rational_decision_making.pdf - Rational Decision Making Franz Eisenf\u00fchr \u2022 Martin Weber Thomas Langer Rational Decision Making ~ Springer Prof Dr

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Unformatted text preview: Rational Decision Making Franz Eisenführ • Martin Weber Thomas Langer Rational Decision Making ~ Springer Prof. Dr. Franz Eisenflihr Franz. Eisen [email protected] Prof. Dr. Thomas Langer University of Münster Finance Center Münster Universitiitsstr. 14-16 48143 Münster [email protected] wiwi.uni-muenster.de Prof. Dr. Dr. h.c. Martin Weber University of Mannheim Lehrstuhl für ABWL, Finanzwirtschaf't, insb. Bankbetriebslehrc L5,2 6813 1 Mannheim Gennany [email protected] bank.bwl.uni-mannheim.de ISBN 978-3-642-02850-2 e-I SBN 978-3-642-02851-9 DOl 10.1007/978-3-642-02851-9 Springer Heidelberg Dordrecht London New York Library of Congrcss Control Numbcr: 2010932032 © Springer-Verlag Berlin Heidelberg 2010 This work is subject to copyright. Ali right s are reserved. whether the wholc or part of the material is concerned. specifically the rightsoftranslation. reprinting. reuseofi !lustrations. recitation , broadcasting. reproduction on microfilm or in any other way. and storage in data banks. Duplication of this publication or parts thereof is permitted only underthe provisions of the German Copyright Law ofSeptember 9, 1965. in its current version , and permission for use must always be obtained from Springer. Violations are liable to prosec ution under the German Copyright Law. The use of general descriptive names. registered names, trademarks , etc. in this publication does not imply, even in the absence of a spec ifie statement. that such names are exempt from the relevant protective laws and regulations and thereforc free for general use. Col'er design: WMXDesign GmbH, Heidelberg, Gennany Printecl on acid-free paper Springer is part of Springer Science+ Business Media (www .springer.com) Preface This book is designed to support you in making difficult decisions in a more rational way. Based on an established theoretical foundation, it shows that simple requirements concerning rational behavior lead to a general calcul us of determining optimal decision alternatives; the book then goes on to present methods and instruments useful for the practical implementation of these concepts. Psychological research has uncovered a multitude of systematic cognitive biases associated with the intuitive decision process, especially concerning the formation of preferences and subjective probability judgments for uncertain events. These developments have elevated prescriptive decision theor·y to the status of an important discipline with increasingly strong practical ties - nowadays, even managers are concerned with decision trees, probability distributions and risk profiles. The re is a Iso a wide range of software av ai table on the market to a id users with the use of the instruments. We would like to convince you, by help of the many practical questions and case studies included with most chapters, that the material covered is not purely an academie di et but a Iso of high practical nutritional value. The mindset suggested by the theory as an approach for decision problems will surely be of much use to you both in your private and professional li fe, even ifyou do not apply the presented methods of decision making support in every little detail. This book is the translation of a German text book released simultaneously in its fifth edition that has established its position as the definitive book on the German market for the topic of "Rational Decision Making" . We hope that this English version will help persuade an even wider readership of the advantages of the modern developments in the area of rational decision making. Completing this book was a long and difficult process, and we would like to thank everyone who contributed; we would especially like to express our gratitude to Dr. Maik Dierkes, Dr. Carsten Erner, Michael Goedde-Menke, Andreas Jacobs, Moritz Lehmensiek-Starke, Sven Nolte, Daniel Smith, Dr. Ulrich Sonnemann, Dr. Dennis Vrecko and Dr. Stefan Zeisberger. A text book is intended to be refined; for this, we are dependent on feedback by the readers, i.e. both the teachers and the students. Please assist us in improving the next edition and provide us with ali of y our suggestions. You may rea ch us at: www .rationalesentscheiden .de Franz Eisenfùhr Martin Weber Thomas Langer Table of contents Chapter 1: What decision analysis is about ........................................................ 1 1.0 Summary ..... ... ................. .. ... ..... ....... .... ..... .. .. .... ......... .... .. .. .... ... .............. 1 1.1 Why is decision making difficult? ................... .... ... ..... ..... ...... ............ ... .. 1 1.2 Basic princip les of decision analysis ......... .... ......... ...... .. ... ....... ..... ... .. ..... 3 1.2.1 Striving for rationality .... .... .. ................................................. .. ....... . 3 1.2 .2 Procedural rationality .. ....... .... .. .... ....................................... ... ... .. .... 5 1.2.3 Consistency of the decision foundation .. .................. ..... .... .............. 6 1.2.4 Decomposition ...... .. ..... .... ..... ..... .. ... ..... ... ... ... .. ... .. ......... ... ... ............. 9 1.2.5 Subjectivity .... ................ ....... .... ... ... ....... .... ....... .... .......... .. ............. 10 1.2.6 lncomplete knowledge and the concept of dominance ........ ... ....... 12 1.3 Applications and practical relevance of decision analysis ..................... 13 Case Study: New business appraisal. ..... ......... .. .......................... ..................... 16 Chapter 2: Structuring the decision problem ................................................... 19 2.0 Summary ................................... ... .......... ....... .... .. ... ........... ......... ........... 19 2.1 The basic structure ....... ............................................. ................. .. .... ...... 20 2.2 The mode ling of alternatives ....... ............................................... .. ........ . 20 2.2 .1 The problem offinding alternatives .............................................. 20 2.2.2 The set of alternatives ........ .... ... ................ .... .... ........... ... .. ......... .... 2 1 2.2.3 One-leve! and multi-level alternatives ......... ... .... ....... ..... ... ... .. .. .. ... 22 2.3 Modeling the states of the world ................. .. ........................ ................ 23 2.3 . 1 Uncertainty and probability ....... .. ............ ... .................. .......... ....... 23 2.3. 2 Combined events or states (scenarios) ... .... .. ... ............. .... .............. 24 2.3 .3 The multiplication rule ............. ... ... .... ... .... .. ... ......... ........ .. ............ 25 2.3.4 Event trees ............. .. ............................ .. ...... ... ....... .............. .. ........ 27 2.3.5 The addition ru le ....... ......... ..................... ... ............... .. .............. .. ... 30 2.3.6 T he cause tree ... ...... ... ....................... .......................... ... ............ .... 30 2.3.7 The dependence ofthe uncertainty mode! on the objectives .... .. ... 32 2.4 The mode ling of conseq uences .... ............ ................ ................. ..... .... .... 33 2.5 The modeling of preferences ..... .... ... ........ ....... .. ... ..... .............. .............. 33 2.5.1 Objectives and preferences ..... .. ... .............. .. ... ..... ... ..... ................. . 33 2.5.2 Conflict of objectives ......................................................... ... ........ 34 2.5 .3 Risk preferences ................................... .. ........... ...... .... ........... ... .... 35 2.5.4 Time preferences .. ....... ...... .................................................. ..... .. .. . 35 2.5.5 Mode ling preferences by functions .............................. ................. 35 2.6 Recursive modeling ...... ........ ......... ... .. .... ....... .. ..... .............. .... .. ............. 36 2.7 Yisualization of decision situations under uncertainty ........... ........ ... .... 38 2. 7.1 Benefits of graphica l representations ...... ....... .... ...... .. .. ... .... ........... 38 2.7.2 The influence diagram ... .... ........ ....... ... .. .... .... ...... .. .... .. ... .. ..... ........ 39 2. 7.3 The decision matrix .... ...... .. ........... .............. .. .... ............................ 44 2. 7.4 The decision tree ........ .. ....................... ......... .. ........ ........ .... ........ .... 45 2. 7.5 Connection between decision ma tri x and decision tree ................. 50 VIII Table of contents Questions and exercises ...................................................................... ............. 51 Case Study 1: Bidding for the "Kuniang" .. ........ ... ......... .............. ....... .... ........ .. 55 Case Study 2: A Scenario analysis about the development of global energy consumption and methods of power generation in the near future ..................... 57 Chapter 3: Generating objectives and hierarchies ........................................... 59 3.0 Summary .......... .. .................................... ..... ......... ..... ...... ... ....... .. ... ....... 59 3.1 The relevance of objectives ..... .................... ... ......... ..... ...... ..... ..... ..... .... 59 3.2 The generation of objectives .................................................................. 60 3.3 Fundamental objectives and means objectives ...................................... 61 3.3.1 Elim ination of means-ends relations ................ .... .......................... 61 3.3 .2 Context-dependence of fundamental objectives ....................... ..... 63 3.4 Requirements for a system of objectives ..................... ... ........... .. ... ....... 65 3.5 Hierarchies of objectives .......................... ......... ........ ............................ 67 3.5.1 Higher-level objectives and lower-level objectives ....................... 67 3.5.2 Top-dawn- and bottom-up-procedure ............................................ 68 3.5.3 Development of a system of objectives ........................................ . 69 3.6 Attributes ............. .......... ... ............................................ ..... .................... 72 3.6.1 Types ofattributes .............................................................. ... ....... . 72 3.6.2 Desirable properties ofattributes ................ ..... ...... ... ......... ..... .... ... 74 3.6.3 Determining suitable attributes ...... .... .......... ...... ... ......................... 76 Questions and exercises ..... ...... .................................... ........ .... .... .................... 77 Case Study: Career Planning Support at ICI.. ............ .. ........ .......... ....... ... ........ 79 Chapter 4: Generating and preselecting alternatives ....................................... 81 4.0 Summary .................. ............................................................................. 81 4.1 The generation of promising alternatives ........... ................................... 81 4.2 Cause-effect analyses .. .. ...................................................... .. ................ 82 4.2.1 Creating alternatives by means of a quantitative impact mode! .... 82 4.2.2 Alternatives as a combination of measures ............... ... .................. 85 4.3 Ideal alternatives .................................................................................... 87 4.4 Context enlargement ............... ........................ ....... ................................ 88 4.5 Decomposition oftasks .................. ..... ................. ... ................. ... .......... 88 4.6 Multi-level alternatives .............................. .......... .... .............................. 90 4.7 Creativity techniques for groups ............ .... ........ ... .......... .. ..................... 92 4.7.1 Brainstorming ................................................................................ 92 4.7.2 Nominal group techniq ue .............................................................. 93 4.8 Preselection of alternatives .................................................................... 93 4.8.1 The need for preselection ............................................................... 93 4.8.2 Restrictions and aspiration levels .................................................. 94 4.8.3 Dominance ........... ............ .......... ................... ................................. 95 Case Study: Mexico City Airport... ................................................................. 101 Table of contents IX Chapter 5: Decision making under certainty with one objective .................. 107 5.0 Summary ........................................................ .......... ........................... 107 5.1 Value function and preference ...... ....................................................... 107 5.2 Methods for determining value functions ............................................ 113 5.2.1 Introduction ... ....................................................... ....................... 113 5.2.2 The direct-rating method ............................................................. 115 5.2.3 The difference standard sequence technique ..... .... ...................... 117 5.2.4 The bisection method ........ ....................... .... ... ............................ 119 5.2.5 Comparison of methods, consistency checks and non-monotonie value functions .................. ....................... .......... 120 5.3 lncomplete information ...... .......... ....... ............................. ................... 122 Questions and exercises ................................................................................. 123 Chapter 6: Decision making under certainty and with multiple objectives: multiattribute value functions .......................................................................... 125 6.0 Summary ........ .................. ................................................................... 125 6.1 Value funct ions for multip le attributes ................................................ 125 6.2 The additive mode! .................................................................. ............ 126 6.3 Requirements for the applicability of the additive mode!. ................... 129 6.4 Determination ofthe weights ................................. ............................. 134 6.4. 1 The attribute value functions in the example "Choosing a job" .. 134 6.4.2 Determination of the weights by use of the trade-off method ..... 135 6.4.3 Determination ofthe weights by use ofthe swing method .......... 139 6.4.4 Determination of the weights by use of the direct-ratio method .. 140 6.4.5 Application of multiple methods and alternative procedures ...... 141 6.5 lncomplete information about the weights .......................................... 142 6.5.1 Hand ling of inconsistent or incomplete information ................... 142 6.5.2 Error minimization .......................................................... ............ 143 6.5.3 Dominance test ............................................................................ 144 6.5.4 Sensitivity analyses of the weights .............................................. 149 The dependence of the weights on the attribute range ......................... !51 6.6 6.7 Cognitive biases in the determination of the weights .......................... 154 6. 7. 1 The range effect .......... .... ............................................................. 154 6. 7.2 The splitting effect... .................................................................... 155 Questions and exercises ................................................................. ... ............. 15 5 Casy Study 1: Safety standards for oil tankers ..................... .... ....... ................ 162 Case Study 2: Choosing and office location through even swaps .. ..... ........... 165 Chapter 7: The generation of probabilities ..................................................... 169 7.0 Summary ............. ... ..... ........................................................................ 169 7.1 lnterpreting probabilities ..... .. .............................................................. 169 The subjectivistic interpretation .................................................. 169 7 .1.1 7 .1.2 The frequentist interpretation .............................. ........................ 170 7 .1.3 The uniform prior interpretation ........................... ....................... 171 7.1.4 Subjective and objective probabilities .......... ............................... 172 X Table of contents 7.2 The need to quantify probabilities ....................................................... 173 7.3 The measurement of subjective probabilities ...................................... 177 7.3.1 Probability and distribution functions .......................................... 177 Measurement methods ................................................................. 180 7.3 .2 7.3.3 Consistency checks and the reduction of error ............................ 186 7.3 .4 The calculation of probabi 1ities ................................................... 187 7.4 Bayes' theorem .................................................................................... 187 7.5 Biases in the generation of subjective probabilities ............................. 193 7.5.1 Introduction ................ .. ............................................................... 193 7.5.2 lncomplete or inappropriate data base ......................................... 194 7.5.3 lnappropriate processing ofprobabilities .................................... 195 7.5.4 lnsufficient critique of one's own j udgment.. .............................. 197 Questions and exercises ................................................................................. 199 Case Study: Immediate appendix surgery? ..................................................... 203 Chapter 8: Simulation of an objective variable's probability distribution .. 205 8.0 Summary ............................................................................................. 205 8.1 Basic princip les of simulation ............................................................. 205 8.2 Interpretation of the simulation results ................................................ 209 8.2.1 Economie interpretation .............................................................. 209 8.2.2 Methodological interpretation ..................................................... 212 8.3 Conducting a simulation ...................................................................... 215 8.3.1 Transformation of a random number into a realization of the causal variable ............................................................................. 215 8.3.2 Flowchart ........................................................ .. ........................... 217 8.3.3 The boomerang example in the continuous case ......................... 217 8.4 Modeling interdependencies between causal variables ....................... 221 8.4.1 Conditional probability distributions ........................................... 221 8.4.2 Accessing causing variables ........................................................ 221 8.4.3 Modeling interdependencies using correlation matrices .............. 222 Questions and excercises ............................................................................... 226 Case Study 1: Bidding for butter ..................................................................... 230 Case Study 2: Portfolio choice ........................................................................ 232 Chapter 9: Decisions un der risk and one objective ........................................ 235 9.0 Summary ................................................................... ....
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