Human beings are continuously making conscious decisions. Life is a stream of decisions made on a continuum from the subconscious to the fully involved conscious state. Many decisions are made “without thinking” as when we have driven our car to a destination and realize that we were not aware of the actions we were taking to maneuver the automobile. Many decisions made during an individual’s typical day are made in a distracted state. This process works well until some external event injects itself into the process; for instance, a pedestrian walking out in front of the car. For this reason airplane pilots are constantly admonished to never lapse into a distracted mode while flying their airplane. The consequences of dealing with an injected event can be catastrophic.
A smaller number of decisions made on a daily basis require a higher focus of attention. Should I schedule a dental appointment; what shall I make for dinner; what shall I read; should I call my mother? Decisions such as these require conscious effort, but the consequences of the decision are typically not of great import. A small number of economic decisions require research, analysis and focused consciousness. The consequences of not deciding well can be severe. Should I buy this house; what stocks and bonds should I purchase; what should be my retirement strategy? The decision process for questions such as these requires rigor. We need to define terms, identify alternatives, devise comparative methods, research and analyze information and data, identify probabilities and risk of consequences, and select a methodology to deal with all these factors. Even after this rigorous analysis we know there is a chance that our decision will prove to have been wrong and we chalk that up to an unknown element of chance.
It is the latter type of decisions that are the subject matter of decisions theory. The modern discipline of decision theory is approximately one hundred years old. Decision theory attempts to provide a model for individuals and groups to be able to make rational decisions. There are two branches of decision theory: normative and descriptive. Normative decision theory describes how rational decisions should be made; and descriptive decision theory describes what actually happens in the process of making decisions.
Classical decision theory is based on several assumptions. (1) the agents making the decision are rational and are seeking a solution on a rational basis; (2) options which can be chosen actually exist; (3) the process of choosing will be nonrandom; (4) the result of the decision will have an expected utility; that is, it will have value to the decision maker; (5) risk in the process of decision-making is quantifiable; and (6) uncertainty in the process exists when probabilities are unknown.
The elements of the decision process are the decision-making agent, the universe of possible options or alternatives, an assignment of the expected value of each possible option, and an estimation of the risk factor associated with each possible option or alternative. Decision theory uses a wide variety of mathematical and statistical methods to evaluate expected value and risk factors.Download Article 500 Club