses loom larger than the corresponding gains. We shall illustrate these phenomena, which were observed in studies of individual judgment and choice, and discuss how these biases could hinder successful negotiation. The present discussion complements the treatment offered by Neale and Bazerman (1991).

Insurance purchases form the basis for an extraordinarily large industry. The industry has assets of $1.6 trillion and employs over 2 million people (Insurance Information Institute, 1990a). Consumers are responsible for a significant proportion of this market, either directly through their own purchase decisions, or indirectly through their choices of employers, mortgages, etc. These investments are sizable and commonplace. For example, the average insured household carries over $100,000 of life insurance, and surveys reveal that 70% of all households report having property insurance. Insurance represents, perhaps, the most significant tool for managing financial risks available to individuals.

The last decade has seen the advent of an “insurance crisis” in the U.S. and several other countries. With respect to liability insurance, for example, there have been large increases in premiums and vanishing coverage for some risks, factors that present major problems for businesses, professionals, and consumers (Committee for Economic Development, 1989).

Decisions of importance have delayed consequences. The choice of education, work, spending and saving, exercise, diet, as well as the timing of life events, such as schooling, marriage, and childbearing, all produce costs and benefits that endure over time. Therefore, it is not surprising that the problem of choosing between temporally distributed outcomes has attracted attention in a variety of disciplinary settings, including behavioral psychology, social psychology, decision theory, and economics.

In spite of this disciplinary diversity, empirical research on intertemporal choice has traditionally had a narrow focus. Until a few years ago, virtually all studies of intertemporal choice were concerned with how people evaluate simple prospects consisting of a single outcome obtained at a point in time. The goal was to estimate equations that express the basic relationship between the atemporal value of an outcome and its value when delayed.

INTRODUCTION

Psychological studies demonstrate that most individuals are overconfident about their own abilities, compared with others, as well as unreasonably optimistic about their futures (e.g., Taylor and Brown 1988, Weinstein 1980). When assessing their position in a distribution of peers on almost any positive trait such as driving ability or income prospects, 90% of people say they are in the top half (see Svenson 1981). Few people say they are below average, although half must be.1

This paper explores one setting in which optimistic biases could plausibly and predictably influence economic behavior: entry into competitive games or markets. Many empirical studies show that most new businesses fail within a few years. For example, using plant level data from the U.S. Census of Manufacturers spanning 1963-1982, Dunne, Roberts, and Samuelson (1988) estimated that 61.5% of all entrants exited within 5 years and 79.6% exited within 10 years. Most of these exits are failures (see also Dunne, Roberts, and Samuelson 1988, 1989a, Shapiro and Khemani 1987).

There are many possible explanations for the high rate of business failure (reviewed below). In this paper we consider the hypothesis that business failure is a result of managers acting on the optimism about relative skill they exhibit in surveys.

This preface is not the one that Amos Tversky and I intended to write. Soon after Amos learned early in 1996 that he only had a few months to live, we decided to edit a joint book on decision making that would collect much of our work on this topic and congenial research by others. The collection was to be a sequel and companion to a volume on heuristics and biases of judgment that we had edited together with Paul Slovic many years earlier, and a substitute for a book that Amos and I had promised the Russell Sage Foundation.

Most of the editorial task was completed quickly, although some new pieces that Amos wanted to include - notably one that I was to write - were only completed long after he was gone. The problem of writing a preface was more difficult than finding articles we liked. Our initial aspirations for the preface were high; we were going to write a broad essay presenting a view of how the field had changed in the preceding 20 years. But we ran out of time before we had a presentable product. Amos advised me to “trust the model of me that is in your mind” and write for both of us. This was not advice that I was able to follow: the risk of writing in his name statements that he might have rejected proved intimidating to the point of paralysis.

The modern theory of decision making under risk emerged from a logical analysis of games of chance rather than from a psychological analysis of risk and value. The theory was conceived as a normative model of an idealized decision maker, not as a description of the behavior of real people. In Schumpeter's words, it “has a much better claim to being called a logic of choice than a psychology of value” (1954, p. 1058).

The use of a normative analysis to predict and explain actual behavior is defended by several arguments. First, people are generally thought to be effective in pursuing their goals, particularly when they have incentives and opportunities to learn from experience. It seems reasonable, then, to describe choice as a maximization process. Second, competition favors rational individuals and organizations. Optimal decisions increase the chances of survival in a competitive environment, and a minority of rational individuals can sometimes impose rationality on the whole market.