Decision theory

Decision theory (or the theory of choice) is the study tributed to a re-evaluation of what rational decision-
of the reasoning underlying an agent’s choices.[1] Deci- making requires.[4]
sion theory can be broken into two branches: normative
decision theory, which gives advice on how to make the
best decisions, given a set of uncertain beliefs and a set 2 What kinds of decisions need a
of values; and descriptive decision theory, which analyzes
how existing, possibly irrational, agents actually make de- theory?
cisions.
Decision theory is closely related to the field of game the- 2.1 Choice under uncertainty
ory;[2] decision theory is concerned with the choices of
individual agents whereas game theory is concerned with For more details on this topic, see Expected utility
interactions of agents whose decisions affect each other. hypothesis.
Decision theory is an interdisciplinary topic, studied by
economists, statisticians, psychologists, political and so- This area represents the heart of decision theory. The
cial scientists, and philosophers.[3] procedure now referred to as expected value was known
from the 17th century. Blaise Pascal invoked it in his
famous wager, which is contained in his Pensées, pub-
lished in 1670. The idea of expected value is that, when
1 Normative and descriptive faced with a number of actions, each of which could
give rise to more than one possible outcome with dif-
Normative or prescriptive decision theory is concerned ferent probabilities, the rational procedure is to identify
with identifying the best decision to make, assuming an all possible outcomes, determine their values (positive or
ideal decision maker who is able to compute with perfect negative) and the probabilities that will result from each
accuracy and is fully rational. The practical application of course of action, and multiply the two to give an expected
this prescriptive approach (how people ought to make de- value. The action to be chosen should be the one that
cisions) is called decision analysis, and is aimed at finding gives rise to the highest total expected value. In 1738,
tools, methodologies and software to help people make Daniel Bernoulli published an influential paper entitled
better decisions. The most systematic and comprehensive Exposition of a New Theory on the Measurement of Risk,
software tools developed in this way are called decision in which he uses the St. Petersburg paradox to show that
support systems. expected value theory must be normatively wrong. He
gives an example in which a Dutch merchant is trying to
In contrast, positive or descriptive decision theory is con-
cerned with describing observed behaviors under the as- decide whether to insure a cargo being sent from Am-
sterdam to St Petersburg in winter. In his solution, he
sumption that the decision-making agents are behaving
under some consistent rules. These rules may, for in- defines a utility function and computes expected utility
rather than expected financial value (see[5] for a review).
stance, have a procedural framework (e.g. Amos Tver-
sky's elimination by aspects model) or an axiomatic In the 20th century, interest was reignited by Abraham
framework, reconciling the Von Neumann-Morgenstern Wald’s 1939 paper[6] pointing out that the two central
axioms with behavioural violations of the expected util- procedures of sampling–distribution–based statistical-
ity hypothesis, or they may explicitly give a functional theory, namely hypothesis testing and parameter esti-
form for time-inconsistent utility functions (e.g. Laib- mation, are special cases of the general decision prob-
son’s quasi-hyperbolic discounting). lem. Wald’s paper renewed and synthesized many con-
The prescriptions or predictions about behaviour that cepts of statistical theory, including loss functions, risk
positive decision theory produces allow for further tests functions, admissible decision rules, antecedent distri-
of the kind of decision-making that occurs in prac- butions, Bayesian procedures, and minimax procedures.
tice. There is a thriving dialogue with experimental eco- The phrase “decision theory” itself was used in 1950 by
nomics, which uses laboratory and field experiments to E. L. Lehmann.[7]
evaluate and inform theory. In recent decades, there The revival of subjective probability theory, from the
has also been increasing interest in what is sometimes work of Frank Ramsey, Bruno de Finetti, Leonard Sav-
called 'behavioral decision theory' and this has con- age and others, extended the scope of expected utility

1
2 3
theory to situations where subjective probabilities can be
used. At this time, von Neumann and Morgenstern theory
of expected utility [8] proved that expected utility max-
imization followed from basic postulates about rational
behavior.
Daniel Kahneman
The work of Maurice Allais and Daniel Ellsberg showed
that human behavior has systematic and sometimes im-
portant departures from expected-utility maximization.
The prospect theory of Daniel Kahneman and Amos
Tversky renewed the empirical study of economic be-
havior with less emphasis on rationality presuppositions.
Kahneman and Tversky found three regularities — in
actual human decision-making, “losses loom larger than
gains"; persons focus more on changes in their utility–
states than they focus on absolute utilities; and the esti-
mation of subjective probabilities is severely biased by
anchoring.
Pascal’s Wager is a classic example of a choice under un-
certainty.
2.2 Intertemporal choice
Main article: Intertemporal choice
Intertemporal choice is concerned with the kind of choice
where different actions lead to outcomes that are realised
at different points in time. If someone received a windfall
of several thousand dollars, they could spend it on an ex-
pensive holiday, giving them immediate pleasure, or they
could invest it in a pension scheme, giving them an in-
come at some time in the future. What is the optimal
thing to do? The answer depends partly on factors such
HEURISTICS
as the expected rates of interest and inflation, the person’s
life expectancy, and their confidence in the pensions in-
dustry. However even with all those factors taken into
account, human behavior again deviates greatly from the
predictions of prescriptive decision theory, leading to al-
ternative models in which, for example, objective interest
rates are replaced by subjective discount rates.
2.3 Interaction of decision makers
Some decisions are difficult because of the need to take
into account how other people in the situation will re-
spond to the decision that is taken. The analysis of such
social decisions is more often treated under the label of
game theory, rather than decision theory, though it in-
volves the same mathematical methods. From the stand-
point of game theory most of the problems treated in de-
cision theory are one-player games (or the one player is
viewed as playing against an impersonal background sit-
uation). In the emerging socio-cognitive engineering, the
research is especially focused on the different types of
distributed decision-making in human organizations, in
normal and abnormal/emergency/crisis situations.
2.4 Complex decisions
Other areas of decision theory are concerned with deci-
sions that are difficult simply because of their complex-
ity, or the complexity of the organization that has to make
them. Individuals making decisions may be limited in re-
sources or are boundedly rational. In such cases the issue
is not the deviation between real and optimal behaviour,
but the difficulty of determining the optimal behaviour
in the first place. The Club of Rome, for example, de-
veloped a model of economic growth and resource usage
that helps politicians make real-life decisions in complex
situations. Decisions are also affected by whether options
are framed together or separately. This is known as the
distinction bias.
3 Heuristics
Main article: Heuristic
One method of decision-making is heuristic. The heuris-
tic approach makes decisions based on routine thinking.
While this is quicker than step-by-step processing, heuris-
tic decision-making opens the risk of inaccuracy. Mis-
takes that otherwise would have been avoided in step-by-
step processing can be made. One common and incorrect
thought process that results from heuristic thinking is the
gambler’s fallacy. The gambler’s fallacy makes the mis-
take of believing that a random event is affected by previ-
ous random events. For example, there is a fifty percent
chance of a coin landing on heads. The gambler’s fallacy
 3

suggests that if the coin lands on tails, the next time it flips
it will land on heads, as if it is “the coin’s turn” to land on
heads. This is simply not true. Such a fallacy is easily
disproved in a step-by-step process of thinking.[9]
In another example, when choosing between options in-
volving extremes, decision-makers may have a heuristic
that moderate alternatives are preferable to extreme ones.
The Compromise Effect operates under a mindset driven
by the belief that the most moderate option, amid ex-
tremes, carries the most benefits from each extreme.[10]
A general criticism of decision theory based on a fixed
universe of possibilities is that it considers the “known un-
knowns”, not the "unknown unknowns": it focuses on ex-
pected variations, not on unforeseen events, which some
argue (as in black swan theory) have outsized impact and
must be considered – significant events may be “outside
model”. This line of argument, called the ludic fallacy,
is that there are inevitable imperfections in modeling the
real world by particular models, and that unquestioning
reliance on models blinds one to their limits.

4 Alternatives 5 See also

• Bayesian statistics
A highly controversial issue is whether one can replace the
use of probability in decision theory by other alternatives. • Causal decision theory

• Choice modelling
4.1 Probability theory
• Constraint satisfaction
Advocates for the use of probability theory point to: • Decision making

• Evidential decision theory

• the work of Richard Threlkeld Cox for justification
of the probability axioms, • Game theory
• the Dutch book paradoxes of Bruno de Finetti as il- • Multi-criteria decision making
lustrative of the theoretical difficulties that can arise
from departures from the probability axioms, and • Operations research

• the complete class theorems, which show that all • Optimal decision
admissible decision rules are equivalent to the
• Decision quality
Bayesian decision rule for some utility function and
some prior distribution (or for the limit of a se- • Preference (economics)
quence of prior distributions). Thus, for every de-
cision rule, either the rule may be reformulated as • Quantum cognition
a Bayesian procedure (or a limit of a sequence of
such), or there is a rule that is sometimes better and • Rationality
never worse.
• Secretary problem

• Signal detection theory

4.2 Alternatives to probability theory
The proponents of fuzzy logic, possibility theory,
quantum cognition, Dempster–Shafer theory, and info-
gap decision theory maintain that probability is only one
of many alternatives and point to many examples where
non-standard alternatives have been implemented with
apparent success; notably, probabilistic decision theory
is sensitive to assumptions about the probabilities of vari-
ous events, while non-probabilistic rules such as minimax
are robust, in that they do not make such assumptions.
4.3 General criticism
Main article: Ludic fallacy
• Small-numbers game
• Stochastic dominance
• Two envelopes problem
6 References
[1] Steele, Katie and Stefánsson, H. Orri, “Decision Theory”,
The Stanford Encyclopedia of Philosophy (Winter 2015
Edition), Edward N. Zalta (ed.), URL =
[2] Myerson, Roger B. (1991). “1.2: Basic concepts of
Decision Theory”. Game theory analysis of conflict.
Cambridge, Mass.: Harvard University Press. ISBN
9780674728615.
4 7 FURTHER READING
[3] Hansson, Sven Ove. “Decision theory: A brief introduc-
tion.” (2005) Section 1.2: A truly interdisciplinary sub-
ject.
[4] For instance, see: Anand, Paul (1993). Foundations of
Rational Choice Under Risk. Oxford: Oxford University
Press. ISBN 0-19-823303-5.
[5] Schoemaker, P. J. H. (1982). “The Expected Utility
Model: Its Variants, Purposes, Evidence and Limita-
tions”. Journal of Economic Literature. 20: 529–563.
[6] Wald, Abraham (1939). “Contributions to the The-
ory of Statistical Estimation and Testing Hypotheses”.
Annals of Mathematical Statistics. 10 (4): 299–326.
doi:10.1214/aoms/1177732144. MR 932.
[7] Lehmann, E. L. (1950). “Some Principles of the The-
ory of Testing Hypotheses”. Annals of Mathematical
Statistics. 21 (1): 1–26. doi:10.1214/aoms/1177729884.
JSTOR 2236552.
[8] Neumann, John von; Morgenstern, Oskar (1953) [1944].
Theory of Games and Economic Behavior (Third ed.).
Princeton, NJ: Princeton University Press.
[9] Johnson, E. J., & Payne, J. W. (1985). EFFORT AND
ACCURACY IN CHOICE. Management Science, 31(4),
395-414.
[10] Roe, R. M., Busemeyer, J. R., & Townsend, J. T. (2001).
Multialternative decision field theory: A dynamic connec-
tionist model of decision making. Psychological Review,
108(2), 370-392. doi:10.1037/0033-295X.108.2.370
7 Further reading
• Akerlof, George A.; Yellen, Janet L. (May 1987).
“Rational Models of Irrational Behavior”. 77 (2):
137–142.
• Anand, Paul (1993). Foundations of Rational
Choice Under Risk. Oxford: Oxford University
Press. ISBN 0-19-823303-5. (an overview of the
philosophical foundations of key mathematical ax-
ioms in subjective expected utility theory – mainly
normative)
• Arthur, W. Brian (May 1991). “Designing Eco-
nomic Agents that Act like Human Agents: A Be-
havioral Approach to Bounded Rationality”. The
American Economic Review. 81 (2): 353–9.
• Berger, James O. (1985). Statistical decision the-
ory and Bayesian Analysis (2nd ed.). New York:
Springer-Verlag. ISBN 0-387-96098-8. MR
0804611.
• Bernardo, José M.; Smith, Adrian F. M. (1994).
Bayesian Theory. Wiley. ISBN 0-471-92416-4.
MR 1274699.
• Clemen, Robert; Reilly, Terence (2014). Making
Hard Decisions with DecisionTools: An Introduction
to Decision Analysis (3rd ed.). Stamford CT: Cen-
gage. ISBN 0-538-79757-6. (covers normative de-
cision theory)
• De Groot, Morris, Optimal Statistical Decisions. Wi-
ley Classics Library. 2004. (Originally published
1970.) ISBN 0-471-68029-X.
• Goodwin, Paul; Wright, George (2004). Deci-
sion Analysis for Management Judgment (3rd ed.).
Chichester: Wiley. ISBN 0-470-86108-8. (covers
both normative and descriptive theory)
• Hansson, Sven Ove. “Decision Theory: A Brief
Introduction” (PDF). Archived from the original
(PDF) on July 5, 2006.
• Khemani, Karan, Ignorance is Bliss: A study on how
and why humans depend on recognition heuristics
in social relationships, the equity markets and the
brand market-place, thereby making successful de-
cisions, 2005.
• Leach, Patrick (2006). Why Can't You Just Give Me
the Number? An Executive’s Guide to Using Proba-
bilistic Thinking to Manage Risk and to Make Better
Decisions. Probabilistic. ISBN 0-9647938-5-7. A
rational presentation of probabilistic analysis.
• Miller L (1985). “Cognitive risk-taking after frontal
or temporal lobectomy—I. The synthesis of frag-
mented visual information”. Neuropsychologia. 23
(3): 359–69. doi:10.1016/0028-3932(85)90022-3.
PMID 4022303.
• Miller L, Milner B (1985). “Cognitive risk-taking
after frontal or temporal lobectomy—II. The syn-
thesis of phonemic and semantic information”. Neu-
ropsychologia. 23 (3): 371–9. doi:10.1016/0028-
3932(85)90023-5. PMID 4022304.
• North, D.W. (1968). “A tutorial introduction
to decision theory”. IEEE Transactions on Sys-
tems Science and Cybernetics. 4 (3): 200–
210. doi:10.1109/TSSC.1968.300114. Reprinted
in Shafer & Pearl. (also about normative decision
theory)
• Peterson, Martin (2009). An Introduction to Deci-
sion Theory. Cambridge University Press. ISBN
978-0-521-71654-3.
• Raiffa, Howard (1997). Decision Analysis: Intro-
ductory Lectures on Choices Under Uncertainty. Mc-
Graw Hill. ISBN 0-07-052579-X.
• Robert, Christian (2007). The Bayesian Choice (2nd
ed.). New York: Springer. doi:10.1007/0-387-
71599-1. ISBN 0-387-95231-4. MR 1835885.
 5

• Shafer, Glenn; Pearl, Judea, eds. (1990). Readings

in uncertain reasoning. San Mateo, CA: Morgan
Kaufmann.

• Smith, J.Q. (1988). Decision Analysis: A Bayesian

Approach. Chapman and Hall. ISBN 0-412-27520-
1.
• Charles Sanders Peirce and Joseph Jastrow (1885).
“On Small Differences in Sensation”. Memoirs of
the National Academy of Sciences. 3: 73–83. http:
//psychclassics.yorku.ca/Peirce/small-diffs.htm
• Ramsey, Frank Plumpton; “Truth and Probability”
(PDF), Chapter VII in The Foundations of Mathe-
matics and other Logical Essays (1931).
• de Finetti, Bruno (September 1989). “Probabilism:
A Critical Essay on the Theory of Probability and on
the Value of Science”. Erkenntnis. 31. (translation
of 1931 article)
• de Finetti, Bruno (1937). “La Prévision: ses
lois logiques, ses sources subjectives”. Annales de
l'Institut Henri Poincaré.

de Finetti, Bruno. “Foresight: its Logical

Laws, Its Subjective Sources,” (translation of
the 1937 article in French) in H. E. Kyburg and
H. E. Smokler (eds), Studies in Subjective Prob-
ability, New York: Wiley, 1964.

• de Finetti, Bruno. Theory of Probability, (transla-

tion by AFM Smith of 1970 book) 2 volumes, New
York: Wiley, 1974-5.

• Donald Davidson, Patrick Suppes and Sidney Siegel

(1957). Decision-Making: An Experimental Ap-
proach. Stanford University Press.
• Pfanzagl, J (1967). “Subjective Probability Derived
from the Morgenstern-von Neumann Utility The-
ory". In Martin Shubik. Essays in Mathematical
Economics In Honor of Oskar Morgenstern. Prince-
ton University Press. pp. 237–251.

• Pfanzagl, J. in cooperation with V. Baumann and H.

Huber (1968). “Events, Utility and Subjective Prob-
ability”. Theory of Measurement. Wiley. pp. 195–
220.

• Morgenstern, Oskar (1976). “Some Reflections on

Utility”. In Andrew Schotter. Selected Economic
Writings of Oskar Morgenstern. New York Univer-
sity Press. pp. 65–70. ISBN 0-8147-7771-6.

• Non-Robust Models in Statistics by Lev B. Kle-

banov, Svetlozat T. Rachev and Frank J. Fabozzi,
Nova Scientific Publishers, Inc. New York, 2009.
6 8 TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

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