Decission Theory Flashcards
Iconic Model
Physical Replica
Analog Model
Physical Model but abstract e.g. Thermometer
Mathematical Model
Representation using formulas
Systematic Approach to Decission Making
- Identify the problem
- Determine possible solutions
- Determine Criteria used for evaluation
- Evaluate possible solutions
- Choose an alternative
- Implement Alternative
- Evaluate the result
Objective Function
Mathematical expression that describes an objective
Capacity constraint
Constraints on the factors of production that can be used
Deterministic Model
All uncontrollable inputs are known and cannot vary
Stochastic Model
Uncontrollable inputs are uncertain and can varry
Probabilistic Model
Uncontrollable inputs are uncertain and can varry
Certainty
An event will hapen with a 100% certainty e.g. patent expiration
Risk
A probability less than 100% that an event will occur e.g. 58%
Uncertainty
A range of probabilities that an event will occur e.g. 10% - 30%
Ambiguity
Individuals cant or wontassign a probability or range of probabilities to an event e.g. The Internet being invented
Optimistic approach
Maximax approach (Maximum of Maximums)
Conservative approach
Minimax approach (Maximum of Minimums)
Minimax Regret approach
Select the Alternative with the minimum of the maximum regrets
Regret
Maximum Payoff in a state of Nature - Actual Payoff given state of nature and decission taken (sunk costs are irrational)
Hurwicz apporach
Maximum of the weighted payoffs using the optimism coefficient
Optimisim coeficcient (alpha)
For every possible decission the payoffs are multiplied by the optimizism coeficient (individually assigned) and the maximum of agood_outcome-(1-a)bad_outcome is choosen
Bayes-Laplace approach
Assign equal probabilities to all outcomes and find the maximum outcome
Expected Value Principle
Multiply expected outcomes by probabilities and choose the maximum return
Expected Utility Theory (Gains)
The Gain in Utility decreases as the total amount of money gained increases (The first euro won is better than the second)
Expected Utility Theory (Losses)
The Disutility increases as the total amount of euros lost increases (The Second Euro lost hurts more than the first)
Axiom
A premise so evident it has to be taken as true
4 Von Neumann-Morgenstern Axioms of Expected Utility Theory
An Individual can enter a lottery
The lottery with the highest expected utility will be chosen
- Completeness: An Individuals has a clear opinion about every lottery (better, worse or indifferent)
- Transitivity: All individuals will always choose a consistent lottery in accordance to the Completeness Axiom
- Independence: All decissions of preffered lotteries stay the same if the player is presented with an aditional lottery
- Continuity: It an individual prefers A to B and B to C than there is is a combination of A and C where the individual is indeffrent between the combination and C
Prospect Theory
Descriptive Theory of decission making (how would people actually react?)
Expected Utility Theory
Normative theory of decission making (how should people behave?)
Fundamental Assumptions of Prospect Theory
- Choices are evaluated relative to an individual reference point (past wealth, expectations, social environment) the change in money is important not the final stage
- Individuals are loss averse
- Individials are risk averse for gains (realizing profits for sure) and risk seeking for losses (try any chance not to loose anything and risk higher losses)
- Very small probabilities are overweighted and very large probabilities are underweighted
