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Lecture 8

# INST 354 Lecture 8: INST354 Lecture 8: Invention of Modern Decision Making

Department
Information Studies
Course Code
INST 354
Professor
Anton
Lecture
8

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INST354 Lecture 8: Invention of Modern Decision Making
Where does this idea of rationality come from? It began in Renaissance Italy, for example, in the
analysis of the practice of gambling by scholars such as Girolamo Cardano (15011576), a true
Renaissance man who was simultaneously a mathematician, physician, accountant, and
inveterate gambler. (He is also credited with inventing the combination lock.) In spite of his
profound insights into risky decision making, he tended to lose, because his analyses of the
numerical structure of random situations were accompanied by lousy arithmetic skills. The most
recent impetus for the development of a rational decision theory, however, comes from a book
published in 1947 entitled Theory of Games and Economic Behavior by
mathematician John von Neumann and economist Oskar Morgenstern. (The first publication in
1944 omitted some of the most important analyses of decision making, so we cite the 1947
edition.) Von Neumann and Morgenstern provided a theory of decision making according to the
principle of maximizing expected utility. The book does not discuss behavior per se;
rather, it is a purely mathematical work that applies utility theory to optimal economic decisions.
Its relevance to non-economic decisions was assured by basing the theoretical development on
general utility (we prefer the term personal value), rather than solely on monetary outcomes.
This criterion of expected utility may most easily be understood by analyzing simple gambling
situations. Because gambling situations are familiar and well-defined, we will rely on them
heavily (as have most scholars in this area) to illustrate basic concepts, though we will try to
provide a diverse collection of nonmonetary, everyday examples as well. Consider, for example,
a choice between two gambles:
The expected value of each is equal to the probability of winning multiplied by the
amount to be won. Thus, the expected value of gamble (a) is .20 × \$45 = \$9, while that of
gamble (b) is .25 × \$30 = \$7.50. People need not, however, prefer gamble (a) simply because
its expected value is higher. Depending upon their circumstances, they may find \$30 to have
more than four-fifths the utility of \$45, in which case they wouldaccording to the theory
choose gamble (b). For example, an individual may be out of money at the end of a week and
simply desire to have enough money to eat until the following Monday. In that situation, the
individual may find the difference in utility between \$30 and \$45 to be negligible compared with