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CHAPTER 2: DECISION THEORY
WHAT IS DECISION THEORY?
In decision theory, we mostly learn to make decision in business and management.
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GOOD DECISION
1. Based on logic 2. Consider all information 3. Use quantitative approach
BAD DECISION
1. Not based on logic 2. Does not consider all information 3. Does not use quantitative approach
STEPS IN MAKING DECISION IN BUSINESS AND MANAGEMENT 1 2 3 4
• Define the problem • Develop payoff table • Determine decision-making environment • Make decision
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Understand what the problem is about.
Identify the limitations to the problem.
Defining the Problem
Identify other problems related to the problem.
Be clear about the objectives of solving the problem.
Developing Payoff Table
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Steps in developing payoff table: Identify alternatives (things that we want to do) Identify states of nature (things that will happen) Identify profits for each combination of alternative and state of nature Build the table
Example 1: Misha is thinking about opening a stationery shop near a student’s college. She has the options of opening a large shop, a small shop or no shop at all. The market for a stationery shop can be good or bad. If Misha opens a large shop, she will gain RM50000 if the market is good. However, if the market is bad, she could lose RM20000. In addition, if Misha opens a small shop, she will obtain a net profit of RM35000 if the market is good, but if the market is bad, she could lose RM5000. Opening no shop will result in no loss and no gain. Develop a payoff table to represent Misha’s case. Alternatives
States of nature
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Solution: Alternative
Open a large shop Open a small shop Open no shop
State of Nature Good Market Bad Market 50000
-20000
35000
-5000
0
0
Decision-Making Environment Decision making under certainty
Decision making under uncertainty
Decision making under risk
Decision maker knows what will happen and straight away makes decision.
Decision maker does not what will happen and does not know the probability of the outcomes.
Decision maker does not know what will happen but knows the probability of the outcomes.
Models for making decision under uncertainty: 1. Maximax 2. Maximin 3. Hurwicz 4. Laplace 5. Minimaxregret
Models for making decision under risk: 1. Expected Monetary Value (EMV) 2. Expected Opportunity Loss (EOL)
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Making Decision From payoff table
For decision making under uncertainty and decision making under risk. Use one of the models: 1. Maximax 2. Maximin 3. Hurwicz 4. Laplace 5. Minimax regret 6. EMV 7. EOL
By using decision tree
For decision making under risk only.
Steps: 1. Draw tree. 2. Write payoff. 3. Identify notations of probability. 4. Assign probabilities. 5. Calculate EMVs. 6.Make decision.
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