Standard Decision Theory
Decision theory has analytical techniques which vary in their degree of formality. They are designed to aid decision maker in the selection of the best alternative depending with their outcome. When making decisions under risk, each alternative has its consequence and the probability for each consequence is known in advance. This shows that each alternative must be associated with some probability distribution (Noone, 2002). In decision theory, a decision maker recognizes a ranking that is consistent with his goals and preferences.
Decision theories have a mathematical way of explaining the decision making process though they can broadly be broken down into normative and descriptive theories. Normative and descriptive theory differs in principle. In that, normative decision theory is much concerned with how rational decisions should be made while descriptive theories are concerned with the actual decision making process. In most readings, the distinction between the normative and descriptive theories are often blurred hence it is not easy draw a line separating the two.
However, slight differences can be drawn by considering what is referred to as the falsification of the decision theory. For instance, a decision theory is said to be a falsified descriptive theory if there exists a decision problem in which humans acts in contradiction with the theory. That is, there exists a conflict between the rational decision making and the theory. Also, a decision theory is classified as weakly falsified normative theory if there exists a decision problem in which an agent acts on the contrary with the theory but still maintains rationality. A decision theory is further classified as a strictly falsified normative theory if there exists a decision problem in which an agent who acts in accordance to it will be considered to be irrational.
Under conditions of risk, decision theory is best explained by the concept of utility. The term utility is used in economics to mean the ability of a good or a service to gratify the human wants. The term is used in decision theory to refer to the measure of desirability of the consequence that arises from a particular action. This is mainly applicable under risk. Utility is applicable to both single attribute and the multi attribute consequences (Douglas, 1992). Utility theory assumes that the decision maker chooses the alternative with the highest expected value of utility.
In light of this, it is worth mentioning that decision theory stipulates that good decisions are those that maximize on the expected utility. This is however developed through a number of stages. First, decision theory presumes that there is an association between a set of outcomes associated with a particular action. However, the theory does not depict the nature of outcomes since it does not give a time frame for the outcomes. This task is left in the hands of the decision maker or the decision analyst.
Secondly, decision theory makes the assumption that a measure P of outcome value that assigns a utility U to each outcome exists. To do this, the theory provides that there is need to determine values which will associated with outcomes. Lastly, the theory assigns some probability to the outcomes associated with every action. From the three stages, the theory nows define expected utility to be the average utility of the outcome associated with a particular alternative. After defining expected utility, decision theory goes further to define a rational decision maker as one who maximizes the expected utility (Farrar, 1992).
At this point, the question that now arises is on how to formulate the decision problem that is confronting the decision maker. Decision theory provides that, it is through an iterative process of hypothesizing, testing and refining a sequence of tentative formulations that one is in a position to identify alternatives, outcomes and probabilities. Decision theory further provides that outcomes, alternatives and utilities can only be identified through direct query.
The theory also gives room to both sequential and non sequential models which are used to formulate solutions to decision problems. A number of stages are used in the decision making process. They include, the identification of the problem, obtaining of necessary information and formulation of feasible solutions. Also, the solutions formulated are to be evaluated before coming up with the optimal alternative or strategy. The non sequential models are the most influential models used in decision theory. They are broadly subdivided in three stages which are namely identification, development and the selection stage. The identification stage calls for the identification of problems and opportunities which are associated with a particular alternative. The development stage defines and clarifies the alternatives (Wagner, 2006). The last phase involved in the non sequential models is the selection stage which involves screening, evaluation and authorization of the alternatives chosen.
Attitudes towards risk
Risk is a commonly used term whose understanding differ form one individual to another. This mainly depends on their area of specialization. Economic theories identify three decision making situations. First, there is the decision making process under condition of certainty. Under conditions of certainty, any alternative leads to one and only one of the consequences. It can also be defined to be a situation where any action leads to a specific outcome.
Under conditions of risk, any action taken by the decision maker leads to a set of possible specific outcomes which have different probabilities. In conditions of uncertainty, any action taken by the decision maker leads to a number of consequences but the probabilities associated with these outcomes are unknown. Also, the definition of the word risk or a risky situation seems to differ from one individual to another. Research conducted on some managers showed that a risky situation is one whose outcome is unknown and this uncertainty leads to making erroneous choices (Brown, 2000). This often arises when making investment decisions though it is still applicable in other fields.
A large percentage of those in managerial positions are often risk averse because they dont believe in the association between risk and return. At this point it is important to establish whether there is any relationship between risk and return. To evaluate this, a number of managers were asked to express their opinion in regards to whether large risks are associated with large returns. A large percentage of them expressed an opinion that for an organization to maximize on their returns then, risks must go hand in hand with returns.
Depending with ones attitude towards risk, people have their own way of dealing with risky situations. Some alternatives available in risky situations include avoiding the risks, collecting detailed in formation about the risk, delaying or delegating a decision. Also, a decision maker may chose to actively deal with a risky situation in order to mitigate the risk associated with it. Research conducted on some managers showed that if they are acting under a risky situation they prefer to collect more information about the particular situation. The research further revealed that the least preferred alternative is to delegate a decision when in risky situation.
The same research sought to determine whether it is possible to manage risk under decision theory. On this, it was evident that risk is manageable if only you have the right information and you are in a capacity to gather all the facts which can mitigate the risk. Different attitudes towards risk can help in determining whether one is risk prone or is risk averse (Kelly, 2003). The risk prone individuals are not afraid of making mistakes and their risk behavior is not an aspect of their education or family background but it is more of something that is in born.
Executive decision-making
In light of the above it is important to show how the executive decision making process deviates from the standard theory. The main difference between the two is the methodology used in the decision making process. The standard decision theory mainly relies on the statistical and mathematical models to describe, analyze and formulate solutions to decision problems. The use of statistical models also ensures that risks can be evaluated and available alternatives can be evaluated (Kelly, 2003). On the other hand, the executive decision making follows a theoretical stepwise method in formulating solutions to decision problems. At this point, it is essential that we get a breakdown of the executive decision making process.
The first step in the executive decision making process is to completely define the problem. This calls for the identification of the problem that needs to be solved. At this stage we define the problem and specify the decision objective. This is also the stage at which we get to define the desired end state of the problem that currently exists. The next stage in the executive decision making process is to ensure that you consider the context of the problem. In this, you consider the stakeholders in the problem as well as what triggered the problem. The stage also calls for the formation of problem boundaries. This involves limiting the scope of the problem solving effort. It also involves the formation of a timeframe within which the problem should be fixed.
After completely defining the problem the next stage deals with the analysis of the same problem. This is another area that the executive decision making process differs from the standard decision theory. In this stage, the decision maker has to establish criteria that he will use in analyzing the problem. The criterion that is most applicable is that which will be effective in terms of cost and schedule. The criterion chosen should also account for the differences between risk and uncertainty. The criteria chosen should also be evaluated in terms of validity, reliability and practicability. This is the time that calls for an understanding of the difference between the risk averse excutive and the risk takers. This can however be represent through the use of a graphical diagram as follows.
The Expected Value (EV) is a as a function of prevailing obstacles against gaining or losing 10. In case of a probability of gaining, such as in graph 1, the EV function line separates the space into two sections risk-seeking, when the focus value is greater than EV, and risk-averse, when focus value is less than EV. In other case of probability of losing, the EV function also divides the space into two sections risk-seeking, when subjective value is less than EV, and risk-averse, when subjective value is greater than EV.
The next stage is the analysis stage which calls for the formation of analysis plan and construct possible alternatives towards solving the decision problem. The alternatives formulated should be viable as in it should meet the minimum requirements stipulated by the decision maker. Also, the alternative should express neutrality (Farrar, 1992). The next part in the analysis stage calls for the organization of criteria which is normally in terms of modeling. This is another deviation of executive decision making from the standard theory. In that, for standard theory, evaluation of alternatives is normally in form of mathematical models but for the executive decision making, the models are normally based on policies or rather qualitative.
After formulating the policy model, the model is also to be evaluated in terms of validity, reliability and practicability. Once the model meets the minimum requirements, it is then used to evaluate the alternatives to determine exactly how the alternatives differ. The last step in the analysis stage is to conduct a sensitivity analysis on the alternatives. This seeks to determine how some variables can be manipulated to alter the outcome.
The next stage is the decision making stage. This stage involves the selection of the best alternatives for an organization or a business. Also, a reality check which will evaluate on the legal and ethical acceptability of the alternative is essential. This represents another deviation of the executive decision making process from the standard decision theory. In that, selection of an alternative in the decision making process follows some rankings which are derived from mathematical analysis (Noone, 2002). For the executive decision making process, it is more of qualitative than quantitative. Presentation of results is also essential after making decisions.
Reconciliation is the other stage. At this decision making stage, score cards are made as well as forming strategies which will add value and promote mutual gain. The last stage in the executive decision making process is the execution stage. This involves planning how one is to implement the chosen alternative. It also involves organizing all the resources needed and establishing controls. Establishment of controls calls for the formation of measurement methods and establishing standards. In line with this is the verification stage. This involves comparing actual results obtained from their best alternative with the expected results.
How executive decision making is coping up with the deviations
Over time, executive decision making process is crossing in on the standard decision theory. In that, the executive decision making process is now using some mathematical and statistical models to conduct sensitivity analysis of the available alternatives. It is also using mathematical techniques in the determination of any errors that are associated in the alternatives present in the decision making process. The executive decision making process is also making use of the mathematical models in evaluating the cost effectiveness of the available alternatives. Finally, quantitative techniques are being used in the executive decision making process especially in determining the measurability of the analysis criteria.
At this point it is worth concluding that standard decision theory is concerned with identifying values under conditions of certainty, uncertainty and risk. It is more of quantitative since it uses both mathematical and statistical models to arrive at the best alternative. Also, we have come to terms that the executive decision making process deviates from the standard decision theory since it is more of qualitative than quantitative. However, executive decision making is crossing in on the standard decision theory since it is now utilizing the mathematical models to conduct sensitivity analysis as well as detection of errors while selecting among alternatives.