DECISION MAKING

Definition

A process which results in the selection from a set of alternative courses of action which is
considered to meet the objectives of the decision problem more satisfactorily then others as
judged by the decision maker

A process of logical and quantitative analysis of all factors that influences the decision problem,
assists the decision-maker in analyzing these problems with several courses of action and
consequences

Applications of Decision Theory

1. Select the best from among several job offers

2. Select the most profitable investment portfolio
3. Select the best way to build a modern electronic component
4. Determine the number of personal computers (PCs) to order for an office supply store
5. Determine whether or not to expand a medical or manufacturing facility
6. Determine if a large plant, small plant, or no plant should be built
7. Decide if it is worthwhile to hire marketing research team to gather additional data
8. Determine whether to lease, subcontract or manufacture or select a quality control plan
9. Decide whether to invest in a new plant, equipment, research programmes, marketing
facilities…
10. Decide about the area of design and development of new and improved products and
equipment from invention to commercialization stage

Steps in decision theory

An analytic, scientific and systematic approach to decision-making consists of the following

steps

1. Clearly identify and define the problem at hand

 2. Specify objectives and the decision criteria
3. Identify and evaluate the possible alternatives
4. Formulate (or select) one of the mathematical decision theory models
5. Apply the model and select the best alternative
6. Conduct a sensitivity analysis of the solution
7. Communication and implementation of decision
8. Follow up and feedback of results of decision

Structure of decision making problem

Main concepts associated with decision theory approach to problem solving

1. The decision maker-refers to individual or a group of individuals responsible for making

the choice of an appropriate course of action amongst the available courses of action
2. Courses of action-the alternative courses of action or strategies, are the acts that are
available to decision maker. The decision analysis involves a selection among two or
more alternative courses of action and the problem is to choose the best of these
alternatives, in order to achieve an objective. An example of an or state of nature is the
number of units of a particular item to be ordered for stock
3. State of nature-the events identify the occurrences which are outside of the decision
maker’s control and which determine the level of success for a given act. These events
are often called state of nature or outcomes. (the decision maker has no control over
which event will take place and can only attach a subjective probability or degree of
belief of occurrences of each) an example of an event or state of nature is the level of
market demand for a particular item during aa stipulated time period
4. Payoff- each combination of a course of action and a state of nature is associated with a
payoff, which measures the net benefit to the decision maker that accrues from a given
combination of decision alternatives and events
5. Payoff Table- for a given problem, payoff table lists the states of nature (outcomes or
events) which are mutually exclusive as well as collectively exhaustive and a set of a
given courses of action (strategies). For each combination of state of nature and course of
action, the payoff is calculated
A profit table (payoff table) is useful for scenario where there is a range of possible outcomes
and a variety of possible responses.

A payoff table simply illustrates all possible profits/losses.

Illustration

Mr. Luck runs a small shop with milk products.

He buys his products for $10 and sell them for $15.

The product is not possible to store, any unsold item is scrapped at the end of day at scrap value
of $2 per product.

Supplies of product to the shop is made before the number of sales is known, however Mr. Luck
has records about last 150 days sales.

Based on the records the sales were:

50 days of 150 days - 150 products sold
70 days of 150 days - 200 products sold
30 days of 150 days - 100 products sold

1. STEP 1: Calculate probabilities of outcomes:

150 products will be sold with probability of 50 days/150 days, which is 0.33
200 products will be sold with probability of 70 days/150 days, which is 0.47
100 products will be sold with probability of 30/150 days, which is 0.2
2. STEP 2: Calculate all possible outcomes:
E.g. if supply is 150 and sales are also 150, the profit is 150*(15-10)=$750;
however if supply is 150 and sales are only 100, the profit will be 100*(15-10)+50*(2-
10)=$100
3. STEP 3: Fill the outcomes to the payoff table.
Daily demand (in qty) Probability Daily supply

150 200 100

150 0.33 750 350 500

200 0.47 750 1000 500

100 0.2 100 -300 500

STEP 4: Make a decision:

a. Maximax (risk seeker) - choose the best - order a supply of 200 products

b. Maximin (risk averse) - choose the outcome with the highest expected return under the worst
possible conditions - order a supply of 100 products

c.Using expected values (EV - risk neutral approach) - calculate EV of each choice using
probabilities - e.g. EV of outcome 150 ordered, 150 sold is $750*0,33. See following table:

Daily demand (in qty) Probability Daily supply

150 200 100

150 0.33 750*0.33=250 350*0.33=117 500*0.33=167

200 0.47 750*0.47=350 1000*0.47=467 500*0.47=233

100 0.2 100*0.2=20 -300*0.2=-60 500*0.2=100

TOTAL EXPECTED VALUES 620 524 500

Using EV we should choose order of 150 products.

d. Minimax regret - outcome with the lowest possible regret (opportunity costs) - regret is
calculated as a difference between the best outcome profit and other choices, see the table:

Daily demand (in qty) Probability Daily supply

150 200 100

150 0.33 750-750=0 750-350=400 750-500=250

200 0.47 1000-750=250 1000-1000=0 1000-500=500

100 0.2 500-100=400 500-(-300)=800 500-500=0

Max opportunity costs of the

400 800 500
choice

So based on minimax regret decision rule we should choose order of 150 products.

Decision-making Under Uncertainty

Under this condition, the probabilities associated occurrence of different states of nature are not
known, ie there is no historical data available or no relative frequency which could indicate the
probability of the occurrence of a particular state of nature. In other words, the decision-maker
has no way of calculating the expected payoff for his courses of action or strategies. Such
situations arise when a new product is introduced in the market or a new plant is set up. The
number of different decision criteria available under the condition of uncertainty are given
below:

Expected Value (Realist)

Compute the expected value under each action and then pick the action with the largest
expected value. This is the only method of the four that incorporates the probabilities of
the states of nature. The expected value criterion is also called the Bayesian principle.
Maximax (Optimist)
The maximax looks at the best that could happen under each action and then chooses the
action with the largest value. They assume that they will get the most possible and then
they take the action with the best best-case scenario. The maximum of the maximums or
 the "best of the best". This is the lotto player; they see large payoffs and ignore the
probabilities.
Maximin (Pessimist)
The maximin person looks at the worst that could happen under each action and then
choose the action with the largest payoff. They assume that the worst that can happen
will, and then they take the action with the best worst-case scenario. The maximum of
the minimums or the "best of the worst". This is the person who puts their money into a
savings account because they could lose money at the stock market.
Minimax (Opportunist)
Minimax decision making is based on opportunistic loss. They are the kind that look back
after the state of nature has occurred and say "Now that I know what happened, if I had
only picked this other action instead of the one I actually did, I could have done better".
So, to make their decision (before the event occurs), they create an opportunistic loss (or
regret) table. Then they take the minimum of the maximum. That sounds backwards, but
remember, this is a loss table. This similar to the maximin principle in theory; they want
the best of the worst losses.

Example: A candy shop

Zed and Adrian and run a small candy shop called "Z to A Candies". They must order candies for
the coming season. Orders for the candies must be placed in quantities of twenty (20). The cost
per candy is Ksh. 70 if they order 20, Ksh. 67 if they order 40, Ksh. 65 if they order 60, and Ksh.
64 if they order 80. The candies will be sold for Ksh. 100 each. Any candies left over at the end
of the season can be sold (for certain) at Ksh. 45 each. If Zed and Adrian run out of candies
during the season, then they will suffer a loss of "goodwill" among their customers. They
estimate this goodwill loss to be Ksh. 5 per customer who was unable to buy a candy. Zed and
Adrian estimate that the demand for candies this season will be 10, 30, 50, or 70 candies with
probabilities of 0.2, 0.4, 0.3, and 0.1 respectively.
Actions

There are four actions available to Zed and Adrian. They have to decide which of the actions is
the best one under each criteria.

1. Buy 20 candies
2. Buy 40 candies
3. Buy 60 candies
4. Buy 80 candies

Zed and Adrian have control over which action they choose. That is the whole point of decision
theory - deciding which action to take.

States of Nature

There are four possible states of nature. A state of nature is an outcome.

1. The demand is 10 candies

2. The demand is 30 candies
3. The demand is 50 candies
4. The demand is 70 candies

Zed and Adrian have no control over which state of nature will occur. They can only plan and
make the best decision based on the appropriate decision criteria.

Payoff Table

After deciding on each action and state of nature, create a payoff table. The numbers in
parentheses for each state of nature represent the probability of that state occurring.
 Action

State of Nature Buy 20 Buy 40 Buy 60 Buy 80

Demand 10
50 -330 -650 -970
(0.2)

Demand 30
550 770 450 130
(0.4)

Demand 50
450 1270 1550 1230
(0.3)

Demand 70
350 1170 2050 2330
(0.1)

Ok, the question on your mind is probably "How the [expletive deleted] did you come up with
those numbers?". Let's take a look at a couple of examples.

Demand is 50, buy 60:

They bought 60 at Ksh. 65 each for Ksh. 3900. That is -Ksh. 3900 since that is money
they spent. Now, they sell 50 candies at Ksh. 100 each for Ksh. 5000. They had 10
candies left over at the end of the season, and they sold those at Ksh. 45 each of Ksh.
450. That makes Ksh. 5000 + 450 - 3900 = Ksh. 1550.
Demand is 70, buy 40:
They bought 40 at Ksh. 67 each for Ksh. 2680. That is a negative Ksh. 2680 since that is
money they spent. Now, they sell 40 candies (that's all they had) at Ksh. 100 each for
Ksh. 4000. The other 30 customers that wanted a candy, but couldn't get one, left mad
and Zed and Adrian lost Ksh. 5 in goodwill for each of them. That's 30 customers at -
Ksh. 5 each or -Ksh. 150. That makes Ksh. 4000 - 2680 - 150 = Ksh. 1170.

Opportunistic Loss Table

The opportunistic loss (regret) table is calculated from the payoff table. It is only needed for the
minimax criteria, but let's go ahead and calculate it now while we're thinking about it.
The maximum payoffs under each state of nature are shown in bold in the payoff table above.
For example, the best that Zed and Adrian could do if the demand was 30 candies is to make
Ksh. 770.

Each element in the opportunistic loss table is found taking each state of nature, one at a time,
and subtracting each payoff from the largest payoff for that state of nature. In the way we have
the table written above, we would subtract each number in the row from the largest number in
the row.

Action

State of Nature Buy 20 Buy 40 Buy 60 Buy 80

Demand 10 0 380 700 1020

Demand 30 220 0 320 640

Demand 50 1100 280 0 320

Demand 70 1980 1160 280 0

Remember that the numbers in this table are losses and so the smaller the number, the better.

Expected Value Criterion

Compute the expected value for each action.

For each action, do the following: Multiply the payoff by the probability of that payoff
occurring. Then add those values together. Matrix multiplication works really well for this as it
multiplied pairs of numbers together and adds them. If you place the probabilities into a 1x4
matrix and use the 4x4 matrix shown above, then you can multiply the matrices to get a 1x4
matrix with the expected value for each action.

Here is an example of the "Buy 60" action if you wish to do it by hand.

 0.2(-650) + 0.4(450) + 0.3(1550) + 0.1(2050) = 720

The expected values for buying 20, 40, 60, and 80 candies are Ksh. 400, 740, 720, and 460
respectively. Since the best that you could expect to do is Ksh. 740, you would buy 40 candies.

Maximax Criterion

The maximax criterion is much easier to do than the expected value. You simply look at the best
you could do under each action (the largest number in each column). You then take the best
(largest) of these.

The largest payoff if you buy 20, 40, 60, and 80 candies are Ksh. 550, 1270, 2050, and 2330
respectively. Since the largest of those is Ksh. 2330, you would buy 80 candies.

Maximin Criterion

The maximin criterion is as easy to do as the maximax. Except instead of taking the largest
number under each action, you take the smallest payoff under each action (smallest number in
each column). You then take the best (largest of these).

The smallest payoff if you buy 20, 40, 60, and 80 candies are Ksh. 50, -330, -650, and -970
respectively. Since the largest of those is Ksh. 50, you would buy 20 candies.

Minimax Criterion

Be sure to use the opportunistic loss (regret) table for the minimax criterion. You take the largest
loss under each action (largest number in each column). You then take the smallest of these (it is
loss, afterall).

The largest losses if you buy 20, 40, 60, and 80 candies are Ksh. 1980, 1160, 700, and 1020
respectively. Since the smallest of those is Ksh. 700, you would buy 60 candies.

Putting it all together.

Here is a table that summarizes each criteria and the best decision.
 Action

Criterion Buy 20 Buy 40 Buy 60 Buy 80 Best Action

Expected Value 400 740 720 460 Buy 40

Maximax 550 1270 2050 2330 Buy 80

Maximin 50 -330 -650 -970 Buy 20

Minimax 1980 1160 700 1020 Buy 60

Practice Problem

Since there aren't any problems of this kind in the text, work this problem out, and then you can
check your answer with the instructor.

Finicky's Jewelers sells watches for Ksh. 50 each. During the next month, they estimate that they
will sell 15, 25, 35, or 45 watches with respective probabilities of 0.35, 0.25, 0.20, and ... (figure
it out). They can only buy watches in lots of ten from their dealer. 10, 20, 30, 40, and 50 watches
cost Ksh. 40, 39, 37, 36, and 34 per watch respectively. Every month, Finicky's has a clearance
sale and will get rid of any unsold watches for Ksh. 24 (watches are only in style for a month and
so they have to buy the latest model each month). Any customer that comes in during the month
to buy a watch, but is unable to, costs Finicky's Ksh. 6 in lost goodwill.