Quantitative Methods for

Marketers

Chapter One

Decision making in marketing

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What is Decision making?

Decision making is the process of choosing the

best alternative.
The success or failure that an individual or
organizations experiences, depends to a large
extent on the ability of making appropriate
decision. Making a decision requires an
enumeration of feasible and viable alternatives
(courses of actions or strategies).

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 Decision Theory
Decision theory is a general approach that helps decision
makers make intelligent choices.
Decision theory problems are characterized by the following:
1. Decision alternatives: A list of alternatives.
2. State of Nature: a possible future condition
(consequence or event) resulting from the choice of a
decision alternative
3. Payoffs: a numerical value resulting from each possible
combinations of alternatives and states of nature.
4. Degree of certainty: An assessment of the degree of
certainty of possible future events.
5. A decision criterion.
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 Example
Example 11
Suppose that a farmer must decide on a plan for sowing a
crop on his plot of land. After careful consideration, the
farmer has ruled out “do nothing” and is left with the
following list of acceptable alternatives:
1. sowing wheat
2. sowing barely
3. sowing teff

Suppose that the farmer views the possibilities as

1. Light rain
2. Moderate rain
3. Heavy rain

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Table 1 General Format of a
Decision Table

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Decision Making Environments

• There are three types of decision making

environments:
• Certainty
• uncertainty
• risk

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Decision making under certainty

• In this case the decision maker has the complete

knowledge (perfect information) of
consequence of every decision choice (course
of action or alternative) with in certainty.
Obviously, he will select an alternative that
yields the largest return (payoff) for the
known future (state of nature).

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 Decision making under certainty: Example

What would the farmer sow if he knows for sure that one of
the state of natures will happen?
Light rain: Barley gives maximum result
Moderate Rain: Wheat gives the greatest payoff
Heavy rain: Teff gives the highest return
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 Decision Making under
Complete Uncertainty

In this case the decision maker is unable to

specify the probabilities with which the various
states of nature (futures) will occur. Several
methods/approaches for arriving at an optimal
solution under uncertainty are discussed below:
1. Maximin
2. Maximax.
3. Minimax regret.
4. Hurwicz
5. Equal likelihood Quantitativ
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Maximin Solution for Real Estate
Problem

Maximin: pessimist approach

The maximin strategy is a conservative one; it consists of identifying the
worst (minimum) payoff for each alternative and then selecting the
alternative that has the best (maximum) of the worst payoffs. In effect, the
decision maker is setting a floor for the potential payoff; the actual payoff
cannot be less than this amount.

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Maximax Solution for Real Estate
Problem

Maximax: Optimist approach

The maximax approach is the opposite of the previous one: The best
payoff for each alternative is identified, and the alternative with the
maximum of these is the designated decision.
a. Locate the maximum payoff values corresponding to each alternative (or
course of action), then
b. Select an alternative with best anticipated payoff value (maximum for
profit).

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 Minimax Solution for Real Estate
Problem

Minimax Regret
An approach that takes all payoffs into account. To use this
approach, it is necessary to develop an opportunity loss table
that reflects the difference between each payoff and the best
possible payoff in a column (i.e., given a state of nature).

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Cont’d
• The working method is summarized as follows
• From the given payoff matrix, develop an opportunity
loss (regret) matrix.
• i. find the best payoff corresponding to each state of
nature, and ii. subtract all other entries (payoff values) in
that column from this value
• For each course of action (strategy) identify the worst or
maximum regret value. Record the number as a new
column
• Select the course of action (alternative) with the smallest
anticipated opportunity loss value.

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Opportunity Loss Table for Real
Estate Problem

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Identifying the Minimax Regret
Alternative

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 The Hurwicz (Realism) Criterion (Weighted
Average or Realism Criterion)

The approach offers the decision maker a

compromise between the maximax and the
maximin criteria.
It takes into account the degree or index of
optimism or pessimism of the decision-maker
in the process of decision-making

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Cont’d

• Requires the decision maker to specify a degree

of optimism, in the form of a coefficient of
optimism α, with possible values of α ranging
from 0 to 1.00.
• The closer the selected value of α is to 1.00, the
more optimistic the decision maker is, and the
closer the value of α is to 0, the more
pessimistic the decision maker is.

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Cont’d
• H(criterion of realism)= α(maximum in row) +
(1-α) (minimum in row)
• The working method is summarized as follows:
• Decide the coefficient of optimism α and then
coefficient of pessimism (1-α)
• For each alternative select the largest and
lowest payoff value and multiply these with α
and (1-α) values respectively.
• Select an alternative with best anticipated
weighted average payoff value.
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Example

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Equal Likelihood
(laplace)Criterion
• Assign equal probability value to each state of nature by
using the formula:
1/number of states of nature
• Compare the expected (or average) payoff for each
course of action by adding the payoffs and dividing by
the number of possible states of nature or by applying
the formula: Probability of state of nature j and Pij
payoff value for the combination of alternative and state
of nature j.
• Select the best expected payoff value (maximum for
profit and minimum for cost)

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Equal Likelihood Criterion

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Table 11 Summary of Methods for
Decision Making under Complete
Uncertainty

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Decision Making under Risk
• Decision making under partial uncertainty
• In this case the decision maker has less than complete
knowledge and certainty of the consequence of every decision
choice (course of action).
 Distinguished by the presence of probabilities for the
occurrence of the various states of nature under partial
uncertainty.
 The term risk is often used in conjunction with partial
uncertainty.
• Sources of probabilities
 Subjective estimates
 Expert opinions
 Historical frequencies
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 Expected Monetary Value (EMV)
approach
The expected monetary value (EMV) for a given course of
action is the weighted average payoff, which is the sum of the
payoffs for each course of action multiplied by the
probabilities associated with each state of nature

It provides the decision maker with a value that represents an

average payoff for each alternative. The best alternative is,
then, the one that has the highest expected monetary value.

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Cont’d
• Steps for calculating EMV
a. Construct a payoff matrix listing all possible courses of
action and states of nature. Enter the conditional payoff
values associated with each possible combination of
course of action and state of nature along with the
probabilities of occurrence of each state of nature.
b. Calculate the EMV for each course of action by
multiplying the conditional payoff by the associated
probabilities and add these weighted values for each
course of action.
c. Select the course of action that yields the optimal EMV.

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EMV example

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Other Approaches Incorporating Probabilities in
the Decision Making Process
Expected Opportunity Loss (EOL)
 The opportunity losses for each alternative are
weighted by the probabilities of their respective
states of nature to compute a long-run average
opportunity loss, and the alternative with the
smallest expected loss is selected as the best
choice.

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EOL- example

S1 = .2 S2 = .5 S3 = .3 EOL

A1 1 0 3 1.10
minimum

A2 0 10 5 6.5

A3 6 12 0 7.2

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Expected Value of Perfect
Information (EVPI)

 A measure of the difference between the certain

payoff that could be realized under a condition of
certainty and the expected payoff under a condition
involving risk.

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Expected value of perfect
information (EVPI)

A firm will be willing to pay up to 1.10 for marketing research

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Figure 1 Decision Tree Format
Decision trees are used by decision
makers to obtain a visual portrayal of
decision alternatives and their possible
consequences.

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Cont’d

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Posterior probability and market
test applications
It is the conditional probability of a given event, computed
after observing a second event whose conditional and
unconditional probabilities were known in advance. It is
computed by revising the prior probability, that is, the
probability assigned to the first event before observing the
second event.
•Definition:  Let   A and B  be two events whose prior
probabilities P (A) and   P (B) are known. Assume that also
the conditional probability  is known. By Bayes' rule, we have
that
•P(A/B) = P(A∩B)/P(B)

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Cont’d

• The conditional probability   thus computed is

called posterior probability.
• The intersection of A and B is the event
consisting of the sample space outcomes
belonging to both A and B. The intersection is
denoted by A∩B. Further more, P(A∩B)
denoted the probability that both A and B will
simultaneously occur.

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Cont’d
• Example
• Suppose that an individual is extracted at random from
a population of men. The probability of extracting a
married individual is 50%. The probability of extracting
a childless individual is 40%. The conditional
probability that an individual is childless given that he
is married is equal to 20%. If the individual we extract
at random from the population turns out to be childless,
what is the conditional probability that he is married?
This conditional probability is called posterior
probability and it can be computed by using Bayes' rule
above.

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Cont’d

The quantities involved in the

computation are

The posterior probability is

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Test Market Payoffs variations leading to
different decisions

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 Reliability of Market Test

The reliability of the market test is determined by its degree

of correlation with the actual state of nature.
The value ranges between 0 and 1

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Probability Calculations Given the Market
Test Indicates a Strong Market

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Probability Calculations Given the Market
Test Indicates a Weak Market

Conditional probabilities express the reliability of the

sampling device (e.g., market test) given the condition of
actual market type.

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 The End
Thank You!

Quantitative methods for marketers