PRESENTED BY

DILEEP KUMAR IMB2010032

Contents
Introduction The Six steps in decision theory Types of decision making environments Decision Making under risk Decision making under uncertainty

The game theory

Introduction
To a extent , the success or failure that a person experiences in life depends upon the decision he or she makes. There are several examples we know where good decisions made individual's destiny. A good decision is one that is based on logic, considers all available data and possible alternatives, and applies quantitative approach. Its rare possibility, that a good decision brings unexpected or unfavorable results/outcomes.

Sometimes it happened when you make a bad decision but are lucky to get favorable outcome, it is said that you still make a bad decision.
So, the decision theory is an analytic and systematic way to tackle problems

Game Theory
Introduction Language of games The Minimax Criterion Pure strategy games Mixed strategy games

Dominance

Introduction
History-According the modern history, the game theory dates back to 1944 when John von Neuman and Oscar Morgestern published their book Theory of games and economic behaviour. Since then the game theory has been used by army generals to plan war strategies , union negotiators and managers in collective bargaining and business of all types to determine the best strategies given a competitive business environment. Game theory is one way to consider the impact of strategiesof others on our strategies and outcomes.A game is a contest involving two or more decision makers,each of whom wants to win .It is the study of how optimal strategies are formulated in conflict .

Language of the Game(Payoff Matrix)

There are two stores in the market having different advertising strategies for the two products , the radio spots and the newspaper ads.

Store Xs Payoff Matrix

Game Game Player Ys Strategies

Player Xs
Strategies

Y1(use radio)
X1(Use Radio) 3 X2(Use news papers) 1

Y2(Use newspaper)
5 -2

Game Outcomes
Store Xs Strategy X1(Use radio) X1(Use radio) Store Ys Strategy Y1(Use radio) Y2(use news paper) Outcome(%Change in Market Share) X wins 3 and Y loses 3 X wins 5 and Y loses 5

X2(Use newspaper)
X2(Use newspaper)

Y1(use radio)
Y2(use newspaper)

X wins 1 and Y loses 1

X loses 2 and Y wins 2

The Minimax Criterion

A player using the minimax criterion will select the strategy that minimizes the maximum possible loss.

The upper value of the game is equal to the minimum of the maximum values in the columns.
The lower value of the game is equal to the maximum values in the rows. An equilibrium or saddle point condition exists if the upper value of the game is equal to the lower value of the game. This is called as value of the game.

Pure strategy Games

When saddle point is present, the strategy each player should follow will always be the same regardless of other players strategy. This called as the pure strategy . The saddle point is situation in which both players are facing pure strategies.

Mixed Strategy Games

In a mixed strategy game, each player should optimize the expected gain. When there is no saddle point, players will play each strategy for certain percentage of time. The most common way to solve a mixed strategy game is to use the expected gain or loss approach.

Dominace
The principle of dominance can be used to reduce the size of the games by eliminating strategies that would never be played . A strategy for a player is said to be dominated if the player can always do as well or better playing another strategy Any dominated strategy can eliminated from the game depending on the outcomes.

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.

Case
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.

Step2
The second step is to list the alternative. Thompsons 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 favourable means there is a high demand of the product or it could be unfavourable means that there is low demand of the product. Optimistic decision makers tend to ignore bad outcomes, where as pessimistic managers may discount a favourable outcome. If you dont 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 are known as states of nature.

Step4
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.

Step6 &7
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 invovled. Decision Table with condition values for ThompsonSTATE ALTERNATIVE Construct a large Plant Construct a small Plant OF NATURE UNFAVOURABLE MARKET($) -180,000 -20,000

FAVOURABLE MARKET($) 200,000 100,000

No Plants

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: Lets 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 invest 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 maximum profit.

Decision Making Under Risk

Here the decision Maker knows about the several possible outcomes for each alternative and the probability of occurance of each outcome.

Example : The probability of being dealt a club is .25.The probability of rolling a 5 on die is 1/6.
In the decision making under risk, the decision maker usually attempts to maximize his or her expected well being . Decision theory models for business problems in this in this environment typically employ two equivalent criteria: maximization of expected monetary value and minimization of expected loss. Expected monetary value is the weighted value of possible payoffs for each alternative

Decision Making under Uncertainty

Here there are several outcomes for each alternative, and the decision maker does not know the probabilities occurrences of various outcomes.

Example The probability that a Democrat/Republican will be the President of a country 25 Years from now is not known.
The criteria that is covered in this section as follows: 1- Maximax-This criterion find the alternative that maximizes the maximum payoffs or consequence for every alternative.here we first locate the maximum payoff with every alternative and then pick that alternative with the maximum number.This is also known as optimistic decision criterion. Maximin- This criterion finds the alternative that maximizes the minimum payoff or consequence for every alternative. Here we first locate the minimum outcome within every alternative and then pick that alternative with maximum number. This is called as pessimistic decision criterion.

Contd
Criterion of Realism:Also called as weighted average, is a compromise between an optimistic and a pessimistic decision.Let the coefficient of realism is a selected.The coefficient is between 0 and 1. when a is close to 1, the decision maker is optimistic about the future.When a is close 0 the decision maker is pessimistic.It helps the decision maker to build feelings about relative optimism and pessimism. Weighted average =a(maximum in row)+(1-a)(minimum in row).

Equally likely(Laplace)-one criterion that uses all the payoffs for each alternative is the equally likely also called Laplace decision criterion.This is to find alternative with highest payoff.
Minimax Regret-The final decision criterion that we discuss is based on opportunity loss or regret.

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