32 terms

Normative decision theory

STUDY
PLAY
What is a decision?
A commitment to a course of action that is intended to produce a satisying state of affairs
Key components of decision making
Choice between actions

Goal orientated

Evaluating possible outcomes
Different types of strategies
Strategic decisions

Tactical decisions

Operational decisions
Strategic decisions
Time to make
Determine how decisions should be taken
General direction of an individual or organisation
Tactical decisions
Implementations of strategy
Represents stream of smaller scale decisions that usually don't take too long to make
Shorter term outcomes
Operational decisions
Day to day decisions
Needed to execute plans and tactics
Structured decisions
Clear objectives, clearly defined choice set and how one must evaluate
Unstructured decisions
General understanding of need to act but no clear idea of relevant goals and objectives
Normative theories
What people SHOULD do to be rational decision makers

Determines how rational people must maximise utility in way of prescribed economics, formal and based on axioms and assumptions

Simple and reasonable, based on underlying mathematical proof

Maximising best interests of decision makers or maximising subjective expected utility
Descriptive theories
What people actually do and how they do it rather than what they ought to do

Mathematical model based

Decision info is combined to determine choice or developed in behavioural terms identifying the psychological thinking process determining choice
Prescriptive decisions
Account of what we know about people's difficulties in decision making

Used to prescribe procedures people should follow if they want to make a good decision
Normative theory of risky decision making
- v influential across economics, management and finance

- people assumed to choose best option for themselves requires they are perfectly informed with available alternatives, their own beliefs and values and events that may happen in the world and likeliness of them to occur

Then determine what's best

Based on axioms
Key elements of Normative decision making
Alternatives

States of the world

Outcomes

Utilities and probabilities
Decisions makers criteria and how is it determined
Maximising subjective expected utility (determined by summing the products of expected probability and utility for each outcome)

Decision maker should always take the option with the highest SEU
Two ways researchers approach choice?
- ignore complexity and assume simple orderliness
Simpler but less realism
Concrete methods for making decisions
More precise problems

- focus on confusion and complexity
More realistic but complex
More real life situ capture
Less concrete help for decision makers
Harder to make predictions
Logic of normative apporach
Decision makers strive to do what is best for themselves
Choose the one that offers the best payoff or minimum loss
Guesses
What the payoffs will be if an option is chosen
How valuable the payoffs will be
What does it mean to think of all risky decisions as gambles
All risky situations reduced to gamble like structures which is how we make decisions
Each option treated as a bet and DM chooses which one to make
Each bet has potential gains and losses depending on the event outcome
Pascal gamble analogy
Bet on existence of God, first development of the theory
Bernoulli's gamble analogy
Games of chance, choose on a basis of multiplying probability of winning/ losing and amount to be won/ lost of each bet and choose the one with the highest outcome, reject any negative in value
Important things Bernoulli added
Need for utility rather than monetary value
Logic for insurance and treating insurance policies as bets
Differences between games against nature and games against people
Against nature: not another person, just against the future e.g. Rolling a dice, weather

Against people: against another person e.g. Competition in the market place

Playing the stock market is a little of both
Prisoners dilemma?
Non zero sum game where payoffs between components are non symmetrical so highlights normative decision theory
Describe the prisoners dilemma?
Arrested after a theft and taken to separate rooms for questioning, given 3 options:
1) confess and friend doesn't = he gets 10 years and you go free

2) you confess and he does= both get 5 years

3) neither confesses= both go to jail on lesser charges
Basic decision dilemma
Situation where opportunity arises to make life better than current but may also make it worse than it is now
How to solve the basic decision dilemma?
Calculate expected utility of both and choose the highest e.g. Changing modules, whether to continue a relationship
Parts of the expected value model?
1) expected value
2) expected utility
3) subjective expected value
4) subjective expected utility
Expected value
Player has known probabilities and utility is isomorphic with objective value of payoffs
Expected utility
Knows objective probabilities but has non isomorphic utility
Subjective expected value
Only has his subjective probabilities but has isomorphic utility
Subjective exoected utility
Player has subjective probabilities and utility is not isomorphic with objective value of payoffs
Important difference between components
Whether the probability and value of outcomes is represented objectively or subjectively
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