DEFINITION of 'Decision Theory '

Decision theory is an interdisciplinary approach to determine how decisions are made given unknown variables and an uncertain decision environment framework. Decision theory brings together psychology, statistics, philosophy and mathematics to analyze the decision-making process. Decision theory is closely related to game theory and is studied within the context of understanding the activities and decisions underpinning activities such as auctions, evolution and marketing.

BREAKING DOWN 'Decision Theory '

There are three main areas of decision theory. Each studies a different type of decision making. Descriptive decision theory examines how irrational beings make decisions. Prescriptive decision theory tries to provide guidelines for agents to make the best possible decisions given an uncertain decision-making framework. Normative decision theory provides guidance for making decisions given a set of values.

Example of Decision Theory

A common example of decision theory stems from the prisoner's dilemma in which two individuals are faced with an uncertain decision where the outcome is not only based on their personal decision, but also on that of the other individual. Since both parties do not know what actions the other person will take, this results in an uncertain decision framework. While mathematics and statistical models determine what the optimal decision should be, psychology and philosophy introduce factors of human behaviors to suggest the most likely outcome.

RELATED TERMS
  1. Decision Analysis - DA

    Decision analysis is a systematic, quantitative and visual approach ...
  2. Mechanism Design Theory

    Mechanism design theory is an economic theory that seeks to study ...
  3. Accelerator Theory

    The accelerator theory is an economic theory whereby as demand ...
  4. New Growth Theory

    New growth theory is a concept that presumes the desire and wants ...
  5. Market Segmentation Theory

    Market segmentation theory posits that there is no relationship ...
  6. Theory of the Firm

    The theory of the firm is the microeconomic concept founded in ...
Related Articles
  1. Investing

    Modern Portfolio Theory Vs. Behavioral Finance

    Or: How financial markets would work in an ideal world vs. how they work in the real world.
  2. Investing

    Efficient Market Hypothesis

    An investment theory that states it is impossible to "beat the market".
  3. Investing

    Using Decision Trees in Finance

    Decision trees are a major tool that can be used in corporate finance and economic forecasting. Discover how binomial trees plays an integral role in pricing of interest rates.
  4. Trading

    The Nash Equilibrium

    Nash Equilibrium is a key concept of game theory, which helps explain how people and groups approach complex decisions. Named after renowned mathematician John Nash, the idea of Nash Equilibrium ...
  5. Investing

    Don't Let Emotions Derail Investment Decisions

    Understanding behavioral finance can help you make better investing decisions.
  6. Investing

    The Evolution of ETFs

    Key 20th-century financial theories changed the way investors viewed markets and created the circumstances in which ETFs could emerge.
RELATED FAQS
  1. What is the chaos theory?

    The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>
  2. What is capital structure theory?

    Discover capital structure theory as it relates to financial management and the methods in which companies attempt to raise ... Read Answer >>
  3. Has the Efficient Market Hypothesis been proven correct or incorrect?

    Explore the efficient market hypothesis and understand the extent to which this theory and its conclusions are correct or ... Read Answer >>
  4. How is marginal analysis used in making a managerial decision?

    Discover why understanding marginal analysis helps to identify the optimal distribution of resources and planning for an ... Read Answer >>
  5. How do modern corporations deal with agency problems?

    Learn about ways capitalist investment markets regulate the principal-agent problems that arise with corporate management ... Read Answer >>
  6. What is the theory of asymmetric information in economics?

    Read a brief overview of asymmetric information theory in economics, the development of its main arguments and why some challenge ... Read Answer >>
Trading Center