In general, there are three different main conditions which you may be faced with when having to make a decision: (1) conditions of certainty; (2) conditions of risk; or (3) conditions of uncertainty.
This article will focus on making decisions under conditions of certainty.
Regardless of the conditions you are faced with, a so-called pay-off matrix is a very useful tool and is often used to represent risk conditions and to gain a necessary overview of options available as well as potential outcomes. It consists of three elements: (1) strategies; (2) states of nature (or scenarios); and (3) outcomes (or consequences).
Each strategy represents a statement of the risks you, as a decision maker, are willing to tolerate in the event of each state of nature occurring, i.e. somewhere within the continuum of avoiding all risks (risk averse) and the willingness to take on any risk whatsoever (a risk taker).
For every plot in between these two extremes, you can define a strategy. In most situations, two to three different strategies (representing different points on the trajectory between the two extremes) should suffice, but can, in principle, be expanded to include an endless number of possible strategies.
For convenience, you can name them simply Strategy 1, Strategy 2 and so on , with Strategy 1 representing the most risk-averse strategy. Put each strategy on your left side of the matrix.
States of Nature (Scenarios):
Each state of nature is equal to a particular scenario. For instance, you could have a situation of the interest rates going up (scenario 1), or staying the same within some predefined interval (scenario 2); or going down (scenario 3).
You could name each of the three states of nature SN1=up, SN2=even, and SN3=down. Put them on top of the matrix as headings.
Each cell of the pay-off matrix should represent an outcome or consequence, preferably a quantifiable result such as profit, but other options are also possible, e.g. grades from 1 through 5.
Now, let's apply what we just learned:
Conditions of Certainty:
For obvious reasons (after all, the world is anything but full of certainty) this typically applies to situations within a narrowly defined scope. A prerequisite for making a decision under conditions of certainty is that everything related to the decision making process is known with 100 percent accuracy. It also implies that each state of nature (or scenario) is equally likely to happen and that there will be one dominant strategy which will deliver a more desirable outcome (e.g. more benefits or less loss) than the other strategies for all states of nature.
Let's go through a practical application:
Let's assume you're a woman, standing on platform 3 on the central train station. Suddenly, you see an absolutely gorgeous man, the kind of man you just want to... well, hug and kiss! Unfortunately for you, you don't have much time; within the next five minutes, the next train is going to arrive and he might be gone forever!
So, what does an intelligent woman like you do?
Firstly, we assume he is not able to see you, or he is preoccupied with something: perhaps his favorite pet just died?!
Obviously, you (apart from remembering this article very clearly!) quickly line up a pay-off matrix inside your head and spot two main possible strategies: either you let it pass (Strategy 1, i.e. the risk-averse) or you act upon it (Strategy 2, i.e. the risk taker). The two possible states of nature are (A) he says no, i.e. to some type of invitation for a drink, dinner, etc.; or (B) he says yes.
What's a girl to do?
Since you have no way of knowing the likelihood of each scenario, you have no other option than to apply equal probability to both states of nature. Also, you know with 100 percent certainty that your heart is beating faster just by looking at the guy; and that's all you need to know! In other words, you are now faced with a situation where you have to make a decision under conditions of certainty.
You may wonder which one you would likely choose. While you are wondering, I'll let you in on a little secret: Strategy 2 will always be the best choice, and here's why:
If the guy says 'yes', he could turn out to be the love of your life. Not a bad outcome for two minutes worth of work, but less could probably also do the trick! If he says no, perhaps even in a rude manner, you will know that he was not meant for you and quite possibly, you can easily and very quickly forget about him.
On the other hand, perhaps you have been taught (manipulated may be a more accurate description) that it is shameful or otherwise inappropriate for a woman to do such a thing, so you would choose Strategy 1, and as a consequence: (a) you will never know whether he was the love of your life and you have certainly lost the opportunity to ever find out; and (b) you have foregone the chance to determine your own destiny.
According to the terminology above, Strategy 2 would be your dominant strategy which will deliver a more desirable outcome than the other strategies for all states of nature.
It ought to be obvious, but let me just mention it anyway: the above-mentioned example applies equally to men; and I'm tempted to call it the Carpe Diem Scenario!
Next time, we will move on to something more exciting and risky; we will go through how to make decisions under conditions of risk!
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