Decision Theory

HADI SUTANTO SARAGI

 Expected Value Criterion
 Suppose you face a situation where you must choose between alternatives A and B as follows:
 Alternative A: $10,000 for sure.
 Alternative B: 70% chance of receiving $18,000 and 30% chance of loosing $4,000.
What is your personal choice?
 Compare to alternative B with :
 Alternative C: 70% chance of winning $24,600 and 30% chance of loosing $19,400.
 Note that EMV(B) = EMV(C), but are they “equivalent”?
 Alternative C seems to be “more risky” than Alternative B even thought they have
the same EMV (Expected Monetary Value).
 Conclusion: EMV does not take risk into account
The Petersburg Paradox
 In 1713 Nicolas Bernouli suggested playing the following games:
 An unbiased coin is tossed until it lands with tails
 The player is paid $2 if tails comes up the opening toss, $4 if heads first appears and tails on
the second toss, $8 if tails appears on third toss, $16 if tails appears on the fourth toss and so
forth.
 What is the maximum you would pay to play the above game ?
 If we follow the EMV criterion :
 k
1 1 1 1
EMV     ($2) k   ($2)   ($4)   ($8)  ...  
k 1  2  2 4 8

 This means that you should be willing to pay up to an infinite amount of money to play the game,
but why people are unwilling to pay more than a few dollars?
The Petersburg Paradox
 25 years later, Nicolas’s cousin, Daniel Bernoulli, arrived at a solution that contained the first
seeds of contemporary decision theory.
 Daniel reasoned that the marginal increase the value or “utility” of money declines with the
amount already possessed.
 Specifically, Daniel Bernoulli argued that the value or utility of money should exhibit some from
of diminishing marginal return with increase in wealth:
The measure to use to value the game
is then the “expected utility”

 c is the charged to enter the

  

1
EU    k  ln w  2 k  c  ln(w)   game. W is wealth
k 1  2 
The Petersburg Paradox
The determination of the value of an item must not be based on the price, but
rather on the utility it yields…. There is no doubt that a gain of one thousand ducats
is more significant to the pauper than to a rich man though both gain the same
amount.
 The Petersburg Paradox
The following table shows the expected value E of the game with various potential bankers and their bankroll W (with
the assumption that if you win more than the bankroll you will be paid what the bank has.
The rule of actional thought
 How a person should acts or decides rationally under uncertainty ?
 Answer: by following the following rule or axioms:
The ordering rule
The equivalence or continuity rule
The substitution or independence rule
Decomposition rule
The choice rule
 The above five rules form the axioms for Decision Theory
1. The Ordering Rule
 The decision maker must be able to state his preference among the prospects,
outcomes, or prizes of any deal.
 Futhermore , the transivity property must be satisfied: that is, if he prefers X to Y
and Y to Z. Then he must prefer X to Z.
 The ordering rule implies that the decision maker can provide a complete
preference ordering of all the outcomes from the best to the worst.
 Suppose a person does not follow the transivity property: the money pump
argument.
2. The equivalence or continuity Rule
 Give a prospect A,B and C such that A > B > C, then there exists p where 0 < p < 1
such that the decision maker will be indifferent between receiving the prospect B
for sure and receiving a deal with a probability p for prospect A and a probability
of 1-p for prospect C.
p A
B ~
1-p
C
 Give that A > B > C
 B: certain equivalent of the uncertain deal on the right
 P: preference probability of prospect B with respect to prospect A and C.
3. The Subtitution Rule

 We can always substitute a deal with its certainty equivalent without affecting
preference.
 For example, suppose the decision maker is indifferent between B and the A – C
deal below p A
B ~
1-p
C
 Then he must be indifferent between the two delas below where B is substituted
for the A-C deal. q B p A
q
~ 1-p C
1-q D 1-q D
 4. The Decomposition Rule
 We can reduce compound deals to simple ones using the rules of probabilities.
 For example, a decision maker should be indifferent between the following two
deals:

q A pq A

p ~
1-q 1 - pq
B B
1-p
C
 5. The choice or monotonicity rule

 Suppose that a decision maker can choose between two deals L1 and L2 as
follows: p1 A
p 2 A
L1 = L2 =
1 – p1 1 – p2 B
B
 For example, a decision maker should be indifferent between the following two
deals: A P A
P1 2

P1 > P2
>
1 – P1 1 – P2
B
B
 Maximum expected utility principle
 Let a decision maker faces the choice between two uncertain deals or lotteries L1 and L2
with outcomes A1, A2, …, An as follows:
A1
A1
P1 q1
L1 =
A2 A2
P2 L2 =
q2
P3 q3
A3 A3
 There is no loss of generally in assuming that L1 and L2 have the same set of outcomes
A1, A2, …, An because we can always assign zero probability to those outcomes that do
not exist in either L1 and L2.
 It’s not clear whether L1 or L2 is preferred
 By ordering rule, let A1 > A2 > … > An
 Maximum expected utility principle
 Again, there is no loss of generality as we can always renumber the subscripts according to
the preference ordering.
 We note that A1 is the most preferred outcome, while An is the least preferred outcomes.
 By equivalent rule, for each outcome Ai (I = 1,…,n) there is a number ui such that 0≤ui ≤1
and
A1
Ui
L1 =
1-Ui
An

 Note that Ui =1 and Un = 0. why?

 Maximum expected utility principle
 By the substitution rule, we replace each Ai (I = 1,…,n) in L1 and L2 with the above
constructued equivalent lotteries.
 Maximum expected utility principle
 By the decomposition rule, L1 and L2 may be reduced to equivalent deals with only two
outcomes (A1 and An) each having different probabilities.
 Finally, by the choice rule, since A1 > An , the decision maker should prefer lottery L1 to
lottery L2 if and only if
n n

u p  u q
i 1
i i
i 1
i i
 Utilities and Utility functions
 We define the quantity u1 (i=1,…,n) as the utility of outcomes Ai and the
function that returns the value ui given Ai as a utility function, i.e. u(Ai) = ui
The quantities
n n

 p u ( A ) and  q u ( A )
i 1
i i
i 1
i i

are known as the expected utilities for lotteries L1 and L2 respectively.

Hence the decision maker must prefer the lottery with higher expected utility.
 Case for more than 2 alternatives
 The previous may be generalized to the case when a decision maker is faced
with more than two uncertain alternatives. He should choose the one with
maximum expected utility
Hence
n
best alternative  arg Max  pij u ( Ai )
j
i 1

Where Pij is the probability for the outcome Ai in the alternative j

 Comparing expected utility criterion with
expected monetary value criterion
 The expected utility criterion takes into account both return and risk whereas
expected monetary value criterion does not consider risk.
The alternative with the maximum expected utility is the best taking into
account the trade off between return and risk.
The best preference trade-off depends on a person’s risk attitude.
Different type utility function represent different attitudes and degree of a
version to risk taking.