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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”

## 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

BEST WORST

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

## 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

## 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

## 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

## 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