Chapter 19 - Decision theory. After studying this chapter you will be able to: Make decisions under uncertainty and under risk and assess the value of perfect information, make decisions using posterior analysis and assess the value of sample information, make decisions using utility theory.
Decision Theory
19.1 Introduction to Decision Theory
19.2 Decision Making Using Posterior
Probabilities
19.3 Introduction to Utility Theory
192
LO19-1: Make decisions
under uncertainty and
under risk and assess
19.1 Introduction to Decision Theory
the value of perfect
information.
States of nature: A set of potential future
conditions that affects decision results
Alternatives: A set of alternative actions for
the decision maker to chose from
Payoffs: A set of payoffs for each alternative
under each potential state of nature
193
LO19-1
Decision Making Under Uncertainty
Maximin: Identify the minimum (or worst) possible
payoff for each alternative and select the alternative
that maximizes the worst possible payoff
(Pessimistic)
Maximax: Identify the maximum (or best) possible
payoff for each alternative and select the alternative
that maximizes the best possible payoff (Optimistic)
Expected value criterion: Using prior probabilities
for the states of nature, compute the expected payoff
for each alternative and select the alternative with
the largest expected payoff
194
LO19-2: Make decisions
using posterior analysis
and assess the value of
sample information. 19.2 Decision Making Using Posterior
Probabilities
When we use expected value to choose the
best alternative, we call this prior decision
analysis
Often, sample information can be obtained to
help us make a better decision
In this case, we compute expected values by
using posterior probabilities
We call this posterior decision analysis
195
LO19-2
Bayes’ Theorem Calculations
196
LO19-3: Make decisions
using utility theory.
19.3 Introduction to Utility Theory
Utilities are measures of the relative value of
varying dollar payoffs for an individual
decision maker and thus capture the decision
maker’s attitude toward risk
Under certain mild assumptions about
rational behavior, decision makers should
replace dollar payoffs with their respective
utilities and maximize expected utility
197
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