Decision Th - DECISION THEORY Session 1 Prof Preetam Basu...

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DECISION THEORY Prof. Preetam Basu IIM Calcutta Session 1
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Introduction What is involved in making a good decision? Decision theory is an analytic and systematic approach to the study of decision making A “good” decision is one that is based on logic, considers all available data and possible alternatives, and uses a quantitative approach
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The 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 of each combination of alternatives and outcomes 5. Select one of the mathematical decision theory models 6. Apply the model and make your decision
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Case: Rao Lumber Company Rao Lumber company is in the lumber business for over 40 years. Management at Rao Lumber is deliberating whether to manufacture and market a new product, backyard sheds. The alternatives are to construct (1) a large new plant, (2) a small plant or (3) no plant at all. There are two possible outcomes: the market for the sheds could be favorable or there could be low demand. The potential profits are as follows: With a favorable market a large facility will result in a net profit of Rs. 200000 whereas if the market is unfavorable there would be a net loss of Rs. 180000. A small plant would result in a net profit of Rs. 100000 in a favorable market but a net loss of Rs. 20000 in a unfavorable market. Doing nothing results in Rs.0 in either market. What should be the decision of Rao Lumber management?
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Rao Lumber Company Step 1 – Define the problem Expand by manufacturing and marketing a new product, backyard storage sheds Step 2 – List alternatives Construct a large new plant A small plant No plant at all Step 3 – Identify possible outcomes The market could be favorable or unfavorable
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Rao Lumber Company Step 4 – List the payoffs Identify conditional values for the profits for large, small, and no plants for the two possible market conditions Step 5 – Select the decision model Depends on the environment and amount of risk and uncertainty Step 6 – Apply the model to the data Solution and analysis used to help the decision making
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Rao Lumber Company STATE OF NATURE ALTERNATIVE FAVORABLE MARKET (Rs) UNFAVORABLE MARKET (Rs) Construct a large plant 200,000 –180,000 Construct a small plant 100,000 –20,000 Do nothing 0 0
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Types of Decision-Making Environments Type 1: Decision making under certainty Decision maker knows with certainty the consequences of every alternative or decision choice Type 2: Decision making under uncertainty The decision maker does not know the chance of occurrence or the probability of the various outcomes Type 3: Decision making under risk The decision maker knows the chance of occurrence or the probability of the various outcomes
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Decision Making Under Uncertainty 1. Maximax (optimistic) 2. Maximin (pessimistic) 3. Criterion of realism (Hurwicz) 4. Minimax regret There are several criteria for making decisions under uncertainty
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Maximax
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