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Decision Making in Business

# Decision Making in Business

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Published by: saikatbala on Feb 04, 2010

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07/12/2013

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Decision-Making in Business – use of probability and expected values, and standard deviation as risk
ActionsProb of eventPossibleeventsSell icecreamSell hotdogsGetmoneyfromparents0.8Goodweather 100 50 1000.2 Rain -50 50 100
From business considerations – you make a
payoff table
or a
table of profits
that youexpect when you take certain actions given some events are true. However, the eventsare not certain. In the table above, the actions you need to decide among are selling icecream at The Big Game, selling hot dogs, or getting money from your parents. What theweather (possible event) will be is uncertain, so there is a probability associated witheach possible weather event. (In real life, these tables involve lots of research. For example, you would look at old newspapers to see how often it has rained on the day of the Big Game as opposed to being good weather. You might do a pilot study to see howmany people buy hot dogs vs ice cream on good days, and on rainy days. Etc. However,we’re ignoring all this for the moment.)One of the first things to look for is a
dominating action.
Basically, a dominating actionis an action that is obviously better than all the others. For example , in the table above,you can see that the action ‘Get money from parents’ is at least as good as selling icecream in good weather, and better than both the other two actions in bad weather.Obviously, you should get money from your parents if you can. When there is adominating action, the actions it dominates (ie is better than) are called
.
In a nutshell, a dominating action is one where the choice of action is obvious, so you don’t need to go through the calculations to decide between it and the inadmissibleevents.
However, dominating actions aren’t ‘interesting’. So we’ll pretend that your parents havedecided you are nuts to ask them for money, so we’re down to the following table:
ActionsProb of eventPossibleeventsSell icecreamSell hotdogs0.8Goodweather100 500.2 Rain -50 50

The easiest way to make decisions is to calculate the Expected Monetary Value (EMV) of each action, and then choose the action that gives the highest expected profit.
EMV1 =EMV2 =The higher one is:So the action decided upon is:The next way to make a decision is to look at Expected Opportunity Lost.This is based on the above payoff table, but we need to do some calculations first:
Payoff/profitLost opportunity(money 'lost' bymaking 'wrong'decision for event)
Actions
Actions
Prob of eventPossibleeventsSell icecreamSell hotdogsMaximumOpportunity(Maximumprofit over alldecisionsfor givenevent)Sell icecreamSell hotdogs0.8Goodweather 100 500.2 Rain -50 50
First, we have to find the maximum profit for each event from the payoff table. In other words, which action would have given us the biggest profit? Take that biggest profit – it’sthe most we had the opportunity to make in that event.

Then we subtract each cell in profit table from the maximum.
The maximum is thefirst number – we subtract from it. The numbers in the table should all be positive,but they denote a loss even though they don’t have a minus sign.
(note there should  be zeroes where the maximum profit occurred.). That is the opportunity lost. We havelost no opportunity to make more profit if we chose the right action for the event thatoccurred, and we have lost opportunityTo make a decision based on EOL, we take the expected value of each action for theopportunity loss table:EOL1 =EOL2 =Another way to make a decision is based on the Return-to-Risk-Ratio. We go back to theexpected payoff table we used for EMV. The expected profit (or monetary value) is our
return for that action
. The risk is the standard deviation of the profit.So the RRR = EMV/SD(MV)Var(MV)1 =SD(MV)1 = , so RRR1 =Var(MV)2 =SD(MV)2 = , so RRR2 =

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