Decision Theory

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Definition of 'Decision Theory'

Decision theory is the study of how people make decisions under uncertainty. It is a branch of economics that uses mathematical models to describe and predict human behavior. Decision theory has been used to study a wide range of problems, including investment decisions, insurance decisions, and medical decisions.

One of the most important concepts in decision theory is the expected value. The expected value of a decision is the average value of all possible outcomes, weighted by their probabilities. For example, if you are considering investing in a stock, the expected value of your investment is the average return you would expect to earn, given the probability of different outcomes.

Decision theory also provides a number of tools for making decisions under uncertainty. One common tool is the decision tree. A decision tree is a graphical representation of the possible outcomes of a decision. Decision trees can be used to help you identify the best course of action, given the uncertainty you face.

Another tool that is used in decision theory is the utility function. A utility function is a mathematical function that describes how much you value different outcomes. Utility functions can be used to help you make decisions when the outcomes are not easily quantifiable.

Decision theory is a powerful tool that can be used to make better decisions under uncertainty. However, it is important to remember that decision theory is not a perfect science. There are always some uncertainties that cannot be quantified, and decision theory cannot always predict how people will actually behave.

Despite these limitations, decision theory can be a valuable tool for helping you make better decisions. By understanding the basic concepts of decision theory, you can make more informed choices about the risks you take and the rewards you pursue.

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