Decision Theory Overview

Decision Theory

• Decision Theory is a framework for making decisions when the outcome is uncertain, yet the potential choices have measurable outcomes.
• It is used in various fields such as economics, business, medicine, and political science.
• Decision Theory involves six steps:
  • Identify the problem: Define the issue/situation that requires a decision.
  • List the alternatives: Identify all possible options or courses of action.
  • Identify the possible outcomes: For each alternative, list all possible results.
  • List payoffs or conditional values: Identify the potential payoffs or costs for each possible outcome.
  • Choose from among the alternatives using a mathematical model: Use a decision-making rule to select the best alternative.
  • Implement the decision and gather feedback: Put the decision into action and observe the results.

Decision-Making Environments

• There are three types of decision environments:
  • Decision-making under certainty: The outcomes of the decision are known with certainty.
  • Decision-making under uncertainty: The probability of occurrence of any outcome is not available or is unknown to the decision-maker.
  • Decision-making under risk: Not mentioned in the text.

Decision-Making Rules Under Uncertainty

• There are different decision rules that can be used in making decisions under uncertainty, including:
  • Maximax: Prioritizes the action with the highest potential payoff, regardless of how likely that outcome might be.
  • Maximin: Prioritizes the action that guarantees the best outcome in the worst-case scenario.
  • Laplace criterion: Selects the alternative that has the highest average value.
  • Hurwicz criterion: Adopts a weighted average approach, using a coefficient of realism (α) that ranges from 0 (pessimism) to 1 (optimism).