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Statistical Decision Theory

• Every individual, big or small, rich or poor, educated or uneducated has to take decision almost every day. • Some of these decisions are of a routine type which do not involve high states and are consequently trivial in nature. Example • A student may decide whether to put on a white or a red shirt while going to the college on a particular day “or” a house wife may decide to serve lemon uice or pineapple uice to a guest “or” business e!ecutive may decide whether to go by train or car to meet a potential customer in a nearby town. • "owever, in contract to these situations, we have quite often to make decisions which we consider to be important from many points of view and which entails a lot of reasoning and thinking. Example • #ecision to buy or not to buy shares of particular company, to accept or not to accept a new recruitment and promotions policy are, by any standard, significant and important decisions and consequently would not be made in a haste or without a detailed analysis of the various pros and cons involved in each situation. • Some of the decisions, like buying or not buying the shares of a company or accepting a new ob affect the decision maker only. "e alone has to suffer the consequences of his decision or his family members may also be affected by it. Such decisions are “personal decisions”. • As against these some people have to make decisions which affect other people like consumers of the products, shareholders of the business unit and employees of the organi$ation.

• Such decisions which affect other people in a society require very careful and objective analyses of the different group of persons are differently affected by these and their interests often clashes. Decision Making Science or an Art • %he very first doubt that arises in the mind of a common person is that whether decision making could ever be science obeying definite laws which may give high of precisions to the consequences of a particular decision. • %he ustification for this doubt is because in decision making we make inferences about “unknown” rather than “known”. • %here is much that we do not know about all the problems that beset us and that is why most of the time we find ourselves guessing and making sub ective decisions. • &ery often it is felt that the choice of the decision is related to the personality of the decision maker and his sub ective assessment of the situation that an unemotional and abstract scientific analysis is in appropriate in this area. • 't is also argued that successful men in business have made right decisions without the aid of scientific tools and techniques and that the choice of a decision is largely a matter of intuition based on e!perience. • (n a closer e!amination it would become obvious that this feeling is not right and its e!ists because people en oy guessing. (therwise we cannot e!plain the popularity of many games of chance which make guessing synonymous with entertainment. • %here can be no shortage of quantitative techniques which can be appropriately and profitably used in such situations and yet are not made rise of our shortage is only of more effective techniques and also our willingness to apply the techniques we already have. • Even if it is accepted that there is always a strong human element in decision making in the final stage, process which are amenable to scientific analysis and treatment.

• Efforts are made to evolve a method by which these components could be woven to help the person to make a coherent and consistent decision. • 't can, therefore, be stated that decision making in the field of business need not be e!clusive sub ective in character. %here are many areas where it is possible to apply statistical tools and techniques and thereby make decision making more ob ective in nature. • #ecision making would, therefore, remain both an art as well as science. Elements in the Decision Making • )or all decisions whether routine or comple! there are some common elements. • A decision situation arises only when the decision maker has “more than one course of action open to him”. • 'f there is only one alternative, there is nothing to decide. • %he first step, therefore, is any decision situation is to find out and list all possible alternatives available. • %he list of alternative choices should be as far as possible “e!haustive” and the list so drawn should provide courses of action which are e!clusive of each other. 't means that out of various courses of action which are e!clusive of each other. 't means that out of various courses of action, if any one is chosen, the others have to be re ected. (ne and only one decision can be choose as it is the best. • Another common element in most of decision problems is “uncertainty”. %his uncertainty is referred to as “ State of Nature” (N) or the “State of the World”. • %he strategy which a decision maker has to choose would depend on the level of uncertainty of the state of nature.

the inferences have to be carefully drawn. • (n the other hand. cost. sales. • %he problem before the decision maker would be a problem of measurement of the e!tent to which an ob ective is being reali$ed. *hereas. labour satisfaction may be studied through labour turn over rate or labour productivity etc. Measuring Conse uences of !arious Decision • 'n order to select a strategy from amongst the various available strategies one has to know the consequences of selecting different strategies. whether a new product is developed or not developed whether a particular quality is achieved or not achieved. there are many ob ectives which provide a vast range of attainments. when we use+quantitative techniques in decision making these qualitative terms have to be studied in the light of related characteristics. . • "owever. production. employee motivation or market goodwill. %here are some ob ectives which are either achieved or not achieved. • 'n other words one should know the e!tent to which a particular strategy would achieve the ob ective which the decision maker has in his mind. • Some of these ob ectives offer natural way of measuring the degree of achievement in term of say rupees or numbers or some other units.rofit in terms of rupees is a natural way of measuring profit but does it really reflects the e!tent of . for e!ample. Such ob ectives are profits.• Statisticians make an effort to reduce the element of uncertainty by trying to assign probabilities to various states of nature on the basis of past records about the problem under study. there are some other ob ectives like goodwill or employee morals or motivation which cannot be measured in this manner. • "ere the decision maker has to face a new type of problem. • 't should be remembered that when our ob ectives can be directly defined in terms of a natural unit. )or e!ample.

if the ob ectives of the firm are. the problem becomes more comple!. "owever. b. %he value of rupee differs from unit to unit and individual to individual. E!ample. . the total number of cells in the pay off matri! would be 5 ! 6 or 17. • A pay off matri! generally assumes the following shape. S1. "ay #ff • *hen the value of a consequence is e!pressed directly in terms of gains e!pressed in money. which may be denoted by S0. • %he consequences of various decisions are given monetary values and when the conditional outcome of the various strategies to possible states of nature is put in the shape of a table. in such comple! situations also. higher profit. 2S &arious states of nature denoted by 30. then there is no single scale of measurement of these ob ectives. it is called a $pay off”. • %hus. higher productivity and a high quality standard of the product. • A pay of matri! takes into account two things a. efforts are made to convert these ob ectives into a “single utility measure”. Alternative strategies /or alternatives.23k.achievement of the ob ectives of higher profits. • 'f the ob ectives to be achieved are multiple and are of types which cannot be measured on same scale.ay off 4atri! would depend on the number of strategies which are available and the various states of nature which are identified. it is called “"ay off Table” or “"ay off Matrix”. • (bviously. the same rupees have different measures to different persons. 't is the “utility” which is more relevant measure of achievement of an ob ective rather than the natural unit like a rupee or any other unit of measurement. 31. the total number of cell in a . • 'f there are 5 strategies and there are 6 states of nature.

.. the pay off is :s. 2. 9ikewise.1 %( .88 . 2. Similarly.00 in the pay off the strategy S 0 when the state of nature is 30.k S0 S1 S8 S5 2. • Example • A carpenter is offered 6 tables for :s. which means no table can be sold then the entire investment of :s. 067.... 2.50 2. • . 'f one table is sold for :s. "e thinks that he may be able to sell each table for :s. <7 per table /provided he is able to sell them.01 .11 . 877 and :s.10 .. .08 .80 .8k . 067 this making a profit of :s.8 %) . 877 or = :s. 'f the state of nature to 37.0 %' .7 per table.15 .0k ...00 . 877 is a loss. 'f two tables are sold the pay off is :s. • Solution %he value of pay off matri! can be easily calculated. . 9ikewise if 8. • 'n pay off matri! . 877 = 877 or :s.2..81 . .85 .5 *++ 2. 577 respectively. 877 /:s.5k 2. 067.. 067 = :s. 7.55 2...repare a pay off matri! to depict the decision situation.. or 6 tables are sold the pay off would be :s. %he state of nature can be shown in rows and strategies or actions in columns. S • %here is no rigidity about the rules that state of nature be shown in column and the strategies in rows. %k . 067. .58 2. .05 is the pay off of strategy S0 when the state of nature is 35. 2. :s... 877. the pay off would be :s. .0k will be the pay off strategy S0 when the state of nature is 3k.1k .. 2.18 .05 .51 2. 5. . .State of Nature Strategy %& .

• Some times instead of gain we may measure less or cost and in such cases the table is known as “9oss or ?ost %able”. According to him if we have selected a strategy and we know our pay off. he will earn of profit of :s. 677 and if an alternative strategy under this state of nature would have given him :s. 3ow we should compare this pay off with the ma!imum pay off which we might have got had we selected another in the state of nature which has occurred. then his regret is :s. • “Savage” argues that the decision maker should try to minimi$e this regret.egret of the decision makers. • 'f he sells less than two tables then he suffers also. 9oss or ?ost is a negative gain. @77. "ay #ff Matrix State of Nature Strategy %. • “Savage” has suggested a different measure to assess the consequences of a strategy. 567 only if he can sell 6 tables at :s. the pay off matri! would show 7 in all states the nature. 677 or :s. .'f the decision is not to buy. • %he ma!imum pay off minus the pay off which we have received is the . • 'n pay off table we select a strategy which gives us ma!imum pay off or minimum cost or loss. +877 7 %& +067 7 %' 7 7 %( 067 7 %) 877 7 %567 7 S0 = >uy S1 = #o not >uy • )rom the above table it is clear that if the carpenter takes a decision to buy the tables. 067 each and he will have no profit /if he sells only 1 tables. • )or e!ample. 877. @77 = :s.. if the pay off of a decision maker under the strategy chosen with the state of nature that has occurred is :s.

31 C << and 38 C 077. 30 C <@.egret Table from the above e!ample would be of the following form Sate of %ature Strategy S0 >uy S1 #onAt >uy %. 067B+.repare a pay off table and a loss table. After this he has no regret. 35 or 36. Example • A fruit dealer buys oranges at the rate of :s. .• 't is called minimi$ing the regret or loss of opportunity. • %he regret or the opportunity loss is simply the difference between the pay off reali$ed and the ma!imum pay off which could have been reali$ed if another strategy was chosen. • So he has three strategies or options open to him. %hus. 'f the state of 3ature is 37. (ranges not sold during the day are treated as stale and thrown away. • 'n case he selects strategy 1 /donAt buy. or << do$ens or 077 do$ens. 30. %he daily sale of oranges in the past has not been less than <@ do$ens and not more than 077 do$ens. "e buys. 6 per do$en. S1 C << and S8 C 077 do$ens. . <@ do$ens. he has no regret. 877B+ and in case of 30 it is :s. 877 7 %& 067 7 %' 7 7 %( 7 067 %) 7 877 %7 567 • )rom the above it is clear that if the carpenter decides to buy the tables his ma!imum regret if the State of 3ature is 3 7 is :s. Solution • %he fruit dealer would not buy less than <@ do$ens and not more than 077 do$ens. 8 per do$en and sells them at the rate of :s. As such S0 C <@. or 31. his regret would start when the state of nature would be 38. • .

0<6 . is S0 and state of nature is 30 . 0<.11 C D<< ! 6 = << ! 8E C :s. . is S1 and state of nature is 31 . 0<.81 C D<< ! 6 = 077 ! 8E C :s.11 C pay of strategy.18 C D<< ! 6 = << ! 8E C :s. 0<. 0<. is S0 and state of nature is 38 .88 C D077 ! 6 = 077 ! 8E C :s.00 C D<@ ! 6 = <@ ! 8E C :s..81 C pay of strategy.10 C pay of strategy. is S0 and state of nature is 31 . 177 Strategy S& /012 State of %ature 30 /<@.80 C D<@ ! 6 = 077 ! 8E C :s.18 C pay of strategy.10 C D<@ ! 6 = <@ ! 8E C :s.08 C D<@ ! 6 = <@ ! 8E C :s. S' /002 0<8 S( /&.00 C pay of strategy. is S8 and state of nature is 30 . is S1 and state of nature is 38 .01 C pay of strategy. 0<.2 0<7 . is S1 and state of nature is 30 . . under various strategies with different states of nature will be. is S8 and state of nature is 38 .88 C pay of strategy.01 C D<@ ! 6 = <@ ! 8E C :s. 0<@ .80 C pay of strategy. . is S8 and state of nature is 31 . 0<@ .08 C pay of strategy.. .• %he e!pected pay off /E. 0<7 ..

0<.. of all the classifications. 7 8 .+0<7. 0<@ 0<@ 0<6 177 . /177+0<@.+0<8. /ii2 Decision making under risk • %his type of problem arises when the state of nature is unknown. would occur. and also knows which state of nature /probability. 5 1 7 Decision Types • #ecision problems can be classified in many ways. /i2 Decision making under certainty • 'n certain problems the information available to the decision maker is almost complete so that he knows all the facts about the states of nature /risk. the one which is based on the quantum of information available is considered to be most useful and rational. /177+177. 1 7 8 38 /177+0<. 0<. 31 /0<@+0<. . decision problems can be classified in the following five categories. • 'n such situation the problem of decision making is simple.31 /<<. /0<. (n this basis. 38 /077. but on the basis of ob ective or empirical evidence it is possible to assign probabilities to various states of nature. /0<@+0<6..+0<.. "owever. %he decision maker has to choose the strategy which will give him ma!imum pay off in terms of utility under the state of nature which he knows will occur. /0<@+0<@.egret Table Strategy S& S' S( State of %ature 30 /0<. /0<.

/iv2 Decision making under partial information • %his is a situation some where between the condition of risk and the condition of uncertainty. "owever. • (f course even in such cases some market surveys are conducted and relevant information gathered but generally it is not sufficient to indicate a probability figure for the occurrence of a particular state of nature. • Such situation arises when a new product is introduced in the market or a new plant is set up. /v2 Decision making under conflicts • A condition of conflict is supposed to be e!it when instead of state of nature we are dealing with rational opponent. decision making is said to done on the basis of partial information. there is no such data available. • 'n such cases there is no historical data or no relative frequency which could indicate the probability of occurrence of a particular state of nature. • 'n the case of condition of risk the probability of the occurrence of various states of nature is known on the basis of past e!perience and in condition of uncertainty. 'f is so. /iii2 Decision making under uncertainty • A decision process is said to be under condition of uncertainty when in states of nature are unknown and no ob ective information is available about their probabilities of occurrence. "ere the decision . there might be many situations where thee is partial information available of the data.• 'n such cases the pay off matri! is of great help and an optimal decision can be arrived at by assigning probabilities to various states of nature.

4nder condition of certainty • Fnder the condition of certainty there is a pay off for each strategy. are problems which come under this category.. it is necessary that the selected strategy is one which is most appropriate for achieving the ob ective in mind of the decision maker. • 't is like paying a game of chess. • 4arket place. hence the largest pay off is chosen and the corresponding strategy is selected. then the strategy with the lowest cost is picked up. Choice of a Decision Criteria • 'n order to select a strategy from amongst the many in different types of decision situations. however. • %he choice of strategy in such situationBconditions is done on the basis of game theory 3here a decision maker anticipates the action of his opponent and then determines his o3n strategy. i.e. • 'n this situation each strategy will have as many pay off as the states of nature. %o pick up the correct strategy we will have to transform all possible pay offs of a strategy into a single figure. profit represents the degree of achievement of the ob ective. 4nder condition of risk • Fnder the condition of risk there would be more than one state of nature but the probabilities of their occurrence are known on the basis of their past e!perience.maker has to choice a strategy which takes into account the action and counter action of his opponents. • %he nature of decision criteria would depend on the types of the decision situation. brand competition military weapons etc. %he pay off measured as utility. the measure is the cost. on . • 'f.

the basis of their probabilities of the states of nature and the e!pected pay off. @ 01 %( . real estate and government bonds respectively. 8 %) 6 +1 +0 1 • 't is assumed that an investor conceives of four strategic investment pro ects S0. 5o3ever6 the analyst has devised some decision rules to impart some objectivity to the subjective decisions . • %o illustrate the e!ample let us consider a hypothetical pay off matri! as "ay off Matrix States of %ature Strategy S0. 3 0. under four different states of nature of the economy. 38 . thus the decision taken under uncertainty are necessarily sub ective. equity. 31. 4nder condition of uncertainty • Fnder the condition of uncertainty. S1. • %he strategy which gives ma!imum pay off is selected in such cases. %he following decisions choices reflect the attitude of the decision maker.lant G 4achinery S1 Equity S8Hovernment >onds S5 :eal Estate %& 17 06 0. since we do not know the probability of the occurrence of various states of nature. S8 and S5 /investment in plant and machinery. /i2 7ald8s Maxim in Decision criterion • *aldAs ma!im in decision criterion tells us that the decision makers should specify first the worst possible outcome of each strategy and accept a strategy that gives the best out of the worst outcomes. 5 . 6 %' 01 0. the problem becomes more comple! and the personality of the decision maker plays an important role in the selection of the strategy.

low growth. it implies a pessimistic approach to investment decision making.egret Criteria • 4inima! regret criterion is another decision rule under uncertainty. 9t gives a conservative decision rule for risk avoidance. /ii2 Maximax Criteria • According to this criterion. %he best or the highest outcome of the worst outcome is 6 of strategy. . • %he ma!imin column presents the worst outcome of each strategy. "e always thinks that the states of nature would be favourable to him and his eyes are on the ma!imum possible pay off of all the strategies. the decision maker needs to find out the worst /minimum. %his can be done by reading the pay off table row wise. • Hoing by the ma!imin criterion. if the decision maker is an optimist by nature he would always think that the state of nature would be the best from his point of view. • 'f the ma!imin rules are closely looked. • %o apply ma!imin criterion. the decision maker would accept strategy S0. /iii2 Minimax . • %his criteria suggests that the decision maker should select a strategy that minimi$e the maximum regret of a wrong decision. stagnation and recession respectively..and 35 /high growth. • "e would find out the e!pected pay off of all the strategies and will pick up the strategy which gives the ma!imum pay off out of ma!imum pay offs of all the strategies. outcome of each strategy.

'n the ne!t strategy S1.777B+. 1. @. >ut.Example • Suppose an investor has three strategies for investment. S0. @ . he gets the ma!imum possible return. find the ma!imum pay off and subtract it from the pay off of all strategies. 5.egret 7 6 5 06 • )or e!ample.. the pay off is 06 and the regret is equal to 6. if he opts for S 1.777B+ respectively. +0 6 01 8 1 . the regret is $ero. )rom the regret .777B+ + :s. Strategy S0 S1 S8 S5 States of %ature %& %' %( %) 17 01 .777B+ C :s. under column 30. S1 and S8. the investor should opt for strategy S1 because it minimi$e the regrets.777B+ C :s. his regret equals :s. 9ikewise if he opts for S8.. by way of incorrect decision. 't means that if S 0 is chosen under the states of nature 30.777B+ = :s. giving returns of :s. 6 06 07 5 +1 0.. %his process gives the pay off column. then his regret on opportunity cost would be :s.777B+.egret Matrix %& %' %( %) 7 7 7 7 6 1 1 8 5 5 7 5 06 7 8 8 Max:Min .777B+ :s. we can construct the regret table. 07. strategy S0 has the ma!imum pay off /17. 07. • >y repeating this process for all strategies and all the states of nature we get regret matri!. 'f the investor opts for strategy S0. • Hoing by the minima! regret criterion. he has no regret. Select a column /the state of nature. 07. • Suppose we have the following pay off table. . %he method is simple. . @.777B+ and :s..

• According to the “>ayesian rule”. Example • A news paper vender buys a newly started local paper for 6 n. 0. strategy S5 strategy should be selected for investment. • %he regret table shows that the ma!imum regret is minimum /06. • >y assuming e ual probability for all events. the 9aplace criterion is also called I>ayesian criterionA. where meaningful estimate of probabilities is not available. and sells it at the rate of 07 n. 0@.. /iv2 . . "ow many papers should he buy. %he vendor knows that he cannot sell more than 17 papers in a day and the minimum sale would not be less than 05. %he unfold paper do not have any value.matri! we can find Ima!imin regretA by listing the ma!imum regret for each strategy.p. 0J.p. Solution • %he strategies open to the newspaper vender are to buy 05. the environment of “uncertainty” is converted into an environment of risk • %his decision rule avoids the problem that arises due to sub ectivity in assuming a probability of pay off.aplace Decision criterion • %he laplace criterion was >ayesian rule to calculate the Iexpected valueA of each strategy. in case of strategy S5. the outcome of each strategy under each state of nature must be assigned the same probability and the sum of probabilities of out come of each strategy must add up to one. 06. )or this reason. 0< or 17 papers. %herefore.

6 .7 66 67 30.7 30J J7 J6 @7 @6 @7 J6 J7 30@ J7 J6 @7 @6 <7 @6 @7 30< J7 J6 @7 @6 <7 <6 <7 317 J7 J6 @7 @6 <7 <6 077 Note > 9n this problem no probability values are assigned to various states of nature6 hence it is a situation of uncertainty+ • 'n a situation of uncertainty.p. if he is pessimistic he would follow the criteria Maximin. . • )or this we would have to prepare a regret table. the profit of other class can be calculated. 0J.rofit of vendor wills as follows if he buys only 05 profit 6 n. • 9ikewise.S&< S&= S&1 S&0 S'. • )or instance. %he states of nature would be 05. the decision makers personality would be reflected in the decision he takes. 06. 'f he is an optimistic he would follow the criteria ma!ima!. J7 J6 @7 J6 J7 .p. • 'f he sells 06 papers he earn a profit of J6 n.6 . • .7 66 67 56 57 306 J7 J6 J7 . 0< or 17. 0@. Strategy S&) S&.6 .• %he states of nature are the number of newspaper he can sell.. • "e may also think in terms of minimi$ing the ma!imin regret or try to estimate the opportunity loss. 0. on each paper J7 n.p. States of %ature 305 J7 .

is @7.egret Table Strategy States of %ature 305 306 30. 87 16 17 06 07 6 7 • 3ow if the state of nature is 305 and S05 the regret would be 7 as he loses nothing but if the strategy is S05 and state of nature is 306 his regret would be 6. • 9ikewise with S05 and 30. %he highest ma!imum pay off is 077.0. . because the ma!imum pay off with 306 to J6 and he would reali$e only J7. )or studying this it is necessary to construct or prepare a regret table. 4a!ima! #ecision - 8. "e will buy 17 papers as it ma!imi$es the pay off. 4inimi$ing ?riterion the 4a!imum :egret - >uy 05 papers. 4a!imin #ecision - 1. 'n all the other strategies the ma!imum regret is more than 06. 4nder Minimax Criteria • "e will buy 0J news paper. %he ma!imum regret with S0J C 06. "e will ma!imi$e the minimum pay off. . his regret would be 07 as the ma!imum pay off under 30. >uy 17 papers. %here he is minimi$ing the ma!imum regret. %he largest minimum pay off is J7. 30J 30@ 30< 317 S&) 7 6 07 06 17 16 87 S&6 7 6 07 06 17 16 S&< 07 6 7 6 07 06 17 S&= 06 07 6 7 6 07 06 S&1 17 06 07 6 7 6 07 S&0 16 17 06 07 6 7 6 S'. so he will buy 05 papers.

.17 07.5 7 0. 7 06.77 *ith the above information the decision maker is in a better position to take a rational decision.7 @ 77.@ S&0 78.@ 7 7<.• All the above decision have been taken under conditions of uncertainty.05 7. 30J 30@ 30< " 77. %he e!pected pay off table would be. 7 01.17 00.01 7.0 7 08.7 7 07.1 7 77.11 7.7 7 00.1 7 0.7 7 00.@7 00.< 7 07.7 7 08.1 7 00..1 7 7<.5 S&76.07 0.1 S&1 75. State of %ature 305 306 30. 78.1 7 05..7@ 7.@ 7 7@.@7 .77 01.17 7.0 S&) 76.8 7 06.05 7.6 7 7<.< 7 00. • 'f the decision maker on the basis of past e!perience could assign some probabilities to the various states of nature.. "ay off Table Strategy States of %ature 305 306 30.6 7 07.0 5 77.0 5 77.0 5 05.6 7 06.6 S&< 75.7 @ 06.7 7 07..77 7<.1 1 77.5 7 05.7 7 00. 30J 30@ 30< 317 "robabilities 7.7 7 7<. %he decision maker did not have any probability values for various states of nature..< 7 00.5 S'.1 7 01. 7 07. S&= 75.6 7 00.

1 7 71. 71.77 0.77 (n the basis of the above e!pected pay off table.7 7 7<.7 7 7 7J. As such he should buy either 0.6 7 7<.J 7 70..@ 7 71.7 7 75.17 is associated with two strategies S 0.J 7 77.7 7 S&77.egret Table Strategy States of %ature 305 306 30.8 7 71. and S0J.1 7 7 7@.0 7 77.5 7 71.@ 7 78..7 7 71.7 7 S&) 77. .67 75.7 7 J.6 7 J5. 7 70.. or 0J papers. %herefore.1 7 7 7@. 'f the decision is to be taken on the basis of regret table.0 7 71.7 7 05.317 1 77.@.07 70.7 @ 77.1 7 77.57 77.5 7 78.7 7 77.0 5 77.7 7 70.J 7 77.7 7 70.0 5 77..77 71.6 7 J1. the result would also be the same.7 7 78.7 77.7 7 7 7J.7 7 J7.@ 7 S&< 77.1 7 70.1 7 70. .1 7 7 7<.6 7 J.J 7 70.0 7 70. the vendor should buy either 0.0 7 70.7 7 J5.0 7 71.0 7 77.7 7 70.5 7 71.57 76.7 7 07.1 1 77.0 7 71. 7 78.5 7 77. or 0J papers..77 • )rom the above table it is clear that the minimum regret of J.@ is associated with S0.7 7 7J.6 7 7J.7 7 S'. and S0J.77 .@ 7 7 7<.aplace Decision .5 7 77.5 7 70.@ 7 S&= 70.1 7 S&0 71. 30J 30@ 30< 317 " 77.7 7 77..7 7 77.0 1 77.@ 7 70.7 7 70.7 7 77.6 7 01. the highest e!pected pay off of J..@ 7 S&1 70.7 7 77.

J 0 07. hence the probability of each state of nature would be 0BJ.J 0 01.@ 6 J6.7 7 07.@ 6 7<.1 @ 07.5 1 00.J0 7J.6 J 07.@6 05.1 < 07.0 5 01.5 1 00.@ 6 7<.0 5 7@.J 0 J8.J 0 07.• 'n 9aplace decision theory. Decision:Tree Method • 4nder the conditions of risk6 the decision makers often confront a situation is which they visuali$e several option available to them each leading to different states of nature.7 7 00.7 7 07.5 1 J6.0 5 01..6 J 07.@ 6 01.0 5 J. the decision maker /in the absence of any past experience2 3ould assign e ual probabilities to all states of nature.7 7 00.5 1 00.5 1 7J.<. J S&= 7J.6 J 08.7 7 07.. 30J 30@ 30< 317 " 0BJ 0BJ 0BJ 0BJ 0BJ 0BJ 0BJ S&) 07.7 7 S&7<.7 7 J7.5 7 S&1 7J.51 01.J 0 07.J 0 07. %he pay off matri! would there be as follows.7 7 07.1@ .6 5 S'.aplace "ay #ff Table Strategy States of %ature 305 306 30.. @ S&0 7.@6 05.57 which is associated with S0J.6 J J8.J 0 07.<J • According to the 9aplace pay off matri! the ma!imum pay off is J. .5 1 01..5 1 00.0 5 01. • %he e!pected pay off under laplace decision would be obtained by multiplying each pay off with 0BJ.@ 6 01.1 @ 07.7 7 07.7 7 07.05 07..J 0 01.77 00.0 5 08. • Since in this case there are J states of nature.6 6 S&< 7@. 76.

• ?irst. %hey are not supposed to leave the matter undecided. • %he decision+tree presents the entire decision options and possible outcomes in the form of a diagram and thereby guides the decision meters to a rational decision. the decision makers know for sure that all the decisions will yield a positive outcome. • Since all possible strategic decisions and their possible outcomes are arranged graphically in the form of branches of a tree. %hey might be knowing that a particular decision will yield a higher return than another but they do not know for sure high or low the outcome will be. but they cannot tell in advance the exact outcome of a decision. • %he method that is used to find an acceptable solution under these conditions is called a Tree:Decision. • A tree+decision is a graphical device to map all possible managerial decisions in a sequence and their e!pected outcomes under different states of economy. the technique is called “decision:tree”. • %he question that decision+makers face under these conditions is how to find the most profitable or gainful solution. from the alternative investment avenues to them. Decision Tree for 9nvestment Decision . • Second. the decision makers are required to make a choice /or series of choices.• %here are two specific problems in this kind of decision making.

677 crore and . . %he decision maker has to make a strategic choice between the two pro ects A and >. • %he investor has the information about the e!pected cash flows under the different states of economy and the demand prospects.• Suppose an investor visuali$es two viable pro ects A and >. and the low growth has a lower probability of 7. medium or low. %he pro ect A costs :s.5. whether the economy has a high or a low growth. shows that the probabilities of the Istates of economyA.. • ?olumn /1. %he economy may grow at a higher or at a low growth rate. of the two pro ects depend upon the states of the economy. #emand may be high.e. • %he decision shows that the process of decision+making begins at Idecision+pointA. %he high growth has a probability of say 7. depending on the market conditions and consumerAs perception and preference. 57 crore.ro ect > cost :s. • %he probable growth rates of the economy determine the demand prospects for the product of each pro ect. i. %he prospective yield /cash flow.

a rational investor would decide to invest in pro ect A and not in . medium and low = under both high and low growth of the economy. .Less Project Cost : Rs.ro ect >. 500 Crore Net expected Value = Rs. #"0 Crore . "0 Crore • According to this calculation. gives the e!pected value of the two pro ects under all the stipulated conditions. the prospect for the product demand again has three probabilities = high. otal Expected Value : Rs.Less Project Cost : Rs.5. 9nvestment decision %he investor can easily find out the net e!pected value of each pro ect and decide in favour of the pro ect having a higher net e!pected value. /. 3ow when the present value of cash flow is multiplied by the corresponding probability in col. %herefore. medium and low = under high growth add up to 7. %hey have two courses of action for selling their product in the market /a. %he investor has now the full information for decision making.... #irect selling. • 9et us now suppose that the investor has the information on the present value of cash flow under each probability as presented in col. the net e!pected value of pro ect A is higher than the pro ect >. 580 Crore Project ! : . :egional distribution through distributors and /b. and in case of low growth they add up to 7. • ?ol.• Fnder both these growth probabilities. • 't should also be noted that the probability distribution in respect of demand prospects = high. /5. #00 Crore Project $ : Net expected Value = Rs. 80 Crore otal Expected Value : Rs.. it gives the Ie!pected valueA of the present value of cash flows. /6. Example • %he ?oca+?ola associates deals with instant soft drink.

e.%he prior probabilities of high penetration and low penetration of regional distribution channel are 7. 07 lakh respectively. 67 lakh and :s. %he prior probabilities of high penetration and low penetration of direct selling channel are 7.J and 7. 07 lakh respectively. %he pay off of high and low penetration of regional distribution channel are :s.. strategy. Solution • %he total e!pected monetary value by regional distribution • 7. 87 lakh and :s. 67 lakh and :s. #raw the decision tree and determine the best selling channel i.8 respectively. %he pay off of high and low penetration of regional distribution channel are :s.5 respectively.87 K 07 C :s. %he pay off of high and low penetration of direct selling channel are :s. 6 lakh respectively. 8@ lakh • %he e!pected monetary value by direct selling .J K 67 L 7. and 7.

Decision Tree Method . K 87 L 7.e. regional distribution in more than direct selling he is should opt for regional distribution. 17 9akh • Since the e!pected monetary value is more i.5 K 6 C :s.• 7. • %heories under conditions of risk and uncertainty e!ist because thee are limitations in the relative frequency approach on the basis of which probabilities are assigned to various states of nature and also because the e!pected pay off matri! does not always provide infallible information for a decision situation.imitation of Distribution Theory • %he decision theories associated with conditions of risk and conditions of uncertainty have many limitations.. .

Squares represent decisions. and write that solution along the line. Starting from the new decision squares on your diagram. 'f you have completed the solution at the end of the line. An e!ample of the sort of thing you will end up with is shown in )igure 0- . 'f the result of taking that decision is uncertain. 'f the result is another decision that you need to make. consider the results. *rite the decision or factor above the square or circle. )rom this bo! draw out lines towards the right for each possible solution. Neep the lines apart as far as possible so that you can e!pand your thoughts. and circles represent uncertain outcomes. )rom the circles draw lines representing possible outcomes. ust leave it blank. draw out lines representing the options that you could select. At the end of each line. Again make a brief note on the line saying what it means. Neep on doing this until you have drawn out as many of the possible outcomes and decisions as you can see leading on from the original decisions. #raw a small square to represent this towards the left of a large piece of paper.Dra3ing a Decision Tree Mou start a #ecision %ree with a decision that you need to make. draw another square. draw a small circle.

redraft your tree if parts of it are too congested or untidy. draw them in. %his is where you can work out which option has the greatest worth to you. Mou should now have a good understanding of the range of possible outcomes of your decisions. ?hallenge each square and circle to see if there are any solutions or outcomes you have not considered. Start by assigning a cash value or score to . Evaluating @our Decision Tree 3ow you are ready to evaluate the decision tree. review your tree diagram.(nce you have done this. 'f there are. 'f necessary.

Estimate how much you think it would be worth to you if that outcome came about. 3e!t look at each circle /representing an uncertainty point. these must add up to 0. the total must come to 077O at each circle. 'f you use percentages. 'f you have data on past events you may be able to make rigorous estimates of the probabilities. %his will give you a tree like the one shown in )igure 1- . (therwise write down your best guess. 'f you use fractions. and estimate the probability of each outcome.each possible outcome.

thorough developmentP is7. %he total for that node of the tree is the total of these values. and work back towards the left.. C 7. Start on the right hand side of the decision tree. do this by multiplying the value of the outcomes by their probability. As you complete a set of calculations on a node /decision square or uncertainty circle.5 /probability moderate outcome. all you need to do is to record the result.Calculating Tree !alues (nce you have worked out the value of the outcomes.. it is time to start calculating the values that will help you make your decision.777.777 Q17.5 /probability good outcome.. and have assessed the probability of the outcomes of uncertainty. ! Q1.1 /probability poor outcome. ! Q0. Calculating the !alue of 4ncertain #utcome %odes *here you are calculating the value of uncertain outcomes /circles on the diagram. C L Q577.777 Q577 A)'.777 /value. 'n the e!ample in )igure 1.777 /value.777 /value. the value for Pnew product. C 7. )igure 8 shows the calculation of uncertain outcome nodes- .6). Mou can ignore all the calculations that lead to that result from then on. ! Q67.

write down the cost of each option along each decision line. %his will give you a value that represents the benefit of that decision. 3ote that amounts already spent do not count for this analysis = these are Psunk costsP and /despite emotional . %hen subtract the cost from the outcome value that you have already calculated. Calculating the !alue of Decision %odes *hen you are evaluating a decision node.3ote that the values calculated for each node are shown in the bo!es.

*e . choose the option that has the largest benefit. *hen you have calculated these decision benefits. and take that as the decision made. )igure 5 shows this calculation of decision nodes in our e!ample- 'n this e!ample. should not be factored into the decision. %his is the value of that decision node. the benefit we previously calculated for Pnew product.counter+arguments.577. thorough developmentP was Q517.

777. %his gives a net benefit of Q1J7. Pnew product.esult >y applying this technique we can see that the best option is to develop a new product. rapid developmentP was Q80. . 't is worth much more to us to take our time and get the product right. . %he net benefit of Pnew product.577. decision tree analysis should be used in con unction with common sense = decision trees are ust one important part of your #ecision 4aking tool kit. (n this branch we therefore choose the most valuable option. and allocate this value to the decision node. thorough developmentP.577. Allow us to analy$e fully the possible consequences of a decision. even though it costs us less.rovide a framework to quantify the values of outcomes and the probabilities of achieving them. "elp us to make the best decisions on the basis of e!isting information and best guesses. 't is better ust to improve our e!isting products than to botch a new product. Bey "oints> #ecision trees provide an effective method of #ecision 4aking because they• • • • ?learly lay out the problem so that all options can be challenged.estimate the future cost of this approach as Q067. than to rush the product to market. As with all #ecision 4aking methods. .