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International Institute of Project Management

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Chapter 4 - Fundamentals of Decision Theory Models


THE SIX STEPS IN DECISION

THEORY

Whether you are deciding about getting a haircut today, building a multimillion-dollar plant, or buying a
new camera, the steps in making a good decision are basically the same:
Six Steps of Decision Making
1.
2.
3.
4.
5.
6.

Clearly define the problem at hand.


List the possible alternatives.
Identify the possible outcomes or states of nature.
List the payoff or profit of each combination of alternatives and
Select one of the mathematical decision theory models.
Apply the model and make your decision.

outcomes.

We use the Thompson Lumber Company case as an example to illustrate these decision theory steps.
John Thompson is the founder and president of Thompson Lumber Company, a profitable firm located in
Portland, Oregon.
Step1:
The problem that John Thompson identifies is weather to expand his product line by manufacturing and
marketing a new product, backyard storage sheds.
Step2:
Thompsons second step is to generate the alternatives that are available to him. In decision theory, an
alternative is defined as a course of action or a strategy that the decision maker can choose. John decides
that his alternatives are to construct (1) a large new plant to manufacture the storage sheds, (2) a small
plant, or (3) no plant at all (i.e., he has the option of not developing the new product line). One of the
biggest mistakes that decision makers make is to leave out some important alternatives. Although a
particular alternative may seem to be inappropriate or of little value, it might turn out to be the best
choice.
Step3:
The third step involves identifying the possible outcomes of the various alternatives. The criteria for
action are established at this time. Thompson determines that there are only two possible outcomes: the
maker for the storage sheds could be favorable, meaning that there is a high demand for the product, or
it could be unfavorable, meaning that there is a low demand for the sheds.
A common mistake is to forget about some of the possible outcomes. Optimistic decision makers tend to
ignore bad outcomes, whereas pessimistic managers may discount a favorable outcome. If you dont
consider all possibilities, you will not be making a logical decision, and the results may be undesirable. If u
do not think the worst can happen, you may design another Edsel automobile. In decision theory, those
outcomes over which the decision maker has little or no control are called states on nature.
Step 4:
Thompsons next step is to express the payoff resulting from each possible combination of alternatives
and outcomes. Because in this case he wants to maximize his profits, he can use profit to evaluate each
consequence. Not every decision, of course, can be based on money alone-any appropriate means of
measuring benefit is acceptable. In decision theory, we call such payoffs or profits conditional values.
John Thompson has already evaluated the potential profits associated with the various outcomes. With a
favorable market, he thinks a large facility would result in a net profit of $200,000 to his firm. This
$200,000 is a conditional value because Thompsons receiving the money is conditional upon both his
building a large factory and having a good market. The conditional value if the market is unfavorable
would be a $180,000 net loss. A small plant would result in a net profit of $100,000 in a favorable
market, but a net loss of $20,000 would occur if the market was unfavorable. Finally, doing nothing would
result in $0 profit in either market.
The easiest way to present these values is by constructing a decision table, sometimes called a payoff
table. A decision table for Thompsons conditional values is shown in Table 4.1. All of the alternatives are
listed down the left side of the table, and all of the possible outcomes or states of nature are listed across
the top. The body of the table contains the actual payoffs.
Steps 5 and 6:
The last two steps are to select a decision theory model and apply it to the data to help make the
decision. Selecting the model depends on the environment in which youre operating and the amount of
risk and uncertainty involved.

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TABLE 4.1 Decision Table with Conditional Values for Thompson

Lumber

TYPES OF DECISION-MAKING ENVIRONMENTS


The types of decisions people make depend on how much knowledge or information they have about the
situation. There are three decision-making environments.
Decision making under certainty
Decision making under risk
Decision making under uncertainty Type
1: Decision Making under Certainty
In the environment of decision making under certainty, decision makers know with certainty the
consequence of every alternative or decision choice. Naturally, they will choose the alternative that will
maximize their well being or will result in the best outcome. For example, lets say that you have $1,000
to invest for a one-year period. One alternative is to open a savings account paying 6% interest and
another is to invest in a government Treasury bond paying 10% interest. If both investments are secure
and guaranteed, there is a certainty that the Treasury bond will pay a higher return. The return after one
year will be $100 in interest.
Type 2: Decision Making under Risk
In decision making under risk, there are several possible outcomes for each alternative, and the decision
maker knows the probability of occurrence of each outcome. We know, for example, that the probability of
being dealt a club is 0.25. The probability of rolling a 5 on a die is 1/6. In decision making under risk, the
decision maker usually attempts to maximize his or her expected well-being. Decision theory models for
business problems in this environment typically employ two equivalent criteria: maximization of expected
monetary value and minimization of expected loss.
Type 3: Decision Making under Uncertainty
In decision making under uncertainty, there are several possible outcomes for each alternative, and the
decision maker does not know the probabilities of the various outcomes. As an example, the probability
that a Democrat will be president of the United States 25 years from now is not known. Sometimes it is
impossible to assess the probability of success of a new undertaking or product.
Lets see how decision making under certainty (the type 1 environment) could affect John Thompson.
Here we assume that John knows exactly what will happen in the future. If it turns out that he knows with
certainty that the market for storage sheds will be favorable, what should he do? Look again at Thompson
Lumbers conditional values in Table 4.1. Because the market is favorable, he should build the large plant,
which has the highest profit, $200,000.
Few managers would be fortunate enough to have complete information and knowledge about the states
of nature under consideration.
DECISION MAKING UNDER RISK
Decision making under risk is a probabilistic decision situation. Several possible states of nature may
occur, each with a given probability. In this section we consider one of the most popular methods of
making decisions under risk: selecting the alternative with the highest expected monetary value. We also
look at the concepts of perfect information and opportunity loss.
Expected Monetary Value
Given a decision table with conditional values (payoffs) that are monetary values, and probability
assessments for all states of nature, it is possible to determine the expected monetary value (EMV) for
each alternative. The expected value, or the mean value, is the long-run average value that would result
if the decision were repeated a large number of times. The EMV for an alternative is just the sum of
possible payoffs of the alternative, each weighted by the probability of that payoff occurring.
EMV (alternative) = (payoff of first state of nature)
(probability of first state of nature)
+ (payoff of second state of nature)

(probability of second state of nature)


+ + (payoff of last state of nature)
(probability of last state of nature)
The alternative with the maximum EMV is then

chosen.

Suppose that John Thompson now believes that the probability of a favorable market is exactly the same
as the probability of an unfavorable market; that is, each state of nature has a 0.50 probability. Which
alternative would give the greatest expected monetary value?
TABLE 4.2 Decision Table with Probabilities and EMVs for Thompson

Lumber

To determine this, John has expanded the decision table, as shown in Table 4.2. His calculations follow:
EMV (large plant) = (0.50)($200,000) + (0.50)(-$180,000) =
$10,000
EMV (small plant) = (0.50)($100,000) + (0.50)(-$20,000) = $40,000
EMV (do nothing) = (0.50)($0) + (0.50)($0) = $0
The largest expected value results from the second alternative, construct a small plant. Thus,
Thompson should proceed with the project and put up a small plant to manufacture storage sheds. The
EMVs for the large plant and for doing nothing are $10,000 and $0, respectively.
DECISION MAKING UNDER UNCERTAINTY
When the probability of occurrence of each state of nature can be assessed, the EMV or EOL decision
criteria are usually appropriate. When a manager cannot assess the outcome probability with confidence
or when virtually no probability data are available, other decision criteria are required. This type of
problem has been referred to as decision making under uncertainty. The criteria that we cover in this
section are as follows:
1.
2.
3.
4.
5.

Maximax
Maximin
Criterion of realism
Equally likely
Minimax regret

The first four criteria can be computed directly from the decision (payoff) table, whereas the Minimax
regret criterion requires use of the opportunity loss table. Lets take a look at each of the five models and
apply them to Thompson Lumber. It is now assumed that no probability information about the two
outcomes is available to Thompson.
Maximax
The Maximax criterion finds the alternative that maximizes the maximum payoff or consequence for
every alternative. You first locate the maximum payoff within every alternative, and then pick that
alternative with the maximum number. Since this decision criterion locates the alternative with the
highest possible gain, it has been called an optimistic decision criterion. In Table 4.3 we see than Thompsons
Maximax choice is the first alternative, construct a large plant.
TABLE 4.3 Thompsons Maximax Decision

TABLE 4.4 Thompsons Maximin Decision

This is the alternative associated with the maximum of the maximum number within each row or
alternative. By using this criterion, the highest of all possible payoffs may be achieved.
Maximin
The Maximin criterion finds the alternative that maximizes the minimum payoff or consequence for
every alternative. You first locate the minimum outcome within every alternative and then pick that
alternative with the maximum number. Since this decision criterion locates the alternative that has the
least possible loss, it has been called a pessimistic decision criterion. This criterion guarantees the payoff
will be at least the Maximin value.
Thompsons Maximin choice, do nothing, is shown in Table 4.4. This is the maximum of the minimum
number within each row or alternative.
The balance three situations (Criterion of realism, Equally likely, Minimax regret) of uncertainty in which
decision have to be made are very rare and seldom used.