149 views

Original Title: Quantative Analysis Chapter 4- Fundamentals of Decision Theory Models

Uploaded by Maulana Fuerra Firdaus

- Business-Plan-For-Rivory Restaurant
- Decision Theory
- Case Study for Location Planning
- Ch 14 Game Theory
- Evidence Record 232
- TREX-04161
- ODI the Data Ethics Canvas User Guide 2017-09-13
- Gui_Notes
- Success Opener
- The Silver Report
- yahudi
- Decision Theory
- 03 Disk
- A Best Practice Reference Model for Asset Lifetime Extension
- Minimax
- How Risky is Your Company
- Social Effectiveness of TLL
- Lecture 3 - Decision Analysis
- Bid or No Bid Assessment
- Chief Risk Officer Job Description

You are on page 1of 4

http://www.iipmchennai.org/shop/db/docs/dloadables/studymat/qmpm/ch...

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.

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.

1 of

4/27/2009 7:38 AM

Lumber

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)

+ + (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

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.

- Business-Plan-For-Rivory RestaurantUploaded byAshmita Mondal
- Decision TheoryUploaded bymariana
- Case Study for Location PlanningUploaded byashishsonileo
- Ch 14 Game TheoryUploaded byOky Tresia
- Evidence Record 232Uploaded byadriana
- TREX-04161Uploaded byOSDocs2012
- ODI the Data Ethics Canvas User Guide 2017-09-13Uploaded byOpen Data Institute
- Gui_NotesUploaded byChristine Gee
- Success OpenerUploaded byparker4
- The Silver ReportUploaded byRitesh Gane
- yahudiUploaded byAzim Sengal
- Decision TheoryUploaded byPratishtha94
- 03 DiskUploaded bymohdsolahuddin
- A Best Practice Reference Model for Asset Lifetime ExtensionUploaded byHugoCabanillas
- MinimaxUploaded byCaioGomes
- How Risky is Your CompanyUploaded byRd Indra Adika
- Social Effectiveness of TLLUploaded byCRADALL
- Lecture 3 - Decision AnalysisUploaded byqwerzhai
- Bid or No Bid AssessmentUploaded by03TALK
- Chief Risk Officer Job DescriptionUploaded byabbey
- 9026 Iaccm Template Contract Contingency Plan Development v10 120916Uploaded byRickesh Nunkoo
- Alpha-Beta Pruning ExampleUploaded byVan Vui Ve
- R&D ProposalUploaded byArafatRasel
- 2bpresentation-rvandongenroom2pptUploaded byRoberto Sava
- Group 13 Module 13Uploaded byaaidanrathi
- Roles and Responsibilities BSAsUploaded byislamelshahat
- Decision Trees for Decision Making.pdfUploaded byRakesh V
- strategy_part_3.docUploaded bySubramanya Seshagiri
- decision-making-改Uploaded byYao Gu
- omega design package 1 docx 1 1Uploaded byapi-371980639

- Material Safety Data SheetUploaded byMaulana Fuerra Firdaus
- TabelDistribusiBinomialUploaded byarieljuwo
- Stat is TikaUploaded byMaulana Fuerra Firdaus
- cvUploaded byMaulana Fuerra Firdaus
- 03SulphuricMSDSRev201109Uploaded byMaulana Fuerra Firdaus
- I Openly Hate 2007Uploaded byMaulana Fuerra Firdaus
- Ghost RiderUploaded byMaulana Fuerra Firdaus
- Book1Uploaded byMaulana Fuerra Firdaus
- Paramore DecodeUploaded byMaulana Fuerra Firdaus
- b.inggrisUploaded byMaulana Fuerra Firdaus
- msds etanolUploaded byMerry Paembonan

- ACCT10 Chapter 4 SolutionsUploaded byOmerGull
- Financial Aspect REVISED GdxwdadUploaded byMay Anne Barlis
- Working Capital Management (Ashok Leyland 2010-11) (Further Information contact jeetesh.s@itm.edu)Uploaded byJeetesh Kumar
- Fin 301sdUploaded byImran Khan
- Full & Final Report Fin 435Uploaded byNumayer Ahmed Chaudhuri
- Integration_&_Trade_Journal_N°_35 BIDUploaded byfergandez
- Jack Lustman and Ida Lustman v. Commissioner of Internal Revenue, 322 F.2d 253, 3rd Cir. (1963)Uploaded byScribd Government Docs
- Curriculum+Vitae+ Alphonse 3Uploaded byPal D' Collo
- Smart TechniquesUploaded byManoj Solankar
- PNOC v CAUploaded bymisterdodi
- Corporation Law Notes Under Atty Ladia RevisedUploaded byCarlo Alexis D. Tabangcura
- Short Prob and Theory Short Quiz MA FS AnalUploaded byAliza Grace Diopido
- TaxationUploaded byAU Sharma
- Marketing (Chapter 10) - KotlerUploaded byMarcus Thong
- Refund (28)Uploaded bys4sahith
- Valuatioin of Arvind Limited by FCF methodUploaded byMayank Shah
- 502 - 2Uploaded byRakibul Islam
- Objection Hearing on Property Assessment Rate Charges in MalaysiaUploaded byAlexander Decker
- 1 Einstein College of EngineeringUploaded byShashi Kumar
- ContentUploaded byArahpOt Asuero
- OSV Financial Statement Analysis-V2.0.0Uploaded byOld School Value
- Agricultural Policy AnalysisUploaded bystriider
- China Forging Pressing Stamping Roll Forming of Metal Industry Profile Isic2891Uploaded byAllChinaReports.com
- Jyoti Structures Ltd - Q2FY12 Results UpdateUploaded byAluha Melvani
- amazon financial statement analysis pt 2 paperUploaded byapi-239699796
- Sivakumar @ UBS CLE 11 Sep 2008Uploaded bySivakumar Surampudi
- General Motors CaseUploaded byhassanalimehdi
- Dont Ask Dont Get Full SessionUploaded bySamuel Kagoru Gichuru
- merged 1Uploaded byapi-317193133
- 1 William Henry Scott - Prehispanic Filipino Concepts of Land Rights.pdfUploaded byRamon Guillermo