Decision Making

1. Decision Making

2. Decision Making • What is decision making? • It is the process of selecting among alternatives. • Chester Bernard in “The Functions of the Executive” gave a comprehensive analytical treatment of decision making and noted: “The process of decision … are largely techniques for narrowing choice.”

3. Example of error in decision-making process • Shane Frederick had used simple puzzles to study cognitive self monitoring, as in the following example: “A bat and a ball cost 1.10 dollars in total. The bat costs 1 dollar more than the ball. How much does the ball cost?” Almost everyone reports an initial tendency to answer “10 cents” because the sum 1.10 dollars separate naturally into 1 dollar and 10 cents and because 10 cents is about the right magnitude. Frederick found that many intelligent people yield to this immediate impulse” 50% (47/93) of Princeton students and 56% (164/293) of students at the University of Michigan gave the wrong answer. Clearly, these respondents offered a response without checking it.

4. Decision Making Intelligence Activity Feedback Design Activity Choice Activity

5. Decision-making process • Herbert A. Simon, the well known Nobel Prize winning organization and decision theorist conceptualized three major phases in decision-making process: • Intelligence activity – Consists of searching the environment for conditions calling for decision making • Design activity – During this phase, inventing, developing, and analyzing possible courses of action take place • Choice activity – This is the actual choice - selecting a particular course of action from among those variables

6. Mintzberg’s Model • Phase 1 • IDENTIFICATION • Recognition • Diagnosis • Phase 2 • DEVELOPMENT • Search • Design • Phase 3 • SELECTION • Judgement • Analysis • Bargaining Authorization

7. Behavioural Decision Making Decision Rationality

8. Behavioral Decision Making Models Economic Rationality Model • This model comes from classic model, in which the decision maker is perfectly and completely rational in every way. Regarding decision-making activities, the following conditions are assumed. • The decision will be completely rational in the means-end sense. • There is a complete and consistent system of preferences which allows a choice among alternatives. • There is complete awareness of all the possible alternatives. • There is no limits to the complexity of computations that can be performed to determine the best alternatives. • Probability calculations are neither frightening nor mysterious.

9. Simon’s Bounded Rationality Model • To present a more realistic alternative to the economic rationality model, Herbert A Simon proposed an alternative model. He felt that management decision-making behavior could best be described as follows” • In choosing between alternatives, managers attempt to satisfice, or look for the one which is satisfactory or “good enough”. Examples of satisficing criteria would be adequate profit or share of the market and fair price. • They recognize that the world they perceive is a drastically simplified model of the real world. They are content with this simplification because they believe the real world is empty anyway.

10. Simon’s Bounded Rationality Model (contd…) • Because they satisfice rather than maximize, they can make their choices without first determining all possible behavior alternatives and without ascertaining that these are in fact all the alternatives. • Because they treat the world rather empty, they are able to make decision with relatively simple rules of thumb or tricks of the trade or force of habits. These techniques do not make impossible demands upon their capacity for thought.

11. New Rational Techniques: ABC and EVA Traditionally, accounting identified costs according to the category of expenses (for example, salaries, supplies and fixed costs). Activity-based Costing (ABC), on the other hand, determines costs according to what is paid for the different tasks employees perform. Under ABC, costs associated with activities such as processing sales orders, expediting supplies and/or customer orders, resolving supplier quality and/or problem, and retooling of machines are calculated. Both the traditional and ABC methods reach the same bottom line costs, but ABC provides decision makers a much more accurate breakdown of the cost data. For instance, at Hewlett-Packard when ABC showed that testing new designs and parts was extremely expensive, engineer changed their plans on the spot to favour components that required less testing, thus greatly lowering costs.

12. New Rational Techniques: ABC and EVA … Another example of rethinking the traditional economic rationality used by management decision makers is the finance technique of Economic Value Added (EVA). A long standing tenet of the economic model has been that a rational decision is one which resulted in the earning higher than the cost of capital. Traditionally, the cost of capital has simply been equated with the interest paid on borrowed capital. Under EVA, however, the true cost of all capital is determined. For example, the true cost of equity capital is the opportunity cost (what shareholders could earn in price appreciation and dividends if they invested in similar company). Also, what a firm spends on research and development or employee training has been traditionally treated as expenses, but under EVA, it is treated as capital investment and is added into the cost of capital. The EVA is determined by subtracting this total cost of capital from the after-tax operating profit.

13. The Social Model • At the opposite extreme from the economic rationality model is the Social Model. Sigmund Freud presented humans as bundles of feelings, emotions, and instincts with their behaviour guided by their unconscious desires. • Although most contemporary psychologists would take issue with the Freudian description of humans, almost all would agree that social influences have significant impact on decision-making behaviour. Furthermore, social pressures and influences may cause managers to make irrational decisions. • There seems to be a tendency on the part of many decision makers to stick with a bad decision alternative, even when it is unlikely that things can be turned around. Staw and Ross have identified four major reasons why this phenomenon of escalation of commitment might happen. • Project Characteristics • Psychological Determinants • Social Forces • Organizational Determinants

14. Judgmental Heuristics and Biases Model (Kahneman &Tversky) • Are there more words in the English language that (a) begin with the letter r or (b) have r as the third letter? • One one day in a large metropolitan hospital, eight birth were recorded by gender in the order of their arrival. Which of the following orders of birth (B= boy, G=girl) was most likely to be reported? • a. BBBBBBBB b. BBBBGGGG c. BGBBGGGB • A newly hired engineer for a computer firm in the Boston metropolitan area has four years of experience and good all-around qualifications. When asked to estimate the starting salary for this employee, Prof. Luthens secretary (knowing very little about the profession or the industry) guesses an annual salary of $50,000. What is your estimate?

15. Judgmental Heuristics and Biases Model (Kahneman &Tversky) The availability heuristic This cognitive input into judgment refers to decision makers’ tendencies to assess the frequency, probability, or likelihood of an event occurring by how readily they can remember it. “An event that evokes emotions and is vivid, easily imagined, and specific will be more ‘available’ from memory than will an event that is unemotional in nature, bland, difficult to imagine, or vague.” The representativeness heuristic This second major heuristic uses decision rules of thumb based on the likelihood of an event’s occurrence as judged by the similarity of that occurrence to stereotypes of similar occurrences. “the problem here is that we believe that a sequence of independent events (such as eight births) generated from a random process should resemble the essential characteristics of random process, even when the sequence is too short for that process to express itself statistically. Decision makers expect a few examples of a random event to behave in the same way as large numbers of the event.”

16. The anchoring and adjustment heuristic In this heuristic, the decision maker makes a judgment by starting from an initial value or anchor and then adjusts to make the final decision.