Taking a view vs. maximizing expected utility

The standard or classical model in decision theory is called Maximum Expected Utility (MEU) theory, which I have excoriated here and here (and which Cosma Shalizi satirized here).   Its flaws and weaknesses for real decision-making have been pointed out by critics since its inception, six decades ago.  Despite this, the theory is still taught in economics classes and MBA programs as a normative model of decision-making.  

A key feature of MEU is the the decision-maker is required to identify ALL possible action options, and ALL consequential states of these options.   He or she then reasons ACROSS these consequences by adding together the utilites of the consquential states, weighted by the likelihood that each state will occur.  

However, financial and business planners do something completely contrary to this in everyday financial and business modeling.   In developing a financial model for a major business decision or for a new venture, the collection of possible actions is usually infinite and the space of possible consequential states even more so.  Making human sense of the possible actions and the resulting consequential states is usually a key reason for undertaking the financial modeling activity, and so cannot be an input to the modeling.  Because of the explosion in the number states and in their internal complexity, business planners cannot articulate all the actions and all the states, nor even usually a subset of these beyond a mere handful.  

Therefore, planners typically choose to model just 3 or 4 states – usually called cases or scenarios – with each of these combining a complex mix of (a) assumed actions, (b) assumed stakeholder responses and (c) environmental events and parameters.  The assumptions and parameter values are instantiated for each case, the model run, and  the outputs of the 3 or 4 cases compared with one another.  The process is usually repeated with different (but close) assumptions and parameter values, to gain a sense of the sensitivity of the model outputs to those assumptions.     

Often the scenarios will be labeled “Best Case”, “Worst Case”, “Base Case”, etc to identify the broad underlying  principles that are used to make the relevant assumptions in each case.   Actually adopting a financial model for (say) a new venture means assuming that one of these cases is close enough to current reality and its likely future development in the domain under study- ie, that one case is realistic.   People in the finance world call this adoption of one case “taking a view” on the future. 

Taking a view involves assuming (at least pro tem) that one trajectory (or one class of trajectories) describes the evolution of the states of some system.  Such betting on the future is the complete opposite cognitive behaviour to reasoning over all the possible states before choosing an action, which the protagonists of the MEU model insist we all do.   Yet the MEU model continues to be taught as a normative model for decision-making to MBA students who will spend their post-graduation life doing business planning by taking a view.

 




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