MODULE -4

Q.1) Distinguish between decisions under uncertainty and under risk for an
appropriate decision analysis.
Key Differences between Risk and Uncertainty

The difference between risk and uncertainty can be drawn clearly on the
following grounds:

1. The risk is defined as the situation of winning or losing something worthy.

Uncertainty is a condition where there is no knowledge about the future
events.
2. Risk can be measured and quantified, through theoretical models.
Conversely, it is not possible to measure uncertainty in quantitative terms,
as the future events are unpredictable.
3. The potential outcomes are known in risk, whereas in the case of
uncertainty, the outcomes are unknown.
4. Risk can be controlled if proper measures are taken to control it. On the other
hand, uncertainty is beyond the control of the person or enterprise, as the
future is uncertain.
5. Minimization of risk can be done, by taking necessary precautions. As
opposed to the uncertainty that cannot be minimised.
6. In risk, probabilities are assigned to a set of circumstances which is not
possible in case of uncertainty.

BASIS RISK UNCERTAINTY

Meaning The probability of winning or Uncertainty implies a situation

losing something worthy is where the future events are not
known as risk. known.

Ascertainment It can be measured It cannot be measured.

 BASIS RISK UNCERTAINTY

Outcome Chances of outcomes are The outcome is unknown.

known.

Control Controllable Uncontrollable

Minimization Yes No

Probabilities Assigned Not assigned

Q2) What is decision making under uncertainty? Name commonly used criteria
for solving problems under condition of uncertainty. Explain any two of them.

Definition of Uncertainty

By the term uncertainty, we mean the absence of certainty or something which is

not known. It refers to a situation where there are multiple alternatives resulting
in a specific outcome, but the probability of the outcome is not certain. This is
because of insufficient information or knowledge about the present condition.
Hence, it is hard to define or predict the future outcome or events.

Uncertainty cannot be measured in quantitative terms through past models.

Therefore, probabilities cannot be applied to the potential outcomes, because the
probabilities are unknown.
Decision Rules Under Uncertainty

• Laplace criterion
• Maximin
• Maximax
 • Hurwicz
• Minimax regret

Laplace Criterion

The Laplace Criterion could be classified under both risk and uncertainty. It
assumes that every outcome has an equal probability of occurrence. Even though
we are using probabilities, we are blindly assuming each outcome has an equal
chance regardless of actual probabilities.

To evaluate the alternatives we simply average the outcomes for each case. For
the decision in Figure 1 we first calculate the average for each alternative.

Alternative 1 = (-100 + 150 + 220)/3 = 90

Alternative 2 = (-200 + 175 + 210)/3 = 61.7

Alternative 3 = (-250 + 160 + 275)/3 = 61.7

Using the Laplace Criterion, we should select alternative 1.

Maximin Criterion

The maximin criterion selects the alternative with the largest minimum
outcome. This is a conservative criterion where we are selecting the alternative
with the best worst case outcome. For the decision in Figure 1 we have the
following worst case outcomes.

Alternative 1: -100

Alternative 2: -200

Alternative 3: -250

Using Maximin, we should select alternative 1 since it has the best worst case
outcome.
Maximax Criterion

The maximax criterion selects the alternative with the largest maximum
outcome. This is an aggressive criterion where we are selecting the alternative with
the best, best case outcome. For the decision in Figure 1 we have the following
best case outcomes.

Alternative 1: 220

Alternative 2: 210

Alternative 3: 275

Using Maximax, we should select alternative 3 since it has the greatest best case
outcome.
Hurwicz Criterion

The Hurwicz criterion is a compromise between maximin and maximax. In this rule
we use a subjective coefficient to strike a balance between maximin and
maximax. The coefficient of pessimissm, α, determines our weighting on
maximin. Consequently, 1 - α determines our weighting on maximax. To calculate
using the Hurwicz criterion we use the following equation.

Hurwicz Criterion = maximin*α + maximax*(1 - α)

A side note: sometimes alpha is called the coefficient of optimism. In this case, α
and 1 - α are reversed.

Minimax Regret

With Minimax Regret we are trying to minimize the worst case regret from our
decision. To do this we construct a regret table as shown below. The decision
matrix from Figure 1 is repeated here with the best outcome for each case shown
in the bottom row. To calculate the regret values, we subtract each outcome from
that case's best outcome. The last column in the regret table shows the worst
regret for each alternative.
 Figure 5 - Regret Table
Using Minimax Regret, we should choose alternative 1 since it has the smallest
worst regret.

Q3) Explain the types of decision-making under statistical decision theory.

Decision theory (or the theory of choice; not to be confused with choice theory) is
a branch of applied probability theory concerned with the theory of making
decisions based on assigning probabilities to various factors and
assigning numerical consequences to the outcome.
There are three branches of decision theory:

1. Normative decision theory: Concerned with the identification of optimal

decisions, where optimality is often determined by considering an ideal
decision-maker who is able to calculate with perfect accuracy and is in some
sense fully rational.
2. Prescriptive decision theory: Concerned with describing observed behaviors
through the use of conceptual models, under the assumption that those
making the decisions are behaving under some consistent rules.
3. Descriptive decision theory: Analyzes how individuals actually make the
decisions that they do.

Decision theory is closely related to the field of game theory and is an

interdisciplinary topic, studied by economists, mathematicians, data scientists,
psychologists, biologists, political and other social scientists, philosophers and
computer scientists.
Empirical applications of this theory are usually done with the help
of statistical and econometric methods.

Normative
Normative decision theory is concerned with identification of optimal decisions
where optimality is often determined by considering an ideal decision maker who
is able to calculate with perfect accuracy and is in some sense fully rational. The
practical application of this prescriptive approach (how people ought to make
decisions) is called decision analysis and is aimed at finding tools, methodologies,
and software (decision support systems) to help people make better decisions.

Descriptive decision theory is concerned with describing observed behaviors often

under the assumption that those making decisions are behaving under some
consistent rules. These rules may, for instance, have a procedural framework
(e.g. Amos Tversky's elimination by aspects model) or an axiomatic framework
(e.g. stochastic transitivity axioms), reconciling the Von Neumann-Morgenstern
axioms with behavioral violations of the expected utility hypothesis, or they may
explicitly give a functional form for time-inconsistent utility functions (e.g.
Laibson's quasi-hyperbolic discounting).

Prescriptive decision theory is concerned with predictions about behavior that

positive decision theory produces to allow for further tests of the kind of decision-
making that occurs in practice. In recent decades, there has also been increasing
interest in "behavioral decision theory", contributing to a re-evaluation of what
useful decision-making requires.

Decision Types:

The decision problems can be classified into five types and they are:
1. Decision Making Under Certainty:
There are a few problems where the decision maker gets almost complete
information so that he knows all the facts about the state of nature and again
which state of nature would occur and also the consequences of the state of
nature. In such a situation, the problem of decision making is simple because the
decision maker has only to choose the strategy which will give him maximum pay-
off in terms of utility.

In cases where the strategy rows are normally very large and it is impossible even
to list them, the technique of operational research like linear and nonlinear
programming and geometric programming would have to be used to achieve the
optimal strategy.

2. Decision Making Under Risk:

A problem of this kind arises when the state of nature is unknown, but based on
the objective or empirical evidence, we can possibly assign probabilities to various
states of nature. In a number of problems on the basis of historical data and past
experience, we are able to assign probabilities to various states of nature. In such
cases, the pay-off matrix is of immense help for reaching an optimal decision by
assigning probabilities to various states of nature.

3. Decision Making Under Uncertainty:

The process of making decision under conditions of uncertainty takes place when
there is hardly any knowledge about states of nature and no objective
information about their probabilities of occurrence. In such cases of absence of
historical data and relative frequency, the probability of the occurrence of the
particular state of nature cannot be indicated.

Such situations arise when a new product is introduced or a new plant is set up.
Of course, even in such cases some market surveys are conducted and relevant
information is gathered though it is not generally sufficient to indicate a
probability figure for the occurrence of a particular state of nature.

4. Decision Making Under Partial Information:

This type of situation is somewhere between the conditions of risk and conditions
of uncertainty. As regards conditions of risk, we have seen that the probability of
the occurrence of various states of nature are known as the basis of past
experience, and in conditions of uncertainty, there is no such data available. But
many situations arise where there is partial availability of data. In such
circumstances, we can say that decision making is done on the basis of partial
information.

5. Decision Making Under Conflict:

A condition of conflict is supposed to occur when we are dealing with rational
opponent rather than the state of nature. The decision maker, therefore, has to
choose a strategy taking into consideration the action or counter-action of his
opponent. Brand competition, military weapons, market place, etc. are problems
which come under this category. The strategy choice is done as the basis of game
theory where a decision maker anticipates the action of the opponent and then
determines his own strategy.

Q.4 Decision tree applications in Business Decisions

Decision Tree
A decision tree is a support tool with a tree-like structure that models probable
outcomes, cost of resources, utilities, and possible consequences. Decision trees
provide a way to present algorithms with conditional control statements. They
include branches that represent decision-making steps that can lead to a favorable
result.
 Simple Decision Tree

The flowchart structure includes internal nodes that represent tests or attributes
at each stage. Every branch stands for an outcome for the attributes, while the path
from the leaf to the root represents rules for classification.

Decision trees are one of the best forms of learning algorithms based on various
learning methods. They boost predictive models with accuracy, ease in
interpretation, and stability. The tools are also effective in fitting non-linear
relationships since they can solve data-fitting challenges, such as regression and
classifications.

Types of Decisions
There are two main types of decision trees that are based on the target variable,
i.e., categorical variable decision trees and continuous variable decision trees.

1. Categorical variable decision tree

A categorical variable decision tree includes categorical target variables that are
divided into categories. For example, the categories can be yes or no. The
categories mean that every stage of the decision process falls into one category,
and there are no in-betweens.

2. Continuous variable decision tree

A continuous variable decision tree is a decision tree with a continuous target
variable. For example, the income of an individual whose income is unknown can
be predicted based on available information such as their occupation, age, and
other continuous variables.

Applications of Decision Trees

1. Assessing prospective growth opportunities

One of the applications of decision trees involves evaluating prospective growth
opportunities for businesses based on historical data. Historical data on sales can
be used in decision trees that may lead to making radical changes in the strategy of
a business to help aid expansion and growth.

2. Using demographic data to find prospective clients

Another application of decision trees is in the use of demographic data to find
prospective clients. They can help streamline a marketing budget and make
informed decisions on the target market that the business is focused on. In the
absence of decision trees, the business may spend its marketing market without a
specific demographic in mind, which will affect its overall revenues.

3. Serving as a support tool in several fields

Lenders also use decision trees to predict the probability of a customer defaulting
on a loan by applying predictive model generation using the client’s past data. The
use of a decision tree support tool can help lenders evaluate a customer’s
creditworthiness to prevent losses.
Decision trees can also be used in operations research in planning logistics
and strategic management. They can help in determining appropriate strategies
that will help a company achieve its intended goals. Other fields where decision
trees can be applied include engineering, education, law, business, healthcare, and
finance.
Advantages of Decision Trees

1. Easy to read and interpret

One of the advantages of decision trees is that their outputs are easy to read and
interpret without requiring statistical knowledge. For example, when using decision
trees to present demographic information on customers, the marketing
department staff can read and interpret the graphical representation of the data
without requiring statistical knowledge.
The data can also generate important insights on the probabilities, costs, and
alternatives to various strategies formulated by the marketing department.

2. Easy to prepare
Compared to other decision techniques, decision trees take less effort for data
preparation. However, users need to have ready information to create new
variables with the power to predict the target variable. They can also create
classifications of data without having to compute complex calculations. For
complex situations, users can combine decision trees with other methods.

3. Less data cleaning required

Another advantage of decision trees is that there is less data cleaning required once
the variables have been created. Cases of missing values and outliers have less
significance on the decision tree’s data.
Disadvantages of Decision Trees
1. Unstable nature
One of the limitations of decision trees is that they are largely unstable compared
to other decision predictors. A small change in the data can result in a major change
in the structure of the decision tree, which can convey a different result from what
users will get in a normal event. The resulting change in the outcome can be
managed by machine learning algorithms, such as boosting and bagging.

2. Less effective in predicting the outcome of a continuous variable

In addition, decision trees are less effective in making predictions when the main
goal is to predict the outcome of a continuous variable. This is because decision
trees tend to lose information when categorizing variables into multiple categories.

5) Explain the components of decision theory?

The Components of Decision Making
The five distinct parts of consumer decision making presented are input,
information processing, a decision process, decision process variables, and external
influences.

1. Input. Input includes all kinds of stimuli from our contact with the world
around us, such as our experiences, marketer-controlled stimuli (e.g.,
advertising, store display, demonstrations), other stimuli (e.g., personal
recollections, conversations with friends) and external search.
2. Information processing. Stimuli are processed into meaningful information
and this task includes the stages of exposure, attention, comprehension,
yielding and retention.
• Exposure. Exposure refers to a kind of stimulation closer to consumer
physical, and one of our five senses may be activated by the kind of
stimulation. And then, the information that is encoded will be sent to the
 brain through the nerve conduction. Subsequently, the consuming
consciousness may be excited by these stimuli and the consumer decision
making begins.

• Attention. Attention refers to the activity or ability which makes one’s

thoughts on the matter. That is to say, the basic factor of attention is focus.
Generally speaking, a product which has more relevant information and
content can attract more people’s attention.

• Comprehension. When the product information intended to attract

consumers, the information will be further classified, and stored in memory.
Because a consumer is attentive toward a stimulus does not mean that the
stimulus can be comprehended as intended. Enterprises expect the
information can be comprehended exactly.

• Yielding. After consumers comprehend this product information, they either

accept this product or refuse it. Product information is aimed at changing or
rectifying the image of products in people’s minds. Making consumers accept
the information is the purpose of enterprises.

• Retention. Retention refers to the memory process that determines which

of the many stimuli that have gone through the initial four stages of
consumer information processing will be remembered. This stage prepares
for future purchases.

3. Decision process. According to the processed information, consumers will

make consuming decision. Decision process is triggered at any time during
information processing. It consists of five steps. They are problem
recognition, search, alternative evaluation, choice and outcomes (post-
purchase evaluation and behavior). Consumer demand is the starting point
of any purchase decision.

• Problem recognition. When consumers realize that they need something,

problem recognition is the first step in the decision-making process. It is the
psychological process used to determine the difference between the
 consumer’s actual benefits state (where you are) and the desired benefits
state (where you want to be). Problem recognition is influenced by situation,
consumer and marketing.

• Search. Information collected by consumers is the basis for evaluation and

choice behavior. It is important for marketers to know why consumers are
searching for information, where will they look, what information consumers
seek and how extensively they are willing to search.

• Alternative evaluation. Consumers will choose the product from the brand
group which has a number of options to choose. When consumers choose
the product brand, the attribute of product will be considered. For instance,
the photo resolution or the price of camera will be considered when
consumers want to buy a camera.

• Choice. In this part, consumers choose one of many retailers firstly. And
then, consumers choose product which can meet their demands in the shop.
These behaviors are influenced by salespeople, product display and
advertisement.

• Outcomes. After purchasing the product, consumers will produce the sense
of satisfaction and dissatisfaction. The level of satisfaction or dissatisfaction
we experience depends upon how well the product’s performance meets our
expectations.

4. Decision Process variables. Those individual qualities what make consumers

unique. Decision process variables include motives, beliefs, attitudes,
lifestyles, intentions, evaluative criteria, normative compliance and
informational influence and other aspects of self. Motives refer to a
tendency for people to behave in a general way in order to satisfy a need.
Motive is an inherent power which can promote individual activities for
attain consumer purpose.
 5. External influences. Such influences are called “Circles of Social Influence.”
They are: culture, sub-culture (co-culture), social class, reference groups, and
family or household influences. Culture refers to non-individual, as members
of society, exchanges and understandings each other. Culture also is the
symbol of values, ideas and other meaning.

6) Assume there are 5 vacancy posts for an appropriate selection of an airhostess

post and number of applications received for the required post is 12. As a result of
this explain the process of decision making.
Decision making is the process of making choices by identifying a decision,
gathering information, and assessing alternative resolutions.
Using a step-by-step decision-making process can help you make more deliberate,
thoughtful decisions by organizing relevant information and defining alternatives.
This approach increases the chances that you will choose the most satisfying
alternative possible.

Step 1: Identify the decision

You realize that you need to make a decision. Try to clearly define the nature of the
decision you must make. This first step is very important.

Step 2: Gather relevant information

Collect some pertinent information before you make your decision: what
information is needed, the best sources of information, and how to get it. This step
involves both internal and external “work.” Some information is internal: you’ll
seek it through a process of self-assessment. Other information is external: you’ll
find it online, in books, from other people, and from other sources.

Step 3: Identify the alternatives

As you collect information, you will probably identify several possible paths of
action, or alternatives. You can also use your imagination and additional
information to construct new alternatives. In this step, you will list all possible and
desirable alternatives.

Step 4: Weigh the evidence

Draw on your information and emotions to imagine what it would be like if you
carried out each of the alternatives to the end. Evaluate whether the need
identified in Step 1 would be met or resolved through the use of each alternative.
As you go through this difficult internal process, you’ll begin to favor certain
alternatives: those that seem to have a higher potential for reaching your goal.
Finally, place the alternatives in a priority order, based upon your own value
system.

Step 5: Choose among alternatives

Once you have weighed all the evidence, you are ready to select the alternative
that seems to be best one for you. You may even choose a combination of
alternatives. Your choice in Step 5 may very likely be the same or similar to the
alternative you placed at the top of your list at the end of Step 4.

Step 6: Take action

You’re now ready to take some positive action by beginning to implement the
alternative you chose in Step 5.

Step 7: Review your decision & its consequences

In this final step, consider the results of your decision and evaluate whether or not
it has resolved the need you identified in Step 1. If the decision has not met the
identified need, you may want to repeat certain steps of the process to make a new
decision. For example, you might want to gather more detailed or somewhat
different information or explore additional alternatives.