This document discusses decision theory and the decoy effect. It provides three key points: 1) Decision theory examines how people make rational decisions under conditions of certainty, uncertainty, and conflict. Independence of irrelevant alternatives is the principle that introducing a new option should not change the preferences between the original options. 2) The decoy effect violates this principle by manipulating preferences. Introducing an asymmetrically dominated option (one that is inferior to one option but comparable to the other) can change which of the original options consumers prefer. 3) To avoid falling for the decoy effect, consumers should focus on the cost per unit of what they need to purchase and the actual number of units they require rather

1. Decision theory :
independenceof irrelevant
alternativesand thedecoy effect

2. DECISION THEORY
Decision theory in economics is concerned with identifying
the values, uncertainties and other issues relevant in a
given decision, its rationality, and the RESULTING optimal decision.
Decision theory divides decisions into three CLASSES -
(1) Decisions under certainty: where one has far too MUCH information to
choose the best alternative.
(2) Decisions under uncertainty: where one has to dig-up a lot of data to
make SENSE of what is going on and what it is leading to.
(3) Decisions under conflict: where one has to anticipate moves and counter-
moves of one or more competitors.

3. Independence of irrelevant alternatives
Independence of irrelevant alternatives is an axiom of decision theory.
If A is preferred to B out of the choice set {A,B}, introducing a third option X,
expanding the choice set to {A,B,X}, must not make B preferable to A.
In other words, preferences for A or B should not be changed by the inclusion
of X, i.e., X is irrelevant to the choice between A and B.
In voting systems, independence of irrelevant alternatives is often
interpreted as, if one candidate (X) would win the election, then addition of a
new candidate (Y) , will have no EFFECT other than now X or Y might win the
election.
Similar is the case if there are two candidates and one more is added.
The Decoy Effect violates this theory.

4. COGNITIVE BIASES - DECOY EFFECT
Cognitive biases are tendencies to think in certain ways that can lead to
systematic deviations from a standard of rationality or good judgment.
Cognitive biases are tendencies of our brains to think in CERTAIN WAYS
The decoy effect is the phenomenon whereby consumers will tend to have
a specific change in preference between two options when also presented
with a third option that is asymmetrically dominated.
WHAT IS ASYMMETRIC DOMINANCE?

5. An option is asymmetrically dominated when it is inferior in all
respects to one option; but, in comparison to the other option, it is
inferior in some respects and superior in others.
Car
A B C
Price $20000 $15000 $22500
Fuel Warranty 100000 miles 70000 miles 80000 miles
In other words, C is completely dominated by A and partially dominated by B

6. Example –
Consideration Set 1
MP3 player A B
price $400 $300
storage 30GB 20GB
MP3 player A B C
price $400 $300 $450
storage 30GB 20GB 25GB
Consideration Set 2
Because A is better than C in both respects, while B is only partially
better than C, more consumers will prefer A now than did before. C is
therefore a decoy whose sole purpose is to increase sales of A.

7. MP3 Player A B D
price $400 $300 $350
storage 30GB 20GB 15GB
Consideration Set 3
The RESULT here is similar: consumers will not prefer D, because it is not as
good as B in any respect.
However, whereas C INCREASED preference for A, D has the opposite EFFECT ,
increasing preference for B.

9. HOW TO DEFEAT THE DECOY EFFECT?
First, focus on shopping per unit.
Convert everything to how much it costs per unit. If you’re buying a bag
of cookies, convert everything to the cost per cookie.
Unfortunately, basing things entirely on price per unit still leaves one
susceptible to the decoy effect. That’s why one also needs to figure out,
in advance, how many units one actually needs.
In other words, if one is buying a bag of cookies, how many cookies will
one actually consume before the cookies go bad?
Using these two figures together – the cost per unit and the
maximum NUMBER of units one needs – one can assess correctly which
item is the best buy for one.