Scribd
Upload
18 views23 pages

Chapter III

Uploaded by

tbosorio
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
18 views23 pages

Chapter III

Uploaded by

tbosorio
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 23

CHAPTER III Decision

Analysis
Six Steps in Decision Making
1. Clearly define the problem at hand.
2. List the possible alternatives.
3. Identify the possible outcomes or states of nature
4. List the payoff (typically profit) of each combination of alternatives
and outcomes.
5. Select one of the mathematical decision theory models.
6. Apply the model and make your decision
Types of Decision-Making Environments
The types of decisions people make depend on how much
knowledge or information they have
about the situation. There are three decision-making
environments:
1. Decision making under certainty
2. Decision making under uncertainty
3. Decision making under risk
TYPE 1: Decision Making Under Certainty
In the environment of decision making under
certainty, decision makers know with certainty the
consequence of every alternative or decision choice.
Naturally, they will choose the alternative that will
maximize their well-being or will result in the best
outcome.
TYPE 2: Decision Making Under Uncertainty

In decision making under uncertainty, there are several


possible outcomes for each alternative, and the decision
maker does not know the probabilities of the various
outcomes.
TYPE 3: Decision Making Under Risk
In decision making under risk, there are several
possible outcomes for each alternative, and the
decision maker knows the probability of occurrence
of each outcome.
Decision Analysis
Managers are generally met with uncertainties about the
consequences of their decisions and actions. Usually, a
manager will face multiple options for decision making – the
distinct choices they will make in certain situations. The
difficulty exists since to some degree, the consequences of
these alternative decisions may be unpredictable.
We can decide to introduce a new product but future sales
will be unpredictable or uncertain. We can decide to
investment in the latest machineries and equipment to boost
productivity but the financial benefits would be unclear. New
medical scanning facilities could be introduced by a hospital
but the exact effects on patients would be unknown. In such
situations, a good analysis will include risk assessment
where the risk associated with a decision is the direct output
of the uncertainty surrounding the result from that decision
Decision analysis is a formal approach to
decision making and can be used to determine
optimal strategies in situations where there are
several decision alternatives and where the
outcomes or consequences of these decisions are
uncertain. In decision analysis, models are used to
test the favorability of different outcomes.
One of the most common models being used is
the decision trees because they are simple to
understand and provide valuable insight into a
problem by giving the outcomes, alternatives and
probabilities of various decisions. A decision tree
provides a graphical representation of the
decision-making process.
Decision Trees used 2 types of Nodes

SQUARE- or rectangle node called DECISION NODE from


which decision alternative branches will originate

CIRCLE NODE-called CHANCE NODE, from which state if


nature or outcome branches will emanate.
The chance node is also referred to as an OUTCOME NODE
or EVENT NODE
Problem Formulation
• The first step in the decision analysis process is problem
formulation.

• We begin with a verbal statement of the problem.

• We then identify the decision alternatives, the


uncertain future events, referred to as chance events and
the consequences associated with each decision
alternative and each chance event outcome
Now let’s construct a decision tree for this payoff table

ALTERNATIVES GROWING DECLINING

STOCKS 70 -13
MUTUAL FUNDS 53 -5
BONDS 20 20
PROBABILITY 0.4 0.6
We first draw a decision node with branches coming out of the decision node representing decision
alternatives
Next we draw the chance node or outcome node with respective states of nature or outcomes

• As it can be seen here for stocks.


• The payoffs are placed at the end of the branches
• We do the same for the Mutual Funds and Bonds

• Notice that the payoff is 20 for


bonds irrespective of the state of
nature. Therefore, we really don’t
need to repeat 20, we simply
need to draw a single branch from
Bonds with payoff of 20
• Notice that the payoff is 20 for
bonds irrespective of the state of
nature. Therefore, we really don’t
need to repeat 20, we simply
need to draw a single branch from
Bonds with payoff of 20
• Now let’s solve the decision tree
• Solving the decision tree is also known as folding back the decision tree
• In essence, we are going to calculate the expected values and then choose the best.
• For stocks, the expected value is calculated as

• So we just usually write the 20.2 on the


chance node for stocks
• We do the same for mutual funds. The
expected value is

• We also write that on the chance node for


mutual funds
• For Bonds, no calculation is required, we can only expect a payoff of 20

• Now, comparing the three values; 20.2, 18.2, and 20


• The best expected value is 20.2
• We usually just place that value close to the decision node
• Therefore, the decision is to invest on Stocks.
Problem 2

Your firm is deciding to invest in one of two products A or B.

Product A will cost ₱ 300 to develop and there’s 60% a chance it will generate
₱ 700 and 40% chance that it will loose ₱ 100.

Product B cost ₱ 500 to develop, but has a 70% chance of earning ₱ 900 for the
firm and a 30% chance of losing ₱ 200.

What is the expected monetary value of the two products? Which should your
firm invest in?
References

▪ David, A., Sweeney, D., Williams, T., Wisniewski, M. (2014). An Introduction to Management
Science. Quantitative Approaches to Decision Making.
▪ Render, B., Stair, R., Hanna, M., (2011). Quantitative Analysis in Management

You might also like