1. Decision Theory: Outcomes and Consequences Not Considered Decision Outcomes Consequences Decision: choose between betting on green or red chip. Objective: maximize return. Assumption: The decision to play the game has been made. Choose to place bet on green. Choose to place bet on red. ??????? ???????? Green or Red

2. Decision Theory Example #1 Decision Outcomes Consequences Decision: choose between betting on green or red chip. Objective: maximize return. Assumption: The decision to play the game has been made. Choose to place bet on Green. Choose to place bet on Red. Probability: There is an 80% chance that a green chip will be drawn and a 20% chance that a red chip will be drawn. Green is drawn. prob. = 80% Red is drawn. prob. = 20% Red is drawn. prob. = 20% Green is drawn. prob. = 80% Win $1.00 Lose $1.00 80% x $1.00 = $.80 expected value 80% x ($1.00) = ($.80) expected value 20% x ($1.00) = ($.20) expected value Ave. exp. value = Win $.60 20% x $1.00 = $.20 expected value Ave. exp. value = Lose $.60 Good Decision, Good Outcome Good Decision, Bad Outcome Bad Decision, Bad Outcome Bad Decision, Good Outcome Green or Red

3. Decision Theory – Outcomes and Consequences Not Considered Decision Outcomes Consequences Decision: choose between investing in ????????? Objective: maximize return. Assumption: The decision to invest has been made. Choose to invest in ?????? Choose to invest in ????? ????????? ?????????? ????? or ?????

4. Decision Theory Example #2 Decision Outcomes Consequences Decision: choose between investing in stocks or investing In bonds Objective: maximize return. Assumption: The decision to invest in the Stock market or bond market has been made. Choose to invest in stocks. Choose to invest in bonds. Probability: There is an 80% chance that the economy will improve significantly and a 20% chance that the economy will deteriorate significantly. Economy improves prob. = 80% Economy deteriorates prob. = 20% Gain 10% Lose 10% 80% x 10% = 8% expected value 80% x (10%) = (8%) expected value 20% x (10%) = (2%) expected value Ave. exp. value = Gain 6% 20% x 10% = 2% expected value Ave. exp. value = Lose 6% Good Decision, Good Outcome Good Decision, Bad Outcome Bad Decision, Bad Outcome Bad Decision, Good Outcome Economy improves prob. = 80% Economy deteriorates prob. = 20% Stocks or Bonds?