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Decision Theory
Decision Theory
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”
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
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