The Six Steps in Decision Theory
* Clearly define the problem at hand.
* List the possible alternatives.
* Identify the possible outcomes or states of nature.
* List the payoff or profit of each combination of alternatives and outcomes. * Select one of the mathematical decision theory models.
* Apply the model and make your decision.
Here we use the Thompson Lumber Company case as an example to illustrate these decision theory steps. John Thompson is the founder and president of Thompson Lumber Company, a profitable firm located in Portland, Oregon. Step 1
The problem that John Thompson identifies is whether to expand his product line by manufacturing and marketing a new product, backyard storage sheds. Step 2
* The second step is to list the alternative.
* Thompson’s second step is to generate alternatives that are available to him .In decision theory the alternative is a course of action or strategy that the decision maker can choose .According to him his alternatives are to construct: 1• a large new plant to manufacture the storage sheds 2• a small plant, or
3• no plant at all
* So, the decision makers should try to make all possible alternatives ,on some occasion even the least important alternative might turn out to be the best choice. Step 3
* Third step is to identify possible outcomes.
* The criteria for action are established at this time. According to Thompson there are two possible outcomes: the market for the storage sheds could be favorable means there is a high demand of the product or it could be unfavorable means that there is low demand of the product. * Optimistic decision makers tend to ignore bad outcomes; where as pessimistic managers may discount a favorable outcome. If you don’t consider all possibilities, it will be difficult to make a logical decision, and the result may be undesirable. * There may be some outcomes over which the decision maker has little or no control is known as states of nature. Step 4
* Fourth step is to list payoffs.
* This step is to list payoff resulting from each possible combination of alternatives and outcomes. Because in this case he wants to maximize his profits, he use profits to evaluate each consequences .Not every decision, of course, can be based on money alone – any appropriate means of measuring benefit is acceptable. In decision theory we call such payoff or profits conditional values. Step 5 & 6
* The last two steps are to select and apply the decision theory model. * Apply it to the data to help make the decision. Selecting the model depends on the environment in which you are operating and the amount of risk and uncertainty involved. * Decision Table with condition values for Thompson
| STATE OF | NATURE |
ALTERNATIVE | FAVOURABLE MARKET($) | UNFAVOURABLE MARKET($) | Construct a large Plant | 200,000 | -180,000 |
Construct a small Plant | 100,000 | -20,000 |
No Plants | 0 | 0 |
TYPES OF DECISION MAKING ENVIRONMENTS
* The types of decisions people make depends on how much knowledge or information they have about the situation. There are three kind of decision making environments: * Decision making under certainty.
* Decision making under risk.
* Decision making under uncertainty.
Decision Making Under Certainty
* Here the decision makers know about the certainty of consequences every alternative or decision choice has. * Naturally they will choose the alternative that will result in the best outcome. * Example: Let’s say that you have $10000 to invest for a period of one year. And you have two alternatives either to open a savings account paying 6% interest and another is investing in Govt. Treasury Bond paying 10% interest. If both the investments are secure and guaranteed, the best alternative is to choose the second investment option to gain...