Decision Theory
The study of a person or agents’ choices
What is Decision Theory?
Decision theory is the study of a person or agents’ choices. The theory helps us understand the logic behind the choices professionals, consumers, or even voters make.
The choices come with consequences and are usually discussed in two separate but distinct branches. The branches consist of Normative Decision Theory and Optimal Decision Theory.
When analyzing decision theory, the analysis often consists of what makes an optimal decision, who that optimal decision-maker may be, and how they can come to that decision. Discussing how people “ought” to make decisions in certain scenarios is part of this study as well.
We will discuss how the two fields differ and how decision theory plays a part in our everyday lives in many different facets. The field of decision theory is often studied in business schools, with appearances in the field of economics and statistics. It can also be found in the scientific realm, with biologists and political scientists studying it as well.
Summary
- Decision theory is the study of a person or agents’ choices. It helps us understand the choices professionals, consumers, or even voters make when coming to a decision.
- There are two branches of decision theory – Normative Decision Theory and Optimal Decision Theory.
- There are three different types of uncertainty that can be found in decision-making theory –States, Consequences, and Actions.
- Understanding how decision theory works and its implications for consumer behavior is an excellent tool for marketers to utilize.
Normative and Optimal Decision Theory Analyses
Decision theory is divided into two different subcategories. The table below discusses and outlines some of the critical differences between the two, and the respective areas they focus on:
| Normative Decision Theory | Optimal Decision Theory |
|---|---|
| Analyzes the outcomes of decisions | The investigation and analysis of why individuals and agents of choice make the decisions that they do |
| Determines the optimal decision based on outcomes | Looks at the assumptions made by individuals making the decisions and the assumptions they make when deciding |
| The theory centers around the ideal decision-maker for a specific situation | |
| "What should the person making the decision do to make this decision?" |
Attempting to Predict Consumer Behavior
Understanding how decision theory works and its implications for consumer behavior is an excellent tool for marketers to utilize. Understanding decision theory can help when making predictive models for which item a consumer may choose or even which type of transportation they may utilize. It can help in understanding alternatives an individual may choose and why they may choose them.
Understanding consumer behavior can be pivotal in determining whether a product will be a success. After all, creating a quality product is not necessarily indicative of whether or not people will buy it and whether a company will be able to recover the investment made in R&D and marketing they put forth trying to sell it.
The Uncertainty Variable in Decision Theory
Different uncertainty variables are a part of the decision-making theory. Former university professor Leonard Jimmie Savage, the author of “The Foundations of Statistics,” outlined the different conditions of uncertainty that exist in modern-day decision-making theory.
Three different types of uncertainty can be found in decision-making theory – States, Consequences, and Actions.
States encompass facts that exist in the universe that can affect a decision. Consequences are the features of a decision made that influence a decision-maker on a micro-level, i.e., whether an individual feels rested. Actions are the link/bridge between both states and consequences. Savage describes them as links between states and consequences.
Related Readings
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:
Financial Analyst Certification
Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!
