Decision Making Conditions:

Decision making involves selection of alternative out of the several available. Many such alternatives involve future events that are difficult to predict like: Competitors reaction to a new price list Interest rates in next few years Reliability of a new supplier

Continuum of Decision Making Conditions:

1) CERTAINTY (Highly Predictable) 2) RISK 3) UNCERTAINTY (Highly Unpredictable)
CERTAINTY RISK UNCERTAINTY

HIGH

MANAGERIAL CONTROL

LOW

Certainty:
Under conditions of certainty, we know our objective and have accurate, measurable and reliable information about the outcome of each alternative we are considering. Here the cause and effect relationships are known to managers. Eg:- Investing money in Fixed Deposit in Public Sector Bank. But if the same money is invested in Share Market one moves from conditions of certainty to conditions of risk or uncertainty.

Risk:
It occurs whenever we cannot predict an alternatives outcome with certainty, but we do have enough information to predict the probability it will lead to the desired state. To improve decision making, we may estimate the objective probabilities of an outcome by using Mathematical models. We can also use subjective probability based on judgement and experience. Eg:-Merger of Bank of America and Security Pacific in 1992.

Concept of Probability:
It is a numerical measure of the likelihood of an occurance of an uncertain event. Eg:-Experiment consists of selecting three items from a manufacturers output and observing whether or not each item is defective. Call Defective = D and non-defective = G. S = Sample space = {DDD, DDG, DGD, GDD, DGG, GDG, GGD, GGG} Total no. of elements = 23 = 8 Suppose all are equally probable; then probability of each simple event = 1/8

Uncertainty:
Under conditions of uncertainty, little is known about the alternatives and their outcomes. Since managers have a very meagre database, they do not know whether or not the data are reliable and they are very unsure about whether or not the situation may change. Moreover they cannot evaluate the interactions of the different variables. Eg:-A Corporation that decides to expand its operation in a new country may know little about the countrys culture, laws, economics, environment and politics. The political situation may be so volatile that even the experts cannot predict a possible change in Government.

Modern Approaches to Decision Making Under Uncertainty:

1) Risk Analysis 2) Decision Trees 3) Preference or Utility Theory

Risk Analysis:
Every decision is based on the interaction of a number of important variables, many of which have an element of uncertainty but, perhaps, a fairly high degree of probability. Eg:-The wisdom of launching a new product might depend on a number of critical variables: the cost of introducing the product, the cost of producing it, the capital investment that will be required, the price that can be set for the product, the size of the potential market and the share of the total market that it will represent.

Let us see the prospective for investment in a new product :

Rate of Return %
0 10 15 20 25 30 35 40

.90 Probability of achieving at least this rate

.80

.70

.65

.60

.50

.40

.30

Decision Trees:
Decision Trees depict, in the form of a tree, the decision points, chance events and probabilities involved in various courses that might be undertaken. Eg:-A common problem occurs in business when a new product is introduced. Managers must decide whether to install expensive permanent equipment to ensure production at the lowest possible cost or to undertake cheaper temporary tooling that will involve higher manufacturing cost but lower capital investments and will result in smaller losses if the product does not sell as well as estimated.

Utility Theory:
In decision making under uncertainty, a decision d may lead to several levels of wealth: w1, w2, , wk, with corresponding probs. p1, p2, , pk, total prob.=sum(pi) = 1. Wealth is usually transformed into consumption, and hence utility (for example, in a business decision, it may be profit of the company) Utility function over wealth: u(w) Different levels of utility: u(w1), u(w2),.., u(wk) These are random quantities, with respective probalilities p1, p2, , pk.

Expected Utility of a decision d: E(u(d)) = average of these utilities = u(w1).p1 + u(w2).p2 + + u(wk).pk

An optimal decision d depends on: a) Optimization of expected utility b) Choice of the utility function u(w)

Application:
Example(Dilemma of a Contractor) A contractor has to choose one of the two contracting jobs: both having chances of labour problems (say, strike). Profit possibilities: Job1: 10K if no strike, 2K if strike Job 2: 20K if no strike, 0.5K if strike Chance of strike: P(strike in Job 1) = ; P(no strike) = P(strike in Job 2) = ; P(no strike) =

No strike Job 1 Job 2 10,000 20,000

Strike 2,000 500

Expected Profit from Job 1 = (10000)(3/4) + (2000)(1/4) = 8,000 Expected Profit from Job 2 = (20000)(1/2) + (500)(1/2) = 10,250 Want to maximize your profit ? Choose Job 2 !

Any other consideration for his choice?

What if he is a born pessimist? Expects the worst: there will be a strike! Choose Job 1: it maximizes his minimum profit.

What if he is an optimist? Expects no strike or neglects the chance of it Choose Job 2: it may give him 20,000

Violations of the expected utility theory:

Lotteries and Gambling If by paying a small amount one has a chance of winning a large amount, individuals often ignore the negative expected payoff, as the loss is small. BUT If potential loss is larger, the same individual may choose very differently preference reversal in decision making

All the very best for taking right decisions, ALWAYS !

Thank You.