Decision making Lecture 3 Agenda • The decision making process • Define decision and decision-making process. • The manager as decision maker • (full) rationality vs. bounded rationality • decision making styles • Structuring the decision making problem • Methods of decision making • One-time decisions • Sequential decisions Where are we? Decisions in the management functions Decision + decision making process ̶ making a choice from two or more alternatives (= alternative solutions to a problem). ̶ „problem“ = discrepancy between an existing and desired state of affairs. Decision defined Decision making process The rational decision making ̶ Managers make consistent, value-maximizing choices with specified constraints. ̶ Assumptions are that decision makers: Ø Are perfectly rational, fully objective, and logical. Ø Have carefully defined the problem and identified all viable alternatives. Ø Have a clear and specific goal Ø Will select the alternative that maximizes outcomes in the organization’s interests rather than in their personal interests. (Full) Rationality Bounded rationality ̶ Managers make decisions rationally, but are limited (bounded) by their ability to process information. ̶ Assumptions are that decision makers: Ø Will not seek out or have knowledge of all alternatives Ø Will satisfice — choose the first alternative encountered that satisfactorily solves the problem — rather than maximize the outcome of their decision by considering all alternatives and choosing the best. ̶ Influence on decision making Ø Escalation of commitment: an increased commitment to a previous decision despite evidence that it may have been wrong. Intuitive decision making ̶ making decisions based on experience, feelings, and accumulated judgment. Decision making styles ̶ Dimensions ̶ Ways of thinking Rational, orderly, and consistent Intuitive, creative, and unique ̶ Tolerance for ambiguity Low tolerance: require consistency and order High tolerance: multiple thoughts simultaneously ̶ Types of Decision Makers ̶ Directive Use minimal information and consider few alternatives. ̶ Analytic Make careful decisions in unique situations. ̶ Conceptual Maintain a broad outlook and consider many alternatives in making decisions. ̶ Behavioral Avoid conflict by working well with others and being receptive to suggestions. Structured vs. unstructured problems ̶ Structured Problems ̶ Involve goals that clear. ̶ Are familiar (have occurred before). ̶ Are easily and completely defined—information about the problem is available and complete. ̶ Programmed Decision ̶ A repetitive decision that can be handled by a routine approach. ̶ Policy A general guideline for making a decision about a structured problem. ̶ Procedure A series of interrelated steps that a manager can use to respond (applying a policy) to a structured problem. ̶ Rule An explicit statement that limits what a manager or employee can or cannot do. Structured Unstructured ̶ Unstructured Problems ̶ Problems that are new or unusual and for which information is ambiguous or incomplete. ̶ Problems that will require custom-made solutions. ̶ Nonprogrammed Decisions ̶ Decisions that are unique and nonrecurring. ̶ Decisions that generate unique responses. Structuring a problem • List of alternatives = possible decisions • available • mutually exclusive • collectively exhaustive • States of nature = future conditions of events • possible to happen • mutually exclusive • collectively exhaustive • Degree of certainty = the level of knowledge of decision maker about the states of nature. • Decision criterion = a factor relevant in a decision. • Payoffs = the value of decision criterion associated with each decision and state of nature. Characteristics of a DM problem Decision making matrix Decision making conditions ̶ Certainty ̶ A situation in which a manager can make an accurate decision because the outcome of every alternative choice is known. ̶ Risk ̶ A situation in which the manager is able to estimate the likelihood (probability) of outcomes that result from the choice of particular alternatives. ̶ Uncertainty ̶ Limited information prevents estimation of outcome probabilities for alternatives associated with the problem and may force managers to rely on intuition, hunches, and “gut feelings”. Attitude towards risk Methods of decision making ̶ Maximin = conservative strategy - selecting the best alternative of the worst payoffs; - pessimistic view because the decision maker must assume that the worst will occur; - it may be viewed as the protection against the worst, even though you neither expect them nor want them to occur. ̶ Maximax = optimistic strategy - selecting the best alternative of the highest payoffs; - you choose the alternative with the best possible payoff. ̶ Principle of Insufficient Reason - under uncertainty, there is now reason to treat the states of nature differently Þ no reason to focus on high or low payoffs; - alternative states of nature are all equally likely; - selecting the highest row average; Uncertainty Methods of decision making ̶ Expected (monetary) value - takes into account the weighted average payoff for each alternative k EMV[i] =  P[j] * V[ij] i = 0 - selecting maximum average payoff; ̶ Expected value of perfect information - represents an upper bound on the amount of money a decision maker would be justified in spending to obtain perfect information. ̶ EPVI = EPC – EMV ̶ That leads to decision under certainty… Risk Sequential decisions ̶ Oriented chart ̶ Decision trees can be used instead of decision matrix in order to structure the decision problems. ̶ Decision trees are used as a method of portraying these sequential decisions. ̶ decision fork à alternatives ̶ chance fork à states of nature Complex sequential decision (example) Must know - keywords ̶ decision ̶ decision-making process ̶ problem ̶ decision criteria ̶ state of nature ̶ payoff ̶ risk ̶ uncertainty ̶ decision style ̶ (bounded) rationality ̶ satisficing ̶ attitude towards risk ̶ mini-max ̶ maxi-max ̶ expected value ̶ decision tree ̶ decision matrix