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STEPS TO GOOD DECISION-MAKING

1. Define problem and influencing factor.


2. Establish decision criteria.
3. Select decision making tool (model)
4. Identify and Evaluate alternatives using
decision-making tool (model).
5. Select best alternative.
6. Implement decision.
7. Evaluate outcome.
Decision Making Under Uncertainty
The outcome of a decision alternative is not known, and even its
probability is not known.
Parameters are estimated with certainty.
Outcome – known
Termed as DETERMINISTIC ANALYSIS
Few criteria (approaches) are available for the decision makers
to select according their preferences.
SOURCES OF UNCERTAINTIES

DEMAND
STRUCTURE

EXTERNALITIES COMPETITORS

UNCERTAINTY

INTERNAL
FORCES SUPPLY
STRUCTURE

TIME
METHODS: Decision-Making
Under UNCERTAINTY
1. Maximax Criterion
2. Maximin Criterion
3. Hurwicz alpha Criterion (Rationality or
Realism)
4. Laplace Criterion (Equally Likelihood)
5. Minimax Criterion
CRITERION 1: MAXIMAX (Optimistic)

• An adventurous and aggressive decision maker may choose to act that


would result in the maximum payoff possible.

Step 1. Pick maximum payoff of each alternative.


Step 2. Pick the maximum of those maximums in Step 1;
its corresponding alternative is the decision.
This is viewed as an optimistic approach, “Best of best”
CRITERION 1: MAXIMAX Maximizes the maximum payoff “Best of Best”

State of Nature or Outcomes

Payoff Table: ECONOMY


Alternatives Growing Stable Declining
Best
Bonds 41 46 5
46
Stocks 72 29 -12
72
Mutual Funds 54 50 -8 54

Decision Alternatives
*Payoffs in PROFIT
CRITERION 2: MAXIMIN (Pessimistic)

• This is called Waldian Criterion. This criterion of decision making


stands for choice between alternative courses of action assuming
pessimistic view of nature.

Step 1. Pick minimum payoff of each alternative.


Step 2. Pick the maximum of those minimums in Step 1;
its corresponding alternative is the decision.
This is viewed as an pessimistic approach, “Best of the worst”
CRITERION 2: MAXIMIN
Maximizes the minimum payoff “Best of Worst”

Payoff Table:
ECONOMY
Alternatives GROWING STABLE DECLINING
Worst
Bonds 41 46 5
5
Stocks 72 29 -12
-12
Mutual Funds 54 50 -8 -8

*Payoff is in PROFIT
CRITERION 3: HURWICZ (Realism)

• This method is the combination of Maximum and Minimax criterion.


Also known as criterion of rationality. This is neither too optimistic
or too pessimistic.

Step 1. Calculate Hurwicz value for each alternative.


Step 2. Pick the alternative of largest Hurwicz value as the decision.
CRITERION 3: HURWICZ (Realism)

Choose the best weighted average payoff based on a


𝛼coefficient = OPTIMISM
Close to of1 realism 𝛼, 0 ≤ 𝛼 ≤ 1
𝛼 Close to 0 = PESSIMISM
Alternatives GROWING STABLE DECLINING

Bonds 41 46 5

Stocks 72 29 -12

Mutual Funds 54 50 -8

𝛼 (best payoff) + (1- 𝛼) (worst payoff)


CRITERION 3: HURWICZ (Realism)

𝛼 = 0.3 1- 𝛼 = 0.7

Alternatives GROWING STABLE DECLINING Weighted Average


Bonds 41 46 5 .3(46) + .7(5) = 17.3
BEST WORST

Stocks 72 29 -12 .3(72) + .7(-12) = 13.2


BEST WORST

Mutual Funds 54 50 -8 .3(54) + .7(-8) = 10.6


BEST WORST

𝛼 (best payoff) + (1- 𝛼) (worst payoff)


CRITERION 4: Equally Likely
• The decision maker makes a simple assumption that each state of
nature is equally likely to occur and compute average payoff for each.
Choose decision with the average payoff.
• Also known as LAPLACE Criterion.

Step 1. Calculate the average payoff of each alternative.


Step 2. The alternative with the highest average is the decision.
CRITERION 4: Equally Likely (LAPLACE)
Maximizes the average payoff “Best of Average”

Payoff Table: ECONOMY


Alternatives GROWING STABLE DECLINING
Average Payoff
Bonds 41 46 5

Payoff1 + Payoff2 + Payoff3


Stocks 72 29 -12 =
3

Mutual Funds 54 50 -8

*Payoff is in PROFIT
CRITERION 4: Equally Likely (LAPLACE)
Maximizes the average payoff “Best of Average”
ECONOMY
Alternatives GROWING STABLE DECLINING Average
Bonds 41 46 5 (41+46+5) /3 = 30.7

Stocks 72 29 -12 (72+29-12)/3 = 29.7

Mutual Funds 54 50 -8 (54+45-8) /3 = 32


CRITERION 5: Minimax Regret
• Application of Minimax criterion requires a table of losses or table of
regret instead of gains.

• Regret = Opportunity Cost = Opportunity Loss

Step 1. Construct a “regret table”


Step 2. Pick a maximum regret of each row in regret table.
Step 3. Pick minimum of those maximums in Step 2, its corresponding
alternative is the decision.
CRITERION 5: Regret Approach

Regret Table:
ECONOMY
Alternatives GROWING STABLE DECLINING

Bonds 50 55 5

Stocks 80 40 -18

Mutual Funds 63 45 -10

Regret = Opportunity Loss

*Payoff in PROFIT
CRITERION 5: Regret Approach

Regret Table:
ECONOMY
Alternatives GROWING STABLE DECLINING

Bonds 50 55 5

Stocks 80 40 -18

Mutual Funds 63 45 -10

Regret = Best of Payoff – Payoff Received

*Payoff in PROFIT
CRITERION 5: Regret Approach

Regret Table: ECONOMY


GROWING STABLE DECLINING
Alternatives

80 – 50 = 30 55 – 55 = 0 5–5=0
Bonds 50 55 5

80 – 80 = 0 55 – 40 = 15 5 – (-18) = 23
Stocks 80 40 -18

80 – 63 = 17 55 – 45 = 10 5 – (-10) = 15
Mutual Funds 63 45 -10
CRITERION 5: Regret Approach

Regret Table ECONOMY


Alternatives GROWING STABLE DECLINING Maximum
Bonds 50 55 5 30

Stocks 80 40 -18 23

Mutual Funds 63 45 -10 17

*Payoff in PROFIT