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6.2 A rational-economic perspective on risk

A rational-economic perspective generally represents risk as a combination of the expected magnitude of a gain or loss, combined with some probability distribution of anticipated outcomes. Economic ideas of risk behaviour are founded largely on expected utility theory. Expected utility theory predicts that investors will always be risk averse. The shape of the utility curve (utility plotted against increasing wealth) is such that utility increases with wealth, but at a declining rate. This is
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6.1 Introduction

An important aspect of decision making which crosses all three perspectives is making decisions about risks. Risk is all-pervasive in organisational life and many decisions require us to weigh up and choose between different kinds of risk. Thus any account of decision making would be incomplete without examining how our perceptions of risk affect our decisions. In this section we will examine risk from the three different perspectives we have identified: rational-economic, psychological and s
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5.6 A way of dealing with social pressures: decoupling

Organisations often deal with these social pressures by decoupling responses to these different pressures. The need to appear legitimate in the eyes of important constituencies is met by actions and practices which have a purely ceremonial character: they are done for the sake of appearances and not with any real engagement. The example in Author(s): The Open University

5.5.3 Normative pressures

Normative pressures concern what we think we ‘should’ do. They concern our values and the broader social values to which we subscribe. Some organisations make explicit attempts to foster particular kinds of value (for example, in relation to customer service), but normative pressures also come from outside the organisation, such as from a particular professional or religious affiliation.

Institutional pressures are important for both private and public-sector organisations.
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5.5.2 Mimetic pressures

Mimetic pressures come from the pressure to imitate what others do. The world is complicated and finding the optimal solution often difficult. One way of dealing with this complexity is to copy others. For example, in my own consulting work I carried out an assignment for British Petroleum (BP). Subsequently, other (smaller) clients would often ask me ‘So how does BP do this?’, usually with little regard for the different circumstances they faced. It is this mimetic pressure that
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5.5.1 Coercive pressures

Coercive pressures come from the social sanctions that can be applied if we do not act in socially legitimate ways. The law is one source of coercive pressure, but so too is the knowledge that you will get promoted only if you act in ways which fit accepted ways of doing things in your organisation.


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5.5 Social pressures which affect our decision making

Broadly, there are three kinds of social pressure which affect how we make decisions:

  • coercive

  • mimetic

  • normative.

We look at these in more detail below.


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5.4 The pursuit of legitimacy

Social institutions affect which actions are seen as legitimate. As we make decisions in organisations it is common to be concerned not just with economic outcomes but also with ‘legitimacy ’: ‘How will this decision be seen by X ’?; ‘Does this fit the way things are done around here?’; ‘What would happen if the press got hold of this?’; and so on.

Some of this can be quite unconscious; the conceptual frameworks and notions of cause and effect that are available to decis
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5.3 Social institutions

Of course, the extent of agreement about meaning can be highly variable: from the ephemeral (a certain style of clothing may come to stand for a shared attitude among a small group of teenagers for a short period) to the more profound (such as the idea of ‘a market’ or ‘marriage’). Sociologists refer to these more profound shared meanings as institutions. In this sense, an institution is a persistently reproduced social pattern that is relatively self-sustaining. However, to sa
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5.2 The social construction of reality

What do we mean when we say reality is socially constructed? We inhabit a social world. Many of the ‘facts’ of our lives which we take for granted are ‘facts’ only in so far as we hold common mental models about them: for example, common understandings of money, contracts, marriage, the rules of the road, democracy, to name just a few. To understand the nature of social influences on decision making we need to start from this idea that the environment within which we exist and the mea
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5.1 Introduction

As we noted earlier, both the rational-economic and psychological perspectives on decision making tend to ignore the social context in which we live and work. We turn now to consider this social context.


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4.6 Post-decision evaluation

For most normally functioning people, maintaining self-esteem is an important internal goal. This can cause us to filter out or discount information that might show us in an unfavourable light. This is what lies behind the fundamental attribution bias. This is the tendency to attribute good outcomes to our own actions and bad outcomes to factors outside our control. While such defences against loss of self-esteem can be helpful to the extent that they help us persist in the face of adv
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4.5 Deciding: problems of judgement

We are constantly bombarded by information. Simply walking though a room risks flooding us with more sensory information that we can possibly process. Stop for a moment and consider all the different things you can see, hear, smell, or feel.


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4.4 Using information

Our use of information is often biased in important regards. First, we pay more attention to information that is easily available (the availability heuristic). Second, we overweight memories which are more easily retrievable – usually because they are emotionally vivid or have personal relevance (the retrievability heuristic).

We pay selective attention to information, often in a self-serving way. We will often give greater weight to information which shows us in a favou
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4.3 Framing the problem

As you saw in Activity 1, how a problem is framed can have a significant effect on how you make decisions. Medical decisions can be affected by whether outcomes are framed as likelihood of deaths or of saving patients. Financial decisions can be affected by whether you see yourself in a position of loss or gain. In a position of gain we tend to become risk averse; in a position of loss we will tend to take risks to avoid or recover losses. You may know people who are good at using this
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4.2 Bounded rationality and the use of heuristics

As decision makers, none of us has infinite resources or time to devote to gathering and analysing information. In addition, we all have significant limitations to the amount of complexity we can cope with. Thus, even where we make conscious efforts to make decisions according to a formally rational process, we often need to make simplifying assumptions and accept limits on the availability of information and the thoroughness of our analysis.

As noted above, we constantly use heuristics
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4.1 Introduction

A psychological perspective does not start from the assumption that people are fundamentally irrational. Rather, it emphasises a different logic: a logic that meets the challenges we have evolved to face (Calne, 1999). For much of our evolution we have faced an environment with major differences from the modern business world. We have developed a range of cognitive mechanisms to cope with adverse environments in which resources are scarce. These include a range of simplifying and confidence-s
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3.3 Limitations of the rational-economic perspective

As an approach to understanding economic life, the assumption of formal rationality has been very successful. For example, there is great deal of evidence that, on average, prices in financial markets behave as if investors were formally rational. However, there is also a great deal of evidence that individuals do not behave in this way (e.g. de Bondt, 1998). Even within the field of financial economics, there is increasing interest in developing theories of market behaviour which take better
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3.2 Utility theory

Utility theory is based on this assumption of rationality and describes all decision outcomes (financial and otherwise) in terms of the utility (or value) placed on them by individuals. Within this framework, decisions can be understood in terms of rationally ordered levels of utility attached to different outcomes.

Bazerman (2001, pp.3–4), for example, describes a formally rational decision process for arriving at a decision with the greatest expected utility in the following terms:<
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3.1 Introduction

Much of economics and finance theory rests on the notion of people as formally rational decision makers. First, people are understood to have ordered preferences. That is, if someone prefers A to B and prefers B to C then they should prefer A to C. Second, decision makers are assumed to engage in a formally rational decision-making process on the basis of those preferences.


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