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Methods of Decision Making
Below are some of the most common approaches used by decision-makers (particularly managers):
What is Expected Value in Decision Making?
Expected Value – If there are two possible results, each may have an identifiable probability of occurrence. Likewise, each potential outcome may have an expected value. So, a manager can multiply the probability (let’s say 80% or .80) by the value of the potential outcome (let’s say $2M). The value of this choice is $1.6M ($2M x .80). If the other potential outcome is a 20% likelihood, but the value of this possible outcome is $10M, the expected value is $2M. In summary, an expected value calculation is a valuable approach employed when the level of certainty of multiple options can be estimated. Generally, the manager will make the decision that produces the highest expected value.
What is a Maximax Decision?
Maximal is an approach to a potential decision that attempts to maximize the potential return. If there is more than one potential outcome to a decision and the probability of each occurrence is not predictable or irrelevant to the decision-maker, this approach will simply look at the stated value of the outcome. A maximax approach would take the decision based upon the biggest potential outcome. This choice is generally employed by optimists who go for the highest payout with concern for the probability of occurrence. For example, someone playing the lottery when the payout is at a record high is focusing on the potential reward rather than the probability of winning it.
What is a Maximin Decision?
The maximin approach is when the managers, presented with one of several courses of action, looks at the worst possible result for each course of action. This assumes that there are multiple potential results for each potential choice. The manager chooses the highest payout out of the worst potential outcomes for each choice. This is effectively choosing the best of the worst-case scenario. This is a common course of action for a pessimist – as she assumes the worst outcome will be realized. An example would be a hypothetical investor who is choosing between two or more courses of action. Venture capital investment may have a huge payout or total loss. Stocks may have a good result or equivalent losses. Treasure Bonds will have a low return but will also not lose much money. The maximin approach would choose the bonds, as this is the highest value for the worst possible outcome (an economy where venture capital and stocks perform poorly).
What is a Minimax Decision?
The Minimax approach seeks to minimize the regret they feel for a course of action. To do this, the manager will look at the potential result for multiple courses of action. For example:
- Choice A: 10, 15, 50, 65
- Choice B: 20, 20, 40, 60
- Choice C: 15, 35, 25, 50
This set shows an equal probability for each column. That is, the probability of A: 10, B: 20, and C: 15 is equal.
She will then identify the best outcome in each course of action. In this sequence, it is A: 40, B: 65, C: 60.
Then, she will deduct the best result for each probability from the other probabilities in that column. Thus, there will be a zero and the rest negatives in each column. Here is the payout table:
• Choice A: -10, -20, 0, 0
• Choice B: 0, 15, -10, -5
• Choice C: -5, 0, -25, -15
Now, the manager will want to choose the best option that minimizes her regret. Regret is what she could have received if she made a different choice.
The manager will identify the largest loss under each choice (A: -20, B: -15, C: -25). You then make the choice with the smallest loss of these available choices. Choice B will minimize the potential regret that you have.