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  • Introduction to Decision Theory

    Introduction

    Professor L. Blume

    Cornell University

  • What is Decision Theory About?

    Decision Theory is about making choices.

    Normative Decision Theory What rational people should

    do.

    Positive Decision Theory What rational people will do.

    Behavioral Decision Theory What irrational people will do.

    Larry Blume Introduction 1

  • What Do We Want From DT?

    Economists:

    Larry Blume Introduction 2

  • What Do We Want From DT?

    Economists: Descriptive models for positive analysis of economic

    systems, normative analysis for welfare economics

    and mechanism design.

    Larry Blume Introduction 2

  • What Do We Want From DT?

    Economists: Descriptive models for positive analysis of economic

    systems, normative analysis for welfare economics

    and mechanism design.

    Statisticians: A normative theory for deriving sensible statistical

    procedures.

    Larry Blume Introduction 2

  • What Do We Want From DT?

    Economists: Descriptive models for positive analysis of economic

    systems, normative analysis for welfare economics

    and mechanism design.

    Statisticians: A normative theory for deriving sensible statistical

    procedures.

    Computer Scientists: A normative theory for desiging software

    agents and expert systems.

    Larry Blume Introduction 2

  • Modelling Approaches

    Axiomatic DT

    List axioms which characterize rational decisionmaking. Then

    show that these axioms characterize a particular approach to

    decisiomaking; e.g. Savages axioms and expected utility.

    Larry Blume Introduction 3

  • Modelling Approaches

    Axiomatic DT

    List axioms which characterize rational decisionmaking. Then

    show that these axioms characterize a particular approach to

    decisiomaking; e.g. Savages axioms and expected utility.

    Descriptive DT

    List a collection of problems and a rule for choice.

    Larry Blume Introduction 3

  • Origins

    Nature has placed mankind under the governance of two sovereign

    masters, pain and pleasure. It is for them alone to point out what

    we ought to do, as well as to determine what we shall do. On the

    one hand the standard of right and wrong, on the other the chain

    of causes and effects, are fastened to their throne.

    Jeremy Bentham

    An Introduction to the Principle

    of Morals and Legislations, 1789

    Larry Blume Introduction 4

  • Ordinalism

    Mill already understood that utility was not a hedonic

    measure.

    Jevons, Menger, Walras, wanted a theory of value, and did

    not care about the psychological origin of utility.

    Fisher and Pareto were the first to understand that demand

    depended only on the shapes of indifference curves.

    Larry Blume Introduction 5

  • Mere Internal Consistency

    The shift in emphasis away from the physiological and

    psychological hedonistic, introspective aspects of utility led to the

    purging out of objectionable, and sometimes unnecessary,

    connotations . . . of the Bentham . . . variety.

    Paul Samuelson

    Foundations of Economic

    Analysis, 1947.

    The purpose of revealed preference theory is . . . to develop the

    theory of consumers behavior freed from any vestigial traces of the

    utility concept.

    Paul Samuelson

    A Note on the Pure Theory of

    Consumers Behavior, 1938.

    Larry Blume Introduction 6

  • Samuelsons Psychology of Choice

    Radical behaviorism asserts that two mental states are

    distinguishable only to the extent that some observable

    behavior distinguishes them.

    Samuelson writes, of a steady tendency toward the removal

    of moral, utilitarian, welfare connotations . . . and of the

    rejection of hedonistic, introspective, psychological elements.

    Larry Blume Introduction 7

  • Samuelsons Psychology of Choice

    Radical behaviorism asserts that two mental states are

    distinguishable only to the extent that some observable

    behavior distinguishes them.

    Samuelson writes, of a steady tendency toward the removal

    of moral, utilitarian, welfare connotations . . . and of the

    rejection of hedonistic, introspective, psychological elements.

    MWG on revealed preference: Perhaps most importantly, it

    makes clear that the theory of individual decision making need

    not be based on a process of introspection but can be given

    an entirely behavioral foundation.

    Larry Blume Introduction 7

  • Rational Choice as Folk Psychology

    In our everyday transactions we use the language of beliefs

    and desires to interpret and forecast the behavior of others.

    Larry Blume Introduction 8

  • Rational Choice as Folk Psychology

    In our everyday transactions we use the language of beliefs

    and desires to interpret and forecast the behavior of others.

    Economists too: The investor believes that the asset price will

    be higher tomorrow. She wants greater wealth tomorrow. So

    she purchases the asset.

    Belief and desire describe mental states and the folk

    psychology is a theory of mind which is both adequate for the

    psychology of decision and accurate in its predictions.

    Larry Blume Introduction 8

  • Characteristics of Economic Rationality

    Rationality is instrumental. Its concern is the efficient

    pursuing of ends by available means; not the sensibility of the

    ends. The preference orders of a mass murderer and a saint

    are treated equally.

    Desire is not anchored by any other aspect of the decision

    problem; either the feasible set nor the context of choice.

    Formally, desires are captured by a preference ordering on

    possible objects of choice whose existence is independent of

    the feasible set or the context of choice. This is the content

    of GCT.

    There is no distinction between choice and judgement.

    Choosing from among a set of objects, and ranking or valuing

    the objects in some fashion, are regarded as equivalent tasks.

    There is no distinction between degree of belief and relative

    likelihood.

    Larry Blume Introduction 9

  • Criticisms I: What is Explained?

    Suppose we seek to explain an observation that in some market

    with fixed supply, buyers incomes have increased and the price of

    the good has increased.

    Larry Blume Introduction 10

  • Criticisms I: What is Explained?

    Suppose we seek to explain an observation that in some market

    with fixed supply, buyers incomes have increased and the price of

    the good has increased.

    Behaviorist The market demand curve has shifted outward.

    Larry Blume Introduction 10

  • Criticisms I: What is Explained?

    Suppose we seek to explain an observation that in some market

    with fixed supply, buyers incomes have increased and the price of

    the good has increased.

    Behaviorist The market demand curve has shifted outward.

    Intentional Change in the budget set and the nature of those

    preferences which could create such a shift.

    Larry Blume Introduction 10

  • Criticisms II: The Content of Consistency

    Anyone whose definition of rationality is only the internal

    consistency implied by the revealed preference axioms must be

    prepared to accept any complete and transitive preference order.

    These would include, for instance preference orders whose

    maximization implies consumption of unsustainable amounts of,

    say, food, when consumption bundles that would sustain life are

    affordable. The fear of slipping any values into a descriptive

    analysis leads to taking serious preference orders which are

    inconsistent with any sensible notion of the rationality principle.

    Larry Blume Introduction 11

  • Criticisms III: The Impossibility of Welfare Economics

    Suppose an obsessive, exacting, driven individual with a preference

    order wakes up on the wrong side of bed one day, and at every step

    makes the worst rather than the best possible choices pursuant to

    his goals. He is perfectly consistent; his choice satisfies all the

    revealed preference axioms. Should welfare calculations be made

    with his revealed preference order? If one does not believe that

    choice expresses individuals values, then there is no point to using

    derived utlity functions to ajudicate among social states.

    Larry Blume Introduction 12