Strategic Decision Making
Individual Decision Making
Lecture 1: The basic elements of SDM
Basic terminology
Decision making
- Decision making = The process (not decision as such) of selecting an alternative from a set of
mutually exclusive alternatives.
- Focus on throughput = structuring of DM process, what happens between input and output
Strategic decision making
- Decisions that relate to the overall long-term strategy of an organization, in relation to its
external environment, which therefore always entail risk and/or uncertainty.
- Consequences of the alternative(s) you choose, depend(s) on the choices made by others.
Becomes strategic when other people are involved. Others’ choices affect my choice.
Rational decision making
- Rational: Selecting what is best (using your reason)
- ‘Best’ requires preferences (over outcomes) prefer one outcome over the other, what do
you prefer more than the other.
- For determining, preferences we need to attach value(s) to things. Without value, you don’t
know what you prefer, and what you prefer more than other things.
- Rational DM: Selecting a best alternative from a set of mutually exclusive alternatives
Example: What do you search for in your (professional) life?
- Money
- Social standing
- Free time
Values (it is not a preference over an outcome; you value money, not prefer)
What profession would you choose?
- Banking
- Science
- Engineering
Depends on what you prefer more (money, social standing, free time)
What constitutes a best choice? To help identify answers Decision Theory
,Decision theory
Theory = A coherent set of propositions/statements that serve to describe and explain a particular
phenomenon (here decision-making).
- Propositions serve to establish the connections between the central elements in the theory
(terms, concepts, variables) (e.g. time, power, voting rules)
- Main requirements:
o Internal consistency
o External (empirical) correspondence
o Parsimony (‘Ockham’s razor’)
Theory Hypothesis: A conjecture derived from a theory, that can be tested by means of empirical
research. Examples:
- The more time decision makers take to discuss a decision, the less they will feel/claim
individual ownership of that decision
- If a decisions are taken by majority voting, then they will not be properly implemented
What decision theory IS NOT:
- Law: An empirical pattern of a deterministic nature. Things that are true all the time.
o More time for discussion will (always) result in better decisions
- Pattern or regularity: An empirical pattern of a probabilistic nature. Things that happen most
of the time.
o There is a strong (cor)relation between having a clear hierarchy in the decision-
making process and taking a good decision
What we DO HAVE Model: A simplified (visual/verbal) reproduction of specific connections
between elements/variables (how). Example
What is decision theory? 3 approaches
- Positive/descriptive decision theory: Study of how real decision makers (people) actually do
take decisions: behavioral models. How do they actually behave?
o Prospect Theory
Normative decision theory: Study of how decision makers should (ought to) take decisions
(based on certain normative standards, equality, justice, fairness)
- Prescriptive/Facilitated decision theory: Study of how decision making could take (better)
decisions (based on frameworks of optimality, efficiency, inclusiveness, satisficing). How to
make the process better.
,Decision theory
- Set of universal propositions/statements applies to any type of decisions, which are true
anywhere/anytime.
o Propositions: universal statements, using primitive and defined terms, that can be
true or not true.
o Three types of statements
Primitive statements (axioms, assumptions, postulates) are propositions
which are plausible a priori or evidently true.
Derived statements are propositions that are deduced from primitive
statements or earlier derived statements, using the rules of logic
Empirical statements = hypotheses are propositions that are true or not true
on the basis of empirical evidence
- Formal theory (build up as axiomatic system from which to derive theorems)
o Theorem = general proposition that is not self-evident. We can test empirically
whether they are (not) true.
Two components of rationality
1. Behavioral component: the act of selecting a best alternative
2. Latent component: based on a preference. Preference itself is hidden (cannot be directly
observed).
a. Preference becomes apparent in our choices/actions (revealed preference = position
on an issue)
Types of decision-making problems
- Decision making under certainty: the outcome is known for every alternative. The
consequences of every alternative are known a priori
- Decision making under risk: there are multiple outcomes for (some of) the alternatives. The
probabilities for arriving at each of these outcomes are known/can be calculated (%).
- Decision making under uncertainty: there are multiple outcomes for (some of) the
alternatives. The probabilities for arriving at each of these outcomes are not know/cannot be
calculated (with certainty).
- Decision making under structural ignorance: (some of the) outcomes for alternatives are
unknown. We don’t even know the consequences, let alone the probability distribution of
these outcomes
Decision making under certainty
- Career example
o Set of options {banking, science, engineering}
o Choice function C({banking, science, engineering}) = {science}
- Suppose this person is told that he is not smart enough to be an engineer. He now thinks: ‘if I
cannot be smart, then let me be rich’. What happens to choice function?
o Set of options {banking, science}
o Choice function C({banking, science}) = {banking}
Problem: Science was best option in first choice, but not the best in the second = preference reversal.
, Choice behavior as described by C({x, y}) = {x} and C({x, y, z}) = {y} is inconsistent:
- The first choice reveals that x is strictly preferred to y or that x is more valued than y (this
should be so at all time), the second choice reveals that y is strictly preferred to x or that y is
more valued than x.
- A third option z reverses the preference for the pair of alternatives x and y.
In DT we call this a violation of the condition of Independency of Irrelevant Alternatives (IIA).
Characterizing DM situations:
- A decision problem: a set of mutually exclusive alternatives, denoted by X
- Existence preferences: each decision maker has preferences, denoted by R.
Notation:
- Alternatives: x, y, ... or x1, x2, xn
- xRy → x is at least as good as y
- xPy → x is strictly preferred to y
- xIy → x and y are indifferent i.e. xRy and yRx.
Definition: 𝑥 is best in a set of alternatives 𝑋 if 𝑥 is at least as good as every other alternative 𝑦 𝑖𝑛 𝑆.
- 𝑥 𝑖𝑠 𝑏𝑒𝑠𝑡 = ∀ 𝑥,𝑦 ∈ 𝑋: 𝑥𝑅𝑦
Back to career example: Our subject cannot handle the cognitive complexity of choosing between
three alternatives. Which makes him perfectly suitable for a career in middle management.
He decides to deal with the decision problem as a series of binary choices:
- Choice function C({banking, science}) = {science}
- Choice function C({banking, management}) = {banking}
- Choice function C({management, science}) = {management}
Problem: depends on where you start, this is not the best not transitive
General notation:
- {𝑥} = 𝐶({𝑥, 𝑦}) reveals 𝑥 is strictly preferred to 𝑦 or 𝑥𝑃𝑦.
- {𝑦} = 𝐶({𝑦, 𝑧}) reveals 𝑦 is strictly preferred to 𝑧 or 𝑦𝑃𝑧
- {𝑧} = 𝐶({𝑥, 𝑧}) reveals 𝑧 is strictly preferred to 𝑥 or 𝑧𝑃𝑥.
- Hence, 𝑥𝑃𝑦, 𝑦𝑃𝑧, 𝑎𝑛𝑑 𝑧𝑃𝑥. This is a cyclical preference. We say that the preference of this
DM is not transitive.
- In this case, the decision maker cannot value her decision.
- Preferences are needed to measure values. Transitivity of preferences is a necessary
requirement for the existence of a value (or utility) scale.
Extending our model of decision making under certainty. Each decision maker has a preference 𝑅
satisfying:
- Axiom1. Completeness: ∀𝑥, 𝑦 ∈𝑋 :𝑥𝑅𝑦 𝑜𝑟 𝑦𝑅𝑥.
- Axiom 2. Transitivity: ∀𝑥, 𝑦, 𝑧 ∈𝑋 :𝑖𝑓 𝑥𝑅𝑦 𝑎𝑛𝑑 𝑦𝑅𝑧, 𝑡ℎ𝑒𝑛 𝑥𝑅𝑧.
Individual Decision Making
Lecture 1: The basic elements of SDM
Basic terminology
Decision making
- Decision making = The process (not decision as such) of selecting an alternative from a set of
mutually exclusive alternatives.
- Focus on throughput = structuring of DM process, what happens between input and output
Strategic decision making
- Decisions that relate to the overall long-term strategy of an organization, in relation to its
external environment, which therefore always entail risk and/or uncertainty.
- Consequences of the alternative(s) you choose, depend(s) on the choices made by others.
Becomes strategic when other people are involved. Others’ choices affect my choice.
Rational decision making
- Rational: Selecting what is best (using your reason)
- ‘Best’ requires preferences (over outcomes) prefer one outcome over the other, what do
you prefer more than the other.
- For determining, preferences we need to attach value(s) to things. Without value, you don’t
know what you prefer, and what you prefer more than other things.
- Rational DM: Selecting a best alternative from a set of mutually exclusive alternatives
Example: What do you search for in your (professional) life?
- Money
- Social standing
- Free time
Values (it is not a preference over an outcome; you value money, not prefer)
What profession would you choose?
- Banking
- Science
- Engineering
Depends on what you prefer more (money, social standing, free time)
What constitutes a best choice? To help identify answers Decision Theory
,Decision theory
Theory = A coherent set of propositions/statements that serve to describe and explain a particular
phenomenon (here decision-making).
- Propositions serve to establish the connections between the central elements in the theory
(terms, concepts, variables) (e.g. time, power, voting rules)
- Main requirements:
o Internal consistency
o External (empirical) correspondence
o Parsimony (‘Ockham’s razor’)
Theory Hypothesis: A conjecture derived from a theory, that can be tested by means of empirical
research. Examples:
- The more time decision makers take to discuss a decision, the less they will feel/claim
individual ownership of that decision
- If a decisions are taken by majority voting, then they will not be properly implemented
What decision theory IS NOT:
- Law: An empirical pattern of a deterministic nature. Things that are true all the time.
o More time for discussion will (always) result in better decisions
- Pattern or regularity: An empirical pattern of a probabilistic nature. Things that happen most
of the time.
o There is a strong (cor)relation between having a clear hierarchy in the decision-
making process and taking a good decision
What we DO HAVE Model: A simplified (visual/verbal) reproduction of specific connections
between elements/variables (how). Example
What is decision theory? 3 approaches
- Positive/descriptive decision theory: Study of how real decision makers (people) actually do
take decisions: behavioral models. How do they actually behave?
o Prospect Theory
Normative decision theory: Study of how decision makers should (ought to) take decisions
(based on certain normative standards, equality, justice, fairness)
- Prescriptive/Facilitated decision theory: Study of how decision making could take (better)
decisions (based on frameworks of optimality, efficiency, inclusiveness, satisficing). How to
make the process better.
,Decision theory
- Set of universal propositions/statements applies to any type of decisions, which are true
anywhere/anytime.
o Propositions: universal statements, using primitive and defined terms, that can be
true or not true.
o Three types of statements
Primitive statements (axioms, assumptions, postulates) are propositions
which are plausible a priori or evidently true.
Derived statements are propositions that are deduced from primitive
statements or earlier derived statements, using the rules of logic
Empirical statements = hypotheses are propositions that are true or not true
on the basis of empirical evidence
- Formal theory (build up as axiomatic system from which to derive theorems)
o Theorem = general proposition that is not self-evident. We can test empirically
whether they are (not) true.
Two components of rationality
1. Behavioral component: the act of selecting a best alternative
2. Latent component: based on a preference. Preference itself is hidden (cannot be directly
observed).
a. Preference becomes apparent in our choices/actions (revealed preference = position
on an issue)
Types of decision-making problems
- Decision making under certainty: the outcome is known for every alternative. The
consequences of every alternative are known a priori
- Decision making under risk: there are multiple outcomes for (some of) the alternatives. The
probabilities for arriving at each of these outcomes are known/can be calculated (%).
- Decision making under uncertainty: there are multiple outcomes for (some of) the
alternatives. The probabilities for arriving at each of these outcomes are not know/cannot be
calculated (with certainty).
- Decision making under structural ignorance: (some of the) outcomes for alternatives are
unknown. We don’t even know the consequences, let alone the probability distribution of
these outcomes
Decision making under certainty
- Career example
o Set of options {banking, science, engineering}
o Choice function C({banking, science, engineering}) = {science}
- Suppose this person is told that he is not smart enough to be an engineer. He now thinks: ‘if I
cannot be smart, then let me be rich’. What happens to choice function?
o Set of options {banking, science}
o Choice function C({banking, science}) = {banking}
Problem: Science was best option in first choice, but not the best in the second = preference reversal.
, Choice behavior as described by C({x, y}) = {x} and C({x, y, z}) = {y} is inconsistent:
- The first choice reveals that x is strictly preferred to y or that x is more valued than y (this
should be so at all time), the second choice reveals that y is strictly preferred to x or that y is
more valued than x.
- A third option z reverses the preference for the pair of alternatives x and y.
In DT we call this a violation of the condition of Independency of Irrelevant Alternatives (IIA).
Characterizing DM situations:
- A decision problem: a set of mutually exclusive alternatives, denoted by X
- Existence preferences: each decision maker has preferences, denoted by R.
Notation:
- Alternatives: x, y, ... or x1, x2, xn
- xRy → x is at least as good as y
- xPy → x is strictly preferred to y
- xIy → x and y are indifferent i.e. xRy and yRx.
Definition: 𝑥 is best in a set of alternatives 𝑋 if 𝑥 is at least as good as every other alternative 𝑦 𝑖𝑛 𝑆.
- 𝑥 𝑖𝑠 𝑏𝑒𝑠𝑡 = ∀ 𝑥,𝑦 ∈ 𝑋: 𝑥𝑅𝑦
Back to career example: Our subject cannot handle the cognitive complexity of choosing between
three alternatives. Which makes him perfectly suitable for a career in middle management.
He decides to deal with the decision problem as a series of binary choices:
- Choice function C({banking, science}) = {science}
- Choice function C({banking, management}) = {banking}
- Choice function C({management, science}) = {management}
Problem: depends on where you start, this is not the best not transitive
General notation:
- {𝑥} = 𝐶({𝑥, 𝑦}) reveals 𝑥 is strictly preferred to 𝑦 or 𝑥𝑃𝑦.
- {𝑦} = 𝐶({𝑦, 𝑧}) reveals 𝑦 is strictly preferred to 𝑧 or 𝑦𝑃𝑧
- {𝑧} = 𝐶({𝑥, 𝑧}) reveals 𝑧 is strictly preferred to 𝑥 or 𝑧𝑃𝑥.
- Hence, 𝑥𝑃𝑦, 𝑦𝑃𝑧, 𝑎𝑛𝑑 𝑧𝑃𝑥. This is a cyclical preference. We say that the preference of this
DM is not transitive.
- In this case, the decision maker cannot value her decision.
- Preferences are needed to measure values. Transitivity of preferences is a necessary
requirement for the existence of a value (or utility) scale.
Extending our model of decision making under certainty. Each decision maker has a preference 𝑅
satisfying:
- Axiom1. Completeness: ∀𝑥, 𝑦 ∈𝑋 :𝑥𝑅𝑦 𝑜𝑟 𝑦𝑅𝑥.
- Axiom 2. Transitivity: ∀𝑥, 𝑦, 𝑧 ∈𝑋 :𝑖𝑓 𝑥𝑅𝑦 𝑎𝑛𝑑 𝑦𝑅𝑧, 𝑡ℎ𝑒𝑛 𝑥𝑅𝑧.
