Derivation and application of the subjective– objective probability relationship from entropy: The entropy decision risk model (edrm)

Thomas Monroe, Mario Beruvides, Víctor Tercero‐gómez

Research output: Contribution to journalArticlepeer-review

1 Scopus citations

Abstract

The uncertainty, or entropy, of an atom of an ideal gas being in a certain energy state mirrors the way people perceive uncertainty in the making of decisions, uncertainty that is related to unmeasurable subjective probability. It is well established that subjects evaluate risk decisions involving uncertain choices using subjective probability rather than objective, which is usually calculated using empirically derived decision weights, such as those described in Prospect Theory; however, an exact objective–subjective probability relationship can be derived from statistical mechanics and information theory using Kullback–Leibler entropy divergence. The resulting Entropy Decision Risk Model (EDRM) is based upon proximity or nearness to a state and is predictive rather than descriptive. A priori EDRM, without factors or corrections, accurately aligns with the results of prior decision making under uncertainty (DMUU) studies, including Prospect Theory and others. This research is a first step towards the broader effort of quantifying financial, programmatic, and safety risk decisions in fungible terms, which applies proximity (i.e., subjective probability) with power utility to evaluate choice preference of gains, losses, and mixtures of the two in terms of a new parameter referred to as Prospect. To facilitate evaluation of the EDRM against prior studies reported in terms of the percentage of subjects selecting a choice, the Percentage Evaluation Model (PEM) is introduced to convert choice value results into subject response percentages, thereby permitting direct comparison of a utility model for the first time.

Original languageEnglish
Article number46
Pages (from-to)1-34
Number of pages34
JournalSystems
Volume8
Issue number4
DOIs
StatePublished - Dec 2020

Keywords

  • Entropy
  • Information theory
  • Prospect theory
  • Risk
  • Subjective probability
  • Uncertainty

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