Operations & Material Management

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Unit 2 – Video 1: Decision Environments

Note: This transcription document is a text version of the video. It is not meant to be read
independently but can be used to complement your video watching experience.

Speaker: Dr. Rajesh Gupta

We are going to understand what is a decision, how decisions are made? What are the various
environments in which decisions are made? If you look at the decision, decision is a situation in
which we have a problem and we have number of alternatives to act upon. Decision involves
selection of the best alternative to solve the problem. There are different decision environments in
which we have to make decisions, and the technique depends upon the environment. Let us
understand what are those environments.

We come across three types of environments of decision making - certainty, risk and uncertainty.
Certainty is the simplest environment in which we know what are the possible alternatives. We
know definitively what is the outcome of each of the alternatives. So, selection of the right
alternative is quite simple. For example, if I have to deposit my money in a bank and I have to
choose between savings bank and recurring account, it is well known what is the interest rate in
savings bank and what is the interest rate in the recurring account. So, it is simple to compare, and it
is easy to arrive at a decision.

Risk is an environment in which each alternative could have more than one possible outcomes, and
the probabilities of these outcomes are known to us. Whereas uncertainty is the most complex
environment in which each alternative can have more than one possible outcomes, and even the
probability of those outcomes is not known to us. We will understand the decision-making process in
all these three environments. Let us begin with a generic understanding of the process of decision
making.

So, decision theory process starts with identifying possible future conditions, i.e., states of nature.
For example, the market could be low, market could be moderate, market could be high in future.
Step number two, develop a list of possible alternatives, one of which maybe do nothing. That
means find out what are the possible courses of action from which we have to choose one, develop
a list of possible alternatives, and number three determine the payoffs associated with each
alternative in every future condition. That means understanding what shall be the possible outcome
for a specific combination of alternative and state of nature. Step number four is determining
likelihood of each possible future condition if it is possible. So, if it is possible to determine
likelihood, we are into a state of risk. And if it is not possible to determine the likelihood, we are in
the state of or we are in the environment of uncertainty and finally, evaluate alternatives according
to some decision criteria and select the best one.

We try to understand that with the help of a payoff table. That's a payoff table. We have three
alternatives available to us. The problem is we want to expand, and if you want to expand, there are
three alternatives available to us. A small facility, a medium facility or a large facility. There are three
possible future conditions. The market could be low, market could be moderate and market could be
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high. The values in the table, they indicate
the possible payoff or the possible profit or loss for every combination of alternative and the future
condition. For example, if I select to go for small facility and the market turns out to be moderate,
the return shall be ten. If I choose to go for a large facility and the market happens to be low, the
payoff shall be minus four. The bracket means minus. So, the payoffs are given for each
combination.

Now the question is how to make a selection. This, in fact, is a condition of uncertainty because the
probabilities are not known to us. Let us try to define some probability to each of the future possible
conditions. Let us say the probability of market being low is .4, the probability of market being
moderate is .3 and probability of market being high is .3 again. Now, we need to determine the
expected return or expected pay off for each of the alternatives. So, if I go for the small facility
today, the expected return shall be probability multiplied by return plus probability multiplied by
return plus probability multiplied by return, which is equal to ten in fact.

If we go for a medium facility, in that case, the expected return shall be probability, that is, .4
multiplied by seven plus .3 multiplied by twelve plus .3 multiplied by twelve again, and we go for a
large facility. The expected return shall be .4 multiplied by minus four because the return is minus
four for this combination plus .3 into two plus .3 into 16. That is the expected return of each of the
alternatives, and the alternative which gives the highest expected payoff becomes the preferred
alternative.

Please remember, the decision is not made only on the basis of financial analysis. There are many
other criteria in making a decision. These tools what we are discussing here, they are only for giving
information to the manager so that he can make a rational decision. So that is the concept of
decision making under risk.

And now, we move to decision making under uncertainty. Decision making under uncertainty is of
various types. There are various methods, various models. One of them is maximin, that is, choosing
the alternative with the best of worst possible payoffs maximax, that is, choosing the alternative
with the best possible payoff. Laplace, choosing the alternative with the best average pay off of any
of the alternatives, and minimax regrets choosing the alternative that has the least of the worst
regrets. Let's try to understand these four with the help of the payoff table.

So, going by the first principle, that is, maximin, that is, maximum of minimum. So, for the small
facility, the maximum value or the maximum payoff under any states of nature is ten. The minimum
is ten. For the medium facility, the minimum payoff is seven, and for large facility, the minimum
payoff is minus four. So, maximin talks about maximum of minimum. Maximum of minimum
happens to be ten. So, on the basis of maximum principle, small facility shall be chosen because it
gives the highest minimum.

Now moving to the second method, i.e., maximax. Maximax, as the name is indicating, it is
maximum of maximum. So, the maximum payoff for small facility is ten. Under any state of nature,
the maximum payoff for medium facility is twelve and the maximum payoff for large facility is 16. So
going by maximax principle, maximum of maximum which happens to be 16, large facility shall be
chosen. We see that when we talk of maximin, actually it is a pessimistic approach, and when we
talk of maximax, it is an optimistic approach.

Going by the principle of LaPlace, which talks about the highest average pay off. So, average pay off
for alternative one that is small facility is ten plus ten plus ten divided by three, which is ten. The
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average payoff for medium facility is seven
plus twelve plus twelve and divided by three, and the average for large facility is minus four plus two
plus 16 and divided by three. So LaPlace works on finding out determining the highest average pay
off for any for any alternative. So, the alternative which gives the highest average becomes the
preferable one on the basis of LaPlace.

And coming to the last one, i.e., Minimax regret. As the name is indicating, it talks about minimum of
maximum regret because we want to regret least. Now we need to create a regret table for that. So,
if I just reproduce this table - small facility, medium facility and large facility. Under low market,
moderate market and high market, and now let us create a regret.

So, if I go for a small facility and market turns out to be low. In that case, there is no regret because
in this column, ten is the highest value. So, regret is zero. If I go for small facility and market happens
to be moderate, the payoff is ten, whereas it would have been if I had gone for a meeting facility. So,
regret is two. If I go for a small facility and market happens to be high, the return is ten, whereas it
could be 16. So regret is six. Going for medium. If I go for medium facility and market turns out to be
low, the payoff is seven, whereas it could be ten if I had gone for small, so regret is three. Similarly,
for medium facility, if the situation happens to be moderate, the return is twelve, which is the
highest return in this column. So, regret is zero. If I go for medium facility and market happens to be
high, then the regret is four, because if I had chosen large facility, I could have earned 16. So, regret
is four. Similarly, for large facility, the regret shall be minus four and minus ten, so regret shall be
how much? 14. I lost four, whereas I could earn ten, so regret is 14. If I go for a large facility and the
market turns out to be moderate, the regret is ten because I earn two whereas I could have earned
12. And if I go for large facility and the market turns out to be high, so it is zero because I earn 16,
which is the highest in this column.

Now let us see what is the maximum regret if I go for a small facility. The maximum regret is six. If I
go for medium facility, the maximum regret is four. And if I go for large facility, the maximum regret
is 14. So going by Minimax regret, minimum of maximum regret, this is the maximum regret for each
of the alternatives. What is the minimum after that? Minimum is 4. So, on the principle of Minimax
regret, medium facility shall be chosen. Thank you.