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Decision theory

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Decision theory is an interdisciplinary field that combines probability, economics, and analytic philosophy. It uses mathematical models to understand how individuals behave when facing uncertainty. Rather than just describing how people act, decision theory is often prescriptive. This means it aims to identify the optimal decisions for a rational agent. A rational agent is an ideal decision maker who calculates outcomes with perfect accuracy. By studying these models, social scientists can better understand human behavior in complex fields. These include sociology, criminology, moral philosophy, and political science.

Jacques-Clément Wagrez - The Judgement of Paris, 1886
Jacques-Clément Wagrez - The Judgement of Paris, 1886

At the heart of this subject is the concept of choice under uncertainty. To make a rational choice, one must follow a specific mathematical procedure. First, a person identifies all possible actions and their potential outcomes. Each outcome is assigned a value, which can be positive or negative. Next, the person determines the probability of each outcome occurring. The rational step is to multiply each value by its probability to find the expected value. This represents the average expectation for that specific action. A person should choose the action that results in the highest total expected value.

The history of these ideas began in the 17th century with probability theory. Mathematicians Blaise Pascal and Pierre de Fermat developed early frameworks for understanding risk. In 1738, Daniel Bernoulli published a paper that changed how we view risk. He used the St. Petersburg paradox to show that expected financial value is not enough. He introduced the concept of expected utility to better measure risk. Bernoulli used the example of a Dutch merchant deciding whether to insure cargo. This showed that the personal value of money matters more than the amount itself.

Roulette - detail
Roulette - detail

Modern decision theory was further shaped in the 1940s by John von Neumann and Oskar Morgenstern. They formalized expected utility theory and helped establish the foundations of Game Theory. Following World War II, the field expanded into economics through scholars like Milton Friedman. They applied these mathematical models to consumer choice and market behavior. Later, Abraham Wald's 1939 paper helped synthesize these concepts with statistical theory. Wald linked decision problems to hypothesis testing and parameter estimation. This revival included new concepts like loss functions and minimax procedures.

NWC wargame 1958
NWC wargame 1958

There are several distinct branches within the field. Normative decision theory focuses on finding the best possible decisions through ideal logic. This branch leads to decision analysis, which creates software known as decision support systems. In contrast, descriptive decision theory attempts to describe how people actually behave. It looks for consistent rules in human actions, such as procedural or axiomatic frameworks. Some researchers also study intertemporal choice, which involves decisions made over different stages of time. This includes choosing between immediate rewards or future benefits, like a holiday today versus a pension later. The outcome depends on interest rates, inflation, and life expectancy.

Despite these mathematical models, human behavior often deviates from rational predictions. Scholars like Maurice Allais and Daniel Ellsberg found systematic departures from expected utility. This led to the development of prospect theory by Daniel Kahneman and Amos Tversky. They discovered that humans use heuristics, which are mental shortcuts for quick decisions. While fast, these shortcuts can lead to cognitive biases. One example is the gambler's fallacy, where people believe a random event is influenced by previous results. For instance, someone might think a coin is "due" to land on heads after many tails.

Roulette - detail
Roulette - detail

Decision theory also explores the complexities of social and organizational environments. In social decisions, one must account for how other people will respond to an action. This is often studied through mathematical methods in fields like socio-cognitive engineering. Military planners use these principles during extensive simulations to predict actor behavior.

NWC wargame 1958
NWC wargame 1958

Additionally, some decisions are difficult because of bounded rationality. This occurs when individuals have limited time or intelligence to process complex information. The way options are framed can also change a person's choice, a phenomenon known as the distinction bias. Understanding these layers helps bridge the gap between mathematical ideals and real-world complexity.

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