Statistics for business

decision making

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 Introduction:
Every individual big or small, rich or poor, educated or uneducated,
manufacturer or dealer, businessman or housewife, etc has to make
decision almost everyday. Without decisions not a single day pass.

 Meaning:
A set of processor or method which is helpful to decision maker to
select wisely the best cause of action from amongstseveral
alternatives is called decision theory.
When we use synthesis of basic fundamental of statistics, economics
and psychology in the decision theory for selecting optimum
strategy from the various strategies we called is decision theory as
the statistical decision theory.
Optimum strategy means that strategy for which the risk or loss is
minimum.
I. Decision making under certainty.
II. Decision making under risk.
III. Decision making under uncertainty.
IV. Decision making under conflict.
V. Decision making under partial information.
 Scope:
The decision theory can be used widely on all the field where we
have to take the important decision which is creates. Effects to a
variety of a person such as consumers, employees, suppliers,
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distributers, shareholders etc. Hence we can say the decision theory

is applicable in business & commerce, government, finance
departments, some political fields and etc.
In decision making under certainty the risk of making decisions is
too simple. But for that under uncertainty on using certain types of
method, rules and laws we can take the best decisions.

 Components Or Elements Of Decision

Theory:
1. Acts:

A decision situations arises only when the decision maken more

than ome courses of action open to him. If there is a one alternative
there is nothing to decide. For ex: If a student have only one shirt he
does not have to decide which shirt to put on. The coloure of action
also known as acts or strategies.

2. States of nature:

The selection of any depends upon the external conditions which

are not in the control of decision maker. This States of nature
depend upon external factors.

3. Pay-Off:

For a certain act under the ceetain states of a nature we shall we

have the outcome. When this outcome is in rs. otherwise any factor.

4. Pay-Off Matrix:

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The arisement of different pay-off from different states of nature

and acts known as the pay-off matrix.
For ex: x1 x2 x3
x4 x5 x6
x7 x8 x9

5. Regret Table:

When the selection of act we consider the again but sometimes we

may measure loss or cost also. It is known for cost table. Now loss or
cost is negative gain in a pay-off table we select a strategy which
gives us a maximum pay-off.

 Types of Problems in Decision Making

Under Different Environments :
Given the pay off matrix for a decision problem, the process of
decision making depends upon the situation under which the
decision is being made. These situations can be classified into three
categories: (a) Decision making under certainty (b) Decision making
under uncertainty and (c) Decision making under risk
(a) Decision making under certainty :
When the result of each strategy can be easily known, the
decision maker has to decide the best action that gives maximum
pay-off. To understand this matter let us take simple illustrations.
Suppose a manufacturer of water glasses can produce and sell a
cheaper variety of glasses at Rs. 20 per glass and earns Rs. 2 per
glass. He can sell 1000 water glasses per day. On the other hand if
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he produces a superior quality of water glasses and sells at Rs. 30

each, and carns Rs. 4 per water glass. But he can sell only 600
water glasses of superior quality.
In this case, we have to decide about the type of water glasses the
manufacturer should produce. For cheaper quality of water glasses
he can earn 1000 x 2 = 2000 rupees per day.
For superior quality of water glasses he can earn 6000 x 4-2400
rupees per day. The profit on the superior quality is more and hence
he should produce water glasses of superior quality.
(b) Decision making under uncertainty:
Under conditions of uncertainty, only pay-offs are known and
nothing is known about the likelihood of each state of nature. The
problems of decision making under uncertainty can be studied
under two heads.
1. Decision making under uncertainty when probabilities of
different states of nature are unknown.
2. Decision making under uncertainty when probabilities of
different states of nature are known.
Different persons have suggested several decision rules for making a
decision under such situation.
(1) Maximin criterion or Maximin principle:
This criterion is used when the decision maker is pessimistic
about the future. According to this criterion the minimum pay-off
of each act is obtained from the given pay-off matrix. The
maximum of these minimum pay-off is identified and the

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corresponding act is selected. This is explained in the following

example:
Pay –off Matrix

E1 E2 E3 E4 Minimum Maximum
Pay-off Pay-off
A1 27 12 14 26 12 27
A2 45 17 36 24 17 45
A3 50 36 29 15 15 50

In the above, 17 is maximum out of the minimum pay-offs, which

corresponds to act A2. Hence according to maxi-min criterion act
A2 should be selected.
(2) Maximax decision criterion or Maximax decision
principle:
This criterion is used when the decision maker is optimistic about
future. Maximax implies the maximization of maximum pay-off.
The optimistic decision maker locates the maximum pay-off for
each possible act. The maximum of these pay-off is identified and
the corresponding action is selected. The optimal act in the above
example, based on this criterion is A3.
(3) Minimax decision criterion or Regret criterion:
Minimax criterion attempts to minimize the maximum regret or
opportunity loss i.e. mini-max choose the act that is the best of
the worst. The practical steps involved in the criterion are as
follows:
Step 1: Prepare pay-off matrix
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Step 2: Prepare opportunity loss table by subtracting all the Pay-

off elements of an event from the largest pay-off for that event.
Step 3: Select the minimum regret for each strategy.
Step 4: Select the minimum of these maximum regrets.
Step 5: Select the strategy having minimum of maximum regrets.
This strategy is based on mini-max criterion.
(4) Harwich Decision criterion:
It is a more realistic approach which takes into account the
degree or index of optimism and pessimism. The practical steps
involved in this criterion are as follows:
Step 1: Prepare Pay-off Matrix.
Step 2: Select the maximum pay-off for each strategy.
Step 3: Select the minimum pay-off for each strategy.
Step 4: Calculate weighted average for each strategy.
Weighted average = α(Maximum pay-off) + (1-α)
(Minimum pay-off)
Step 5: Select the strategy with the highest weighted average.
(5) Laplace Decision criterion:
Laplace criterion assumes that all the states of nature are equally
likely to occur. Thus, if there are n states of nature, probability of
occurrence of each state of nature will be 1/n. Using these equal
probabilities, we compute the expected pay-off for each act Xs

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and the act with maximum expected value is regarded as optimal

and this act is selected as the best act.
(c) Decision making under risk:
The criterion that is generally accepted as the most appropriate
stochastic problems is that of maximizing the expected utility and is
often termed either by Expected Monetary Value (EMV) criterion or
Expected Opportunity Loss (EOL) criterion. To select the best
alternative, we select the alternative for which EMV is highest
possible or EOL is the lowest possible.
(1) Expected Monetary Value:
This is very commonly used technique of decision making. In this
technique, probabilities are assigned for different Events (states of
nature). The expected pay-off associated with a given combination
of an act and event, is obtained by multiplying the pay-off for that
act event combination by the probability of occurrence of the given
event. The practical steps involved in the calculation of EMV.
Step 1: Prepare the pay-off matrix.
Step 2: Assign Probabilities to the event.
Step 3: Calculate EMV for each act.
Step 4: Select the act with the highest EMV.
(2) Expected Opportunity Loss:
The concept of EOL provides an alternative method of solving a
decision problem for the optimal action. Rather than maximizing
expected gain, one can minimize the value of regret or the

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opportunity loss. The steps involved in the calculation of EOL are as

follows:
Step 1: Prepare the pay-off table or pay-off matrix.
Step 2: Prepare opportunity loss table (Regret table).
Step 3: Assign probabilities to the events.
Step 4: Calculate EOL for each act.
 Expected Value of Perfect Information (EVPI):
The maximum amount which the decision maker can spend to
obtain the perfect information on which to base a given decision is
called EVPI. EVPI is difference between expected pay-off with
perfect information (EPPI) and Expected maximum pay-off under
uncertainty probability of that state of nature. Total of these
expected pay-offs gives EPPI.
EVPI = EPPI – EMV

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