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MBA-024

UNIT I

DECISION-MAKING ENVIRONMENTS/DECISION THEORY

**Decision Theory: Introduction
**

The managerial activity includes broadly four phases, namely, planning, organising, directing and controlling. In performing all of these activities the management has to face several such situations where they have to make a choice of the best among a number of alternative courses of action.

This choice making is technically termed as decision-making. A decision is simply a selection from two or more courses of action. Decision theory provides a rich set of concepts and techniques to aid the decision maker in dealing with complex decision problems.

**Decision Theory: Definition
**

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

**Decision Theory: Applications
**

Select the best from among several job offers. Select the most profitable investment portfolio. Determine whether or not to expand a manufacturing facility. Determine whether a large plant, a small plant, or no plant should be built. Decide whether to invest in a new plant, equipment, research programme, marketing facilities, etc.

**Decision Theory: Steps
**

Clearly identify and define the problem at hand. Specify objectives and the decision criteria. Identify and evaluate the possible alternatives. Formulate (or select) one of the mathematical decision theory models.

**Decision Theory: Steps
**

Apply the model and select the best alternative. Conduct a sensitivity analysis of the solution. Communication and implementation of decision. Follow-up and feedback of results of decision.

**Decision Theory: Concepts
**

Decision Maker. An individual or a group of individuals responsible for making the choice of an appropriate course of action amongst the available courses of action. Courses of Action. The alternative courses of actions or strategies are the acts that are available to the decision maker.

States of Nature. The events or occurrences which are outside the control of the decision maker, but which determine the level of success for a given decision. Payoff. Each combination of a strategy and event is associated with a payoff, which measures the net benefit to the decision maker.

Payoff Table. For a given problem, payoff table lists the payoffs for each combination of event and strategy. Regret/Opportunity Loss Table. An opportunity loss is the loss incurred due to failure of not adopting the best possible strategy. For a given state of nature the opportunity loss of possible strategy is the difference between the payoff for that strategy and the payoff for the best possible strategy that could have been selected.

**Types of Decision-Making Environments
**

Certainty. Complete and accurate knowledge of the outcome of each alternative. There is only one outcome for each alternative. Risk. Multiple possible outcomes for each alternative. A probability of occurrence attached to each possible outcome. Uncertainty. Multiple outcomes for each alternative. But no knowledge of the probability of their occurrence.

**Decision-Making under Certainty
**

The consequence of selecting each course of action known with certainty. It is presumed that only one state of nature is relevant for the purpose of the decision maker. He identifies this state of nature, takes it for granted and presumes complete knowledge as to its occurrence.

**Decision-Making under Certainty
**

Some techniques used:

± System of equations. ± Linear programming. ± Integer programming. ± Dynamic programming. ± Queuing models. ± Inventory models. ± Capital budgeting analysis. ± Break even analysis.

**Decision-Making under Risk
**

The decision maker faces several states of nature. He is supposed to have believable evidential information, knowledge, experience or judgement to enable him to assign probability values to the likelihood of occurrence of each state of nature. The course of action which has the largest expected payoff value is selected.

**Decision-Making under Risk
**

The most widely used decision criterion is the expected monetary value (EMV) or expected payoff. The objective of decision making is to optimise expected payoff. It means maximisation of expected profit or minimisation of expected regret.

EMV

Given a payoff table with payoffs and probability assessments for all states of nature, it is possible to determine EMV for each course of action if the decision is repeated a large number of times. The EMV for a given course of action is the sum of possible payoffs of the alternatives, each weighted by the probability of that payoff occurring.

**Steps for Calculating EMV
**

Construct payoff table along with the probabilities of the occurrence of each state of nature. Calculate EMV for each course of action, as shown earlier. Select the course of action that yields the optimal EMV.

**Expected Value with Perfect Information
**

The expected value with perfect information is the expected or average return, in the long run, if we have perfect information before a decision has to be made. It is calculated by choosing the best alternative for each state of nature and multiplying its payoff with the probability of that state of nature.

Expected value with perfect information = (Best outcome for 1st state of nature) x (Probability of 1st state of nature) + (Best outcome for 2nd state of nature) x (Probability of 2nd state of nature) + + (Best outcome for last state of nature) x (Probability of last state of nature)

**Expected Value of Perfect Information (EVPI)
**

EVPI is the expected value with perfect information minus the expected value without perfect information, namely the maximum EMV.

**Expected Opportunity Loss (EOL)
**

An alternative approach to maximising EMV is to minimise EOL or expected value of regrets.

**Decision-Making under Uncertainty
**

The probabilities are not known. No historical data available. Expected payoff cannot be calculated. Example: Introduction of a new product in the market. The choice of a course of action depends largely upon the personality of the decisionmaker or policy of the organisation.

**Decision Criteria under condition of Uncertainty
**

Maximin. Maximax. Minimax Regret. Hurwicz Criterion. Baye s/Lapalce s Criterion.

**Criterion of Pessimism (Maximin)
**

Also called Waldian Criterion. Determine the lowest outcome for each alternative. Choose the alternative associated with the best of these.

**Criterion of Optimism (Maximax)
**

Suggested by Leonid Hurwicz. Determine the best outcome for each alternative. Select the alternative associated with the best of these.

**Minimax Regret Criterion
**

Attributed to Leonard Savage. For each state, identify the most attractive alternative. Place a zero in those cells. Compute opportunity loss for other alternatives. Identify the maximum opportunity loss for each alternative. Select the alternative associated with the lowest of these.

**Criterion of Realism (Hurwicz Criterion)
**

A compromise between maximax and maximin criteria. A coefficient of optimism (0 1) is selected. When is close to 1, the decision-maker is optimistic about the future. When is close to 0, the decision-maker is pessimistic about the future.

Hurwicz Criterion

Select the strategy which maximises:

Laplace Criterion

Assign equal probabilities to each state. Compute the expected value for each alternative. Select the alternative with the highest alternative.

**Decision Tree Approach
**

Using a decision tree the decision problem, alternative courses of action, states of nature and the likely outcomes are diagrammatically depicted. A decision tree consists of a network of nodes, branches, probability estimates and payoffs. Nodes are of two types: decision-node (square) and chance node (circle).

Alternative courses of action originate from decision nodes as main branches (decision branches). At the terminal of each decision branch, there is a chance node. Chance events emanate from chance nodes in the form of sub-branches (chance branches). The respective payoffs and the probabilities associated with the alternative courses and chance events are shown alongside the chance branches. At the terminal of the chance branches expected payoffs are shown.

**Types of Decision Trees
**

Deterministic. Probabilistic. These can further be subdivided into single stage and multistage trees. A single stage deterministic decision tree involves making only one decision under conditions of certainty (no chance events).

In a multi stage deterministic tree a sequence or chain of decisions are to be made. A problem involving only one decision to be made under conditions of risk or uncertainty (more than one chance events) can be represented using a single stage probabilistic decision tree. In the above problem, if a sequence of decisions is required, a multi stage probabilistic decision tree is required.

**Drawing a Decision Tree: Conventions
**

Identify all decisions (and their alternatives) to be made and the order in which they must be made. Identify the chance events or states of nature that might occur as a result of each decision alternative. Develop a tree diagram showing the sequence of decisions and chance events.

Estimate probabilities that the possible events will occur as a result of the decision alternatives. Obtain outcomes (usually expressed in economic terms) of the possible interactions among decision alternatives and events. Calculate the expected value of all possible decision alternatives. Select the decision alternative (or course of action) offering the most attractive expected value.

**Roll-Back Technique
**

Used for analysing a decision tree. Proceeds from the last decision in the sequence and works back to the first for each of the possible decisions. Two rules concerning this technique:

± If branches emanate from a circle, the total expected payoff may be calculated by summing up the expected values of all the branches. ± If branches emanate from a square, we calculate the total expected payoff for each branch emanating from that square and the branch with the highest expected benefit gives the solution.

**Decision Tree: Advantages
**

Useful for portraying the interrelated, sequential and multidimensional aspects of a decision problem. Focuses attention on the critical elements in a decision problem. Especially useful in cases where an initial decision and its outcome affect the subsequent decisions. Enables the decision maker to see the various elements of the decision problem in a systematic way. Complex managerial problems can be explicitly defined. Can be applied in various fields.

**Decision Tree Approach: Applications
**

Introduction of a new product. Marketing strategy. Make or buy decisions. Pricing assets acquisition. Investment decisions.

A company owns a lease on a property. It may sell the lease for Rs.12000 or it may drill the said property for oil. Various possible drilling results are as under along with the probabilities of happening and rupee consequences:

Possible Result Dry well Gas well Oil & gas well Oil well Probability 0.10 0.40 0.30 0.20 Rupee Consequence -100000 45000 98000 199000

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