Hands-on Labs

In problems involving choices from many alternatives, one must identify all the actions that may be taken and all the states of nature whose occurrence may influence decisions. The action to take none of the listed alternatives whose outcome is known with certainty may also be included in the list of actions. Associated with each action is a list of payoffs. If an action does not involve risk, the payoff will be the same no matter which state of nature occurs.

The payoffs associated with each possible outcome in a decision problem should be listed in a payoff table, defined as a listing, in tabular form, of the value payoffs associated with all possible actions under every state of nature in a decision problem.

The payoff table is usually displayed in grid form, with the states of nature indicated in the columns and the actions in the rows. If the actions are labeled a1, a2, …, an, and the states of nature labeled s1, s2,

…, sk, a payoff table for a decision problem appears as in table 3.2.1 below. Note that a payoff is entered

in each of the nk cells of the payoff table, one for the payoff associated with each action under every possible state of nature.

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Table 3.2.1: The Payoff Table

Example

The managing director of a large manufacturing company is considering three potential locations as sites at which to build a subsidiary plant. To decide which location to select for the subsidiary plant, the managing director will determine the degree to which each location satisfies the company’s objectives of minimising transportation costs, minimising the effect of local taxation, and having access to an ample pool of available semi-skilled workers. Construct a payoff table and payoff measures that effectively rank each potential location according to the degree to which each satisfies the company’s objectives.

Solution

Let the three potential locations be sites A, B, and C. To determine a payoff measure to associate with each of the company’s objectives under each alternative, the managing director subjectively assigns a rating on a 0 – to – 10 scale to measure the degree to which each location satisfies the company’s objectives. For each objective, a 0 rating indicates complete dissatisfaction, while a 10 rating indicates complete dissatisfaction. The results are presented in table 3.2.2 below:

To combine the components of payoff, the managing director asks himself, what are the relative measures of importance of the three company objectives I have considered as components of payoff?

Suppose the managing director decides that minimising transportation costs is most important and twice as important as either the

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minimization of local taxation or the size of workforce available.

He/she thus assigns a weight of 2 to the transportation costs and weights of 1 each to taxation costs and workforce. This will give rise to the following payoff measures:

Payoff (Site A) = 6(2) + 6(1) + 7(1) = 25 Payoff (Site B) = 4(2) + 9(1) + 6(1) = 23 Payoff (Site C) = 10(2) + 5(1) + 4(1) = 29 3.3 SELF-ASSESSMENT EXERCISE

Enumerate the major areas of business decision-making.

How does the study of managerial economics help a business manager in decision-making?

4.0 CONCLUSION

This unit focuses on business decision analysis. The idea is that the most plausible way

of making business decisions is to look at and analyse business opportunities, variables, and challenges. To help you carry out these important tasks, the unit presents important discussions on:

1. Certainty and uncertainty in decision analysis 2. Analysis of decision problems

5.0 SUMMARY

This unit informs you that most decision-making situations involve the choice of one among several alternatives actions. The alternative actions and their corresponding payoffs are usually known to the decision-maker in advance.

When the state if nature, si, whether known or unknown, has no influence on the outcomes of given alternatives, you will say that the decision maker is operating under certainty. Otherwise, he/she is operating under uncertainty. Decision making under certainty appears to be simpler than that under uncertainty. Under certainty, the decision maker simply appraises the outcome of each alternative and selects the one that best meets his/her objective.

In problems involving choices from many alternatives, one must identify all the actions that may be taken and all the states of nature whose

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occurrence may influence decisions. The action to take none of the listed alternatives whose outcome is known with certainty may also be included in the list of actions. Associated with each action is a list of payoffs. If an action does not involve risk, the payoff will be the same no matter which state of nature occurs.

6.0 TUTOR-MARKED ASSIGNMENT

For each of the following business decision-making problems, list the actions available to the decision maker and the states of nature that might result to affect the payoff:

(a) The replacement of manually operated packaging machines by a fully automated machine;

(b) The leasing of a computer by a commercial bank o process checks and handle internal accounting;

(c) The expansion of the market of a brewery from a two-state market to either a four-state market or a seven-state market;

(d) The assignment of seven secretaries to seven executives; and, (e) The investment of a company pension fund.

7.0 REFERENCES/FURTHER READING

Dwivedi, D. N. (2002) Managerial Economics, sixth edition (New Delhi: Vikas Publishing House Ltd).

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UNIT 7: EXPECTED MONETARY VALUE DECISIONS,