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. Quantitativ
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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 S2 = .5 S3 EOL
= .2 = .3
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!

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