TKI 4210 – Decision Analysis

03 – Decision Theory

Sinta Sulistyo, MSIE

sinta.sulistyo@ugm.ac.id
Expected value criterion
Suppose you face a situation where you must choose between
alternatives A and B as follows:
○ Alternative A: $10,000 for sure.
○ Alternative B: 70% chance of receiving $18,000 and 30% chance of
losing $4,000.
What is your personal choice?
Expected value criterion
Suppose you face a situation where you must choose between
alternatives A and B as follows:
○ Alternative A: $10,000 for sure.
○ Alternative B: 70% chance of receiving $18,000 and 30% chance of
losing $4,000.

Compare now Alternative B with:

○ Alternative C: 70% chance of winning $24,600 and 30% chance of
losing $19,400

What is your personal choice?

Expected value criterion
Note that EMV(B) = EMV(C), but are they “equivalent”?
Alternative C seems to be “more risky” than Alternative B even thought
they have the same EMV.
Conclusion: EMV does not take risk into account

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The Petersburg Paradox
In 1713 Nicolas Bernoulli suggested playing the following games:
○ An unbiased coin is tossed until it lands with Tails
○ The player is paid $2 if tails comes up the opening toss, $4 if tails first
appears on the second toss, $8 if tails appears on third toss, $16 if
tails appears on the forth toss, and so forth
What is the maximum you would pay to play the above game?
If we follow the EMV criterion:
 k
1 1 1 1
EMV     ($2)   ($2)   ($4)   ($8)  ...  
k

k 1  2  2 4 8

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 Bernoulli suggested that one should not act based on the
expected monetary reward, but on a different kind of expectation,
which he called moral expectation.
◎ Daniel reasoned that the marginal increase the value or “utility” of
money declines with the amount already possessed.
◎ A gain of $1,000 is more significant to a poor person than to a rich
man through both gain same amount
The Petersburg Paradox
◎ Daniel Bernoulli proposed that the game should be valued by
computing the Expected Utility instead of the expected monetary value
that should exhibit some form of diminishing marginal return with
increase in wealth:

∞ 𝑘
1
𝐸𝑈 = 𝑢(𝑤0 + 2𝑘 )
2
𝑘=1

◎ 𝑢 is an increasing concave function, converge to a finite number

The Rules of Actional Thought
◎ How a person should acts or decides rationally under uncertainty?

◎ By following the following rules or axioms:

1. The ordering rule
2. The equivalence or continuity rule
3. The substitution or independence rule
4. Decomposition rule
5. The choice rule

◎ The above five rules form the axioms for Decision Theory
1: The Ordering Rule
◎ The decision maker must be able to state his preference among the
prospects, outcomes, or prizes of any deal. For any outcomes 𝑋 and
𝑌, he must be able to state whether he:
• Prefers 𝑋 to 𝑌 (denoted 𝑋 ≻ 𝑌)
• Prefers 𝑌 to 𝑋 (denoted 𝑌 ≻ 𝑋)
• Is indifferent between 𝑋 and 𝑌 (denoted 𝑋~𝑌)
◎ Furthermore, the transitivity property must be satisfied: that is, if he
prefers 𝑋 to 𝑌, and 𝑌 to 𝑍, then he must prefer 𝑋 to 𝑍.
Mathematically, 𝑋 ≻ 𝑌 and 𝑌 ≻ 𝑍 ⇒ 𝑋 ≻ 𝑍
◎ The ordering rule implies that the decision maker can provide a
complete preference ordering of all the outcomes from the best to
the worst
Money Pump Argument
◎Suppose a person does not follow the transitivity property
◎Three cars: Toyota Yaris, Honda Jazz, Suzuki Swift
◎His preference be:
• Yaris ≻ Swift
• Jazz ≻ Yaris
• Swift ≻ Jazz

Suppose he currently owns a Swift. He can be made to switch from Swift

to Yaris, then from Yaris to Jazz, and then from Jazz to Swift again. Each
time he switches, he is willing to pay an amount of money. The cycle can
be repeated, turning a person who violates the transitivity property into a
money pump.

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2: The Equivalence or Continuity Rule
◎ Given a prospect 𝐴, 𝐵, and 𝐶 such that 𝐴 ≻ 𝐵 ≻ 𝐶, then there exists 𝑝
where 0 < 𝑝 < 1 such that the decision maker will be indifferent
between receiving the prospect 𝐵 for sure and receiving a deal with a
probability 𝑝 for prospect 𝐴 and a probability of 1 – 𝑝 for prospect 𝐶

◎ Given that 𝐴 ≻ 𝐵 ≻ 𝐶,
• 𝐵: Certainty Equivalent of the uncertain deal on the right
• 𝑝: Preference Probability of prospect 𝐵 with respect to prospects 𝐴
and 𝐶
3: The Substitution Rule
◎ 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

◎ Then he must be indifferent between the two deals below where B is

substituted for the A – C deal
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:
5: The Choice or Monotonicity Rule
◎ Suppose that a decision maker can choose between two deals 𝐿1 and
𝐿2 as follows:

◎ If the decision maker prefers 𝐴 to 𝐵, then he must prefer 𝐿1 to 𝐿2 if

and only if 𝑝1 > 𝑝2 . That is, if 𝐴 ≻ 𝐵 then

◎ In other words, the decision maker must prefer the deal that offers the
greater chance of receiving the better outcome
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:

◎ There is no loss of generality 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 outcome
◎ By equivalent rule, for each outcome 𝐴𝑖 (𝑖 = 1, … , 𝑛) there is a number
𝑢𝑖 such that 0 ≤ 𝑢𝑖 ≤ 1 and

◎Note that 𝑢1 = 1 and 𝑢𝑛 = 0. Why?

Maximum Expected Utility Principle
◎ By the substitution rule, we replace each 𝐴𝑖 (𝑖 = 1, … , 𝑛) in 𝐿1 and
𝐿2 with the above constructed equivalent lotteries
Maximum Expected Utility Principle
◎ By the substitution rule, we replace each 𝐴𝑖 (𝑖 = 1, … , 𝑛) in 𝐿1 and
𝐿2 with the above constructed equivalent lotteries
Maximum Expected Utility Principle
◎ By the decomposition rule, 𝐿1 and 𝐿2 may be reduced to equivalent
deals with only two outcomes (𝐴1 and 𝐴𝑛) each having different
probabilities
◎ Finally, by the choice rule, since 𝐴1 ≻ 𝐴𝑛 , the decision maker should
prefer lottery 𝐿1 to lottery 𝐿2 if and only if

𝑛 𝑛

𝑢𝑖 𝑝𝑖 > 𝑢𝑖 𝑞𝑖
𝑖=1 𝑖=1
Utilities and Utility Functions
◎ We define the quantity 𝑢𝑖 (𝑖 = 1, … , 𝑛) as the utility of outcome 𝐴𝑖 and
the function that returns the values 𝑢𝑖 given 𝐴𝑖 as a utility function,
i.e. 𝑢 𝐴𝑖 = 𝑢𝑖
◎ The quantities 𝑛𝑖=1 𝑝𝑖 𝑢(𝐴𝑖 ) and 𝑛𝑖=1 𝑞𝑖 𝑢(𝐴𝑖 ) are known as the
expected utilities for lotteries 𝐿1 and 𝐿2 respectively
◎ Hence the decision maker must prefer the lottery with a higher
expected utility
 Case of More Than 2 Alternatives
◎ The previous may be generalized to the case when a decision maker is faced
with more than two uncertain alternatives. He should choose the one with
Maximum Expected Utility
◎ Hence,
𝑛
𝑗
best alternative = 𝑎𝑟𝑔 max 𝑝𝑖 𝑢(𝐴𝑖 )
j
𝑖=1
𝑗
where 𝑝𝑖 is the probability for the outcome 𝐴𝑖 in the alternative 𝑗
Comparing EU with EMV criterion
◎ The expected utility criterion takes into account both return and risk
whereas expected monetary value criterion does not consider risk
◎ The alternative with the maximum expected utility is the best taking
into account the trade off between return and risk
◎ The best preference trade-off depends on a person’s risk attitude
◎ Different types of utility function represent different attitudes and
degree of aversion to risk taking
 Readings
◎ Clemen, R.T. and Reilly, T. (2001). Making Hard Decisions with Decision Tools.
Chapter 14
thankyou

Acknowledgement:
Prof Poh KL
Dr. Nur Aini Masruroh