5S

Decision Theory

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning Objectives

 Describe the different environments under

which operations decisions are made
 Describe and use techniques that apply
decision making theory under uncertainty
 Describe and use the expected-value
approach

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 Learning Objectives
 Construct a decision tree and use it to
analyze a problem
 Compute the expected value of perfect
information
 Conduct sensitivity analysis on a simple
decision problem

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 Decision Theory
Decision Theory represents a general approach to
decision making which is suitable for a wide range of
operations management decisions, including:

Capacity Product
Product and
and
planning service
service design
design

Location Equipment
planning selection

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 Decision Theory Elements

 A set of possible future conditions exists

that will have a bearing on the results of
the decision
 A list of alternatives for the manager to
choose from
 A known payoff for each alternative
under each possible future condition

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 Decision Theory Process

 Identify possible future conditions called

states of nature
 Develop a list of possible alternatives,
one of which may be to do nothing
 Determine the payoff associated with
each alternative for every future
condition

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Decision Theory Process (Cont’d)
 If possible, determine the likelihood of
each possible future condition
 Evaluate alternatives according to some
decision criterion and select the best
alternative

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 Causes of Poor Decisions

Bounded Rationality
The limitations on decision
making caused by costs,
human abilities, time,
technology, and availability of
information

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Causes of Poor Decisions (Cont’d)

Suboptimization
The result of different
departments each
attempting to reach a
solution that is
optimum for that
department

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 Decision Process
1. Identify the problem
2. Specify objectives and criteria for a solution
3. Develop suitable alternatives
4. Analyze and compare alternatives
5. Select the best alternative
6. Implement the solution
7. Monitor to see that the desired result is
achieved

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 Decision Environments
 Certainty - Environment in which
relevant parameters have
known values
 Risk - Environment in which
certain future events have
probable outcomes
 Uncertainty - Environment in
which it is impossible to assess
the likelihood of various future
events

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Decision Making under Uncertainty
Maximin - Choose the alternative with the best
of the worst possible payoffs

Maximax - Choose the alternative with the best

possible payoff

Laplace - Choose the alternative with the best

average payoff of any of the alternatives

Minimax Regret - Choose the alternative that

has the least of the worst regrets

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 Decision Making Under Risk
 Risk: The probability of occurrence for each
state of nature is known
 Risk lies between the extremes of
uncertainty and certainty
 Expected monetary value (EMV) criterion:
 The best expected value among alternatives
 Determine the expected payoff of each
alternative, and choose the alternative with the
best expected payoff

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 Decision Trees
 Decision tree: a Schematic representation
of the available alternatives and their
possible consequences.
 Useful for analyzing situations that involve
sequential decisions
 See Figure 5S.1

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 Format of a Decision Tree
Figure 5S.1
1
f n a t u re Payoff 1
o
Decision Point State
Chance Event eA ’1 Payoff 2
’ C hoos
A St a t e
se o f n at 2
o o u re 2
h C h o o se Payoff 3
C A’2
B
1
e A’ 3 Payoff 4
1 C hoos
a t u re
C

o f n 2
ho

State
os

C h o o se Payoff 5
e

A’4
A
’2

St a t e
o f n at Payoff 6
u re 2

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Expected Value of Perfect Information
Expected value of perfect information: the
difference between the expected payoff under
certainty and the expected payoff under risk

Expected value of Expected payoff - Expected payoff

perfect information = under certainty under risk

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 Sensitivity Analysis
 Sensitivity Analysis: Determining the range
of probability for which an alternative has the
best expected payoff
 Useful for decision makers to have some
indication of how sensitive the choice of an
alternative is to changes in one or more of
these values

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 Sensitivity Analysis
Example S-8

#1 Payoff #2 Payoff
16 B 16
14 14
12 A 12
C
10 10
8 8
6 6
4 4
2 B best C best A best 2
0 0
Sensitivity analysis: determine the range of
probability for which an alternative has the best
expected payoff

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Solved Problem 5

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