5s-1 Decision Theory

Operations Management

William J. Stevenson

8th edition
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5s-2 Decision Theory

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5s-3 Decision Theory

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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5s-4 Decision Theory

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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5s-5 Decision Theory

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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5s-6 Decision Theory

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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5s-7 Decision Theory

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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5s-8 Decision Theory

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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5s-9 Decision Theory

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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5s-10 Decision Theory

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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5s-11 Decision Theory

Format of a Decision Tree

Figure 5S.1

a t ure 1 Payoff 1
Decision Point Stat e of n
Chance Event eA ’1 Payoff 2
’ Choos
A State
se of
o natur 2
o e2
Ch Choose
A’2 Payoff 3
B
1
s e A ’3 Payoff 4
Ch oo
u re 1
a t
C

o f n 2
ho

State
os

Choose Payoff 5
e

A’4
A
’2

State
o f natu Payoff 6
re 2
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5s-12 Decision Theory

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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5s-13 Decision Theory

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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5s-14 Decision Theory

Solved Problem 5

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