Chapter 19: Decision Theory

Chapter 19Decision TheoryCopyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinDecision Theory19.1 Introduction to Decision Theory19.2 Decision Making Using Posterior Probabilities19.3 Introduction to Utility Theory19-*19.1 Introduction to Decision TheoryStates of nature: A set of potential future conditions that affects decision resultsAlternatives: A set of alternative actions for the decision maker to chose fromPayoffs: A set of payoffs for each alternative under each potential state of natureLO19-1: Make decisions under uncertainty and under risk and assess the value of perfect information.19-*Decision Making Under UncertaintyMaximin: 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 payoffLO19-119-*19.2 Decision Making Using Posterior ProbabilitiesWhen we use expected value to choose the best alternative, we call this prior decision analysisOften, sample information can be obtained to help us make a better decisionIn this case, we compute expected values by using posterior probabilitiesWe call this posterior decision analysisLO19-2: Make decisions using posterior analysis and assess the value of sample information.19-*Bayes’ Theorem CalculationsLO19-219-*19.3 Introduction to Utility TheoryUtilities are measures of the relative value of varying dollar payoffs for an individual decision maker and thus capture the decision maker’s attitude toward riskUnder certain mild assumptions about rational behavior, decision makers should replace dollar payoffs with their respective utilities and maximize expected utilityLO19-3: Make decisions using utility theory.19-*Introduction to Utility TheoryLO19-319-*