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G Decision Theory

G Decision Theory

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Published by Utkarsh Sethi

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Published by: Utkarsh Sethi on Jan 31, 2010
Copyright:Attribution Non-commercial


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Every day we, are humans, make many decisions; and occasionally we make an important
that can have immediate and/or long-term effects on our lives. Such decisions as whereto attend school, whether to rent or buy, whether your company should accept a merger proposal,and so on, are important decisions for which we would prefer to make correct choice.The success or failure that an individual or organization experiences, depends to a large extent onthe ability of making appropriate decisions. Making of a decision requires an enumeration of feasible and viable alternatives (courses of action or strategies), the projection of consequencesassociated with different alternatives, and the measure of effectiveness (or an objective) toidentify best alternative to be used.Everyone engages in the process of making decisions on a daily basis. Some of these decisionsare quite easy to make and almost automatic. Other decisions can be very difficult to make andalmost debilitating. Likewise, the information needed to make a good decision varies greatly.Some decisions require a great deal of information whereas others much less. Sometimes there isnot much if any information available and hence the decision becomes intuitive, if not just aguess. Many, if not most, people make decisions without ever truly analyzing the situation andthe alternatives that exist. There is a subjective and intrinsic aspect to all decision making, butthere are also systematic ways to think about problems to help make decisions easier. The purpose of decision analysis is to develop techniques to aid the process of decision making, notreplace the decision maker.Earlier, the decisions were taken subjectively based on the skill, experience and intuition of thedecision maker. But in today’s world of dynamism, the decision making has become verycomplex, particularly in business, marketing and management because they involve a number of interactive variables (factors) whose values and relationships cannot be determined accurately. Insuch situations, mere intuition and expertise of the decision maker are inadequate and we requirewell considered judgement and analysis based on the use of several quantitative techniques andeven computers in solving problems. It is in this context that we need a full-fledged decisiontheory which provides a sound and scientific basis for improved decision making.Decision making is the essence of management. In general, the process of making decisions callsfor (i) identifying the alternatives, (ii) gathering all the relevant information about them, and (iii)selecting the best alternative on the basis of some criterion.The decision theory, also called the decision analysis, is used to determine optimal strategieswhere a decision-maker is faced with several decision alternatives and an uncertain, or risky, pattern of future events. To recapitulate, all decision-making situations are characterized by thefact that two or more alternative courses of action are available to the decision-maker to choosefrom. Further, a decision may be defined as the selection by the decision-maker of an act,considered to be best according to some pre-designated standard, from among the availableoptions.When analyzing the decision making process, the context or environment of the decision to bemade allows for a categorization of the decisions based on the nature of the problem or the
nature of the data or both. There are two broad categories of decision problems: decision makingunder certainty and decision making under uncertainty.
The entity responsible for making the decision. This may be a single person, acommittee, company, and the like. It is viewed here as a single entity, not a group.
A finite number of possible decision alternatives or courses of action available tothe decision maker. The decision maker generally has control over the specification anddescription of the alternatives. These alternatives are also called courses of action (actions, actsor strategies) and are known to the decision-maker.
States of Nature:
The scenarios or states of the environment that may occur but are not under control of the decision maker. These are the circumstances under which a decision is made. Thestates of nature are mutually exclusive events and exhaustive. This means that one and only onestate of nature is assumed to occur and that all possible states are considered.
Payoff or Outcome:
Outcomes are the measures of net benefit, or payoff, received by thedecision maker. This payoff is the result of the decision and the state of nature. Hence, there is a payoff for each alternative and outcome pair. The measures of payoff should be indicative of thedecisions maker’s values or preferences. The payoffs are generally given in a payoff matrix inwhich a positive value represents net revenue, income, or profit and a negative value representsnet loss, expenses, or costs. This matrix yields all alternative and outcome combinations andtheir respective payoff and is used to represent the decision problem.
General form of payoff matrix
1 2 n12
Courses of Action(Alternatives)States of Nature Probability S S SNN
1 11 12 1n2 21 22 2nm m m1 m2 mn
p pp pp pp p  N p pp p
The decision making process involves the following steps:1.Identify and define the problem.2.Listing of all possible future events, called states of nature, which can occur in thecontext of the decision problem. Such events are not under the control of decision-maker  because these are erratic in nature.3.Identification of all the courses of action (alternatives or decision choices) which areavailable to the decision-maker. The decision-maker has control over these courses of action.
Expressing the payoffs (P
) resulting from each pair of course of action and state of nature. These payoffs are normally expressed in a monetary value.
Apply an appropriate mathematical decision theory model to select best course of actionfrom the given list on the basis of some criterion (measure of effectiveness) that results inthe optimal (desired) payoff.
To arrive at a good decision it is required to consider all available data, an exhaustive list of alternatives, knowledge of decision environment, and use of appropriate quantitative approachfor decision-making. In this section four types of decision-making environments: Certainty,uncertainty, risk and conflict have been described. The knowledge of these environments helpsin choosing appropriate quantitative approach for decision-making.
Type 1 Decision-Making under Certainty
The process of choosing an act or strategy when the state of nature is completely known, iscalled decision making under certainty. The decision-maker has the complete knowledge (perfectinformation) of consequence of every decision choice (course of action or alternative) withcertainty. Obviously, he will select an alternative that yields the largest return (payoff) for theknown future (state of nature). In such situation, each act will only result in one event and theoutcome of the act can be predetermined with certainty. Hence, such situations are also termed asdeterministic situations. For example, the decision to purchase either National Saving Certificate(NSC); Indira Vikas Patra, or deposit in National Saving Scheme (NSS) is one in which it isreasonable to assume complete information about the future because there is no doubt that theIndian government will pay the interest when it is due and the principal at maturity. In thisdecision-model, only one possible state of nature (future) exists.
Type 2 Decision-Making under Risk 
In this case the decision-maker has less than complete knowledge with certainty of theconsequence of every decision choice (course of action) because it is not definitely known whichoutcome will occur. This means there is more than one state of nature (future) and for which hemakes an assumption of the probability with which each state of nature will occur. For example, probability of getting head in the toss of a coin is 0.5. Decision-making under risk is a probabilistic decision situation, in which more than one state of nature exists and the decision-maker has sufficient information to assign probability values to the likely occurrence of each of these states. The probabilities of various outcomes may be determined objectively from the pastdata. Knowing the probability distribution of the states of nature, the best decision is to selectthat course of action which has the largest expected payoff value. The expected (average) payoff of an alternative is the sum of all possible payoffs of that alternative weighted by the probabilities of those payoffs occurring. However, past records may not be available to arrive atthe objective probabilities. In many cases the decision-maker may, on the basis of his experienceand judgement, be able to assign subjective probabilities to the various outcomes. The problemcan then be solved as decision problem under risk.Under conditions of risk, the most popular decision criterions for evaluating the alternative is theexpected monetary value/expected opportunity loss of the expected payoff.
(i)Expected monetary value (EMV)

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