decision theory

Dictionary of Accounting Terms for: decision theory
decision theory

systematic approach to making decisions especially under uncertainty. Although statistics such as expected valueand standard deviationare essential for choosing the best course of action, the decision problem can best be approached, using what is referred to as a payoff table(ordecision matrix), which is characterized by: (1) the row representing a set of alternativeavailable to the decision maker; (2) the columnrepresenting the or conditions that are likely to occur and over which the decision maker has no control; and (3) the entries in the body of the table representing the outcome of the decision, known as payoffs,which may be in the form of costs, revenues, profits, or cash flows. By computing expected value of each action, we will be able to pick the best one.
Example 1: Assume the following probability distribution of daily demand for strawberries:

With existing information, the best that the decision maker could obtain was select (stock 2) and obtain $1.90. With perfect information (forecast), the decision maker could make as much as $3. Therefore, the expected value of perfect information is $3.00 – $1.90 = $1.10. This is the maximum price the decision maker is willing to pay for additional information.

Copyright (c) by Barron's Educational Series. Reprinted by arrangement with the publisher of this site.