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SUPPLEMENT TO CHAPTER 5

DECISION THEORY

Teaching Notes
The presentation of decision theory is standard except for the addition of material on sensitivity analysis.
Decision theory can be omitted if it does not suit your purposes, without loss of continuity.

The presentation should emphasize that decision tables are developed for one-phase decision-making,
whereas decision trees are developed for multi-phase decision-making where several interrelated
decisions and state of nature are considered, and the decisions are dependent on each other and the states
of nature. Decision analysis forces the decision maker to study the states of nature (conditions) carefully
because probabilities must be assigned to each state of nature. The decision analysis provides the
decision maker with reasonably objective method of evaluating the relative value of each decision
alternative
Answers to Discussion and Review Questions
1. The chief role of the operations manager is as a decision maker.
2. Decision making consists of the following steps:
(1) Identify possible future conditions (states of nature).
(2) Develop alternatives.
(3) Determine the payoffs.
(4) Estimate the probability of each future condition.
(5) Evaluate alternatives according to decision criteria, and select the best alternative.
3. Bounded rationality is a term that refers to rational decision-making made within limits imposed
by costs, human abilities, time, technology, and availability of information. Another name for it is
satisficing.
4. Suboptimization occurs as a result of different departments, each attempting to reach a solution
that is optimum for that department but may not be optimum for the organization as a whole.
5. Poor decisions can be due to bounded rationality, which refers to limits on decision making in
terms of cost, technology, human abilities and availability of information; managerial style
(including quick decisions, unwillingness to admit a mistake, and procrastination); and
organization difficulties, which can be related to departmentalized decisions (which often lead to
interdepartment conflicts and suboptimization).
6. A payoff table shows the expected payoffs for each alternative in every possible state of nature.
7. Sensitivity analysis refers to examining how sensitive a given solution is to a change in one or
more parameters of a problem. High sensitivity indicates to decision makers that a parameter
must be carefully estimated or determined; low sensitivity would not require such careful
estimation. Also, decision makers can use sensitivity analysis to explore how a change in the
value of a parameter would effect a solution.
8. Maximax is an optimistic approach that calls for selection of the alternative which has the best
possible payoff; maximin is a conservative approach which seeks the alternative with the best
"worst payoff. Thus, if the mood is "go for it" maximax would be used, while if the mood is
cautious, maximin would be more appropriate.

66
Operations Management, 2/ce
9. The expected monetary value approach implies a linear utility for payoff (e.g., a payoff of $2 has
twice the utility of a payoff of $1) and risk-neutral attitude towards risk. When multiple decisions
are to be made, the expected payoff approach is often used; similarly, when a series of on-going
decisions on projects, new equipment, etc. are to be made, expected value can be useful.
Conversely, for unique, one-time type decision, where utilities are nonlinear, and for people with
risk aversion and risk lovers, expected value would not be appropriate. Of course, the expected
value approach requires probabilities for states of nature. If these are not available, the approach
cannot be used.
10. a. The Laplace criterion is an approach to decision making under uncertainty. It treats the states
of nature as equally likely.
b. Minimax regret is an approach to decision making under uncertainty. It seeks to minimize the
maximum opportunity loss, or regret, associated with decisions.
c. Expected monetary value is an approach to decision making under risk: the probabilities of
states of nature are assumed to be known. It involves choosing that decision that has the
highest expected payoff value.
d. Expected value of perfect information is the maximum amount a decision maker should be
willing to pay to move from a position of decision making under risk to a position of decision
making under certainty.
11. In order to use an expected monetary value approach to decision making, a decision maker must
have state of nature probabilities (in addition to a list of alternatives, a list of states of nature, and
a set of payoffs). If probabilities are unknown, either additional resources can be used to attempt
to ascertain the probabilities, or an approach can be adopted which does not call for probabilities.
Sensitivity analysis could be used to show the range of probability for which a particular
alternative would be optimal. Thus, it may not be necessary for a decision maker to pinpoint a
probability; rather, it may only be necessary to decide if a probability is in this "ballpark."
12. First using sensitivity analysis, the manager can find out which decision is more robust, i.e., will
result in highest EMV under varied probabilities for future conditions. The manager can also look
at other criteria such as maximin. Finally, other non-monetary operations factors such as space
availability can be used to break the tie.

67 Operations Management, 2/ce


Solutions
1. a. Maximax: Expand [$80 is the highest payoff]
b. Maximin: Worst payoffs:
Do Nothing: 50 [best of the worst payoffs]
Expand: 20
Subcontract: 40
c. Laplace: Average Payoff
Do Nothing 55 [Indifferent between Do Nothing
Expand 50 And Subcontract]
Subcontract 55
d. Minimax Regret
Low High Worst = maximum regret
Do Nothing 0 20 20
Expand 30 0 30
Subcontract 10 10 10 [best of worst]
2. a. Expected profit
Do Nothing .3 (50) + .7 (60) = $57
Expand .3 (20) + .7 (80) = $62 [Best]
Subcontract .3 (40) + .7 (70) = $61
b. .3 $50
$57 .7
Do Nothing $60
$62 .3 $20
Expand
.7
$80
$61 .3
Subcontr. $40
.7
$70

c. Expected profit under certainty: .30(50) + .70(80) = $71


Expected profit under risk: 62
EVPI: $9
Any market research is at most worth $9000 to the contractor.

80
3. Let P = P (high) 70
Equations: Do Nothing 60
Do Nothing: 50 (1 - P) + 60P = 50 + 10P 50
Expand: 20 (1 - P) + 80P = 20 + 60P 40 Subcontract
Subcontract: 40 (1 - P) + 70P = 40 + 30P
20 Expand
Optimal ranges: ___P___
Do nothing: 0 to < .50
Expand: .67 to 1.00 P
0 .50 .67 1.0
Subcontract: .50 to .67

Instructors Manual, Chapter 5 Supplement 68


Solutions (continued)
4. a. (1) Draw the tree diagram:

Demand Low (.4) $400,000 (1)

Maintain $50,000 (2)


Build Small
2
Demand High (.6) Expand
1 $450,000 (3)
Demand Low (.4) $-10,000 (4)
Build Large

Demand High (.6) $800,000 (5)

(2) Analyze decisions from right to left (i.e., work backwards from the end of the tree
towards the root). For instance begin with decision 2 and choose expansion because it has
a higher present value ($450,000 vs. $50,000).
(3) Compute the expected value of the ends of the remaining branches (numbered 1 to 5 in
the diagram), and then determine the expected value for the two initial alternatives.
(1) .4 x $400,000 = $160,000
(2) (eliminated) $430,000 (expected value if
(3) .6 x $450,000 = $270,000 Build small is chosen)
(4) .4 x -$10,000 = $-4,000
(5) .6 x $800,000 = $480,000 $476,000 (expected value if
Build large is chosen)
(4) Since the expected value of building a large plant has the higher expected value, select
the large plant alternative.
b. Expected payoff under certainty: .4(400,000) + .6 (800,000) = $640,000
Expected payoff under risk: 476,000
Expected value of perfect information: $164,000
Build small = 400P + 450 (1 P) 800
= 450 50P

Build large = -10P + 800 (1 P)


= 800 810P
450
450 50P = 800 810 P Build Small
400
760 P = 350
P = .46
Build Large
Build small if P(low) .46
Build large if P(low) < .46
0
.46 1
P (low)
-10

69 Operations Management, 2/ce


Solutions (continued)
5. EVsubcontract= (.4)(1.0) + (.5)(1.3) + (.1)(1.8) = 1.23
EVexpand = (.4)(1.5) + (.5)(1.6) + (.1)(1.7) = 1.57

EVbuild = (.4)(1.4) + (.5)(1.1) + (.1)(2.4) = 1.35

Since 1.57 is the maximum build.

6. MaxiMax MaxiMin Laplace Minimax


Alternative (a) Max. Payoff (b) Min. Payoff (c) Average (d) Max. Regret
Renew $4,000,000 $500,000* $2,250,000 $4,500,000
Relocate $5,000,000* $100,000 $2,550,000* $3,900,000*
Decision: Relocate Renew Relocate Relocate

7. Alternative Expected Value


a. Renew 500,000(.35) + 4,000,000(.65) = $2,775,000*
Relocate 5,000,000(.35) + 100,000(.65) = $1,815,000
Decision: Renew lease
c. EVPI = EPC EMV
Motel Approved (.35)
= .35(5,000,000) + .65(4,000,000) - 2,775,000 = $1,575,000E.V.
$500,000
Yes, the manager should sign the lease for $24,000 since it$2,775,000*
is less than the EVPI of
$1,575,000. Rejected (.65)
Renew $4,000,000
8. Let P (application is approved) = x. Then P (application rejected) = 1 - x.
From Problem 6.
Renew: 500,000x + 4,000,000(1 - x) = 4,000,000 - 3,500,000x
Relocate: 5,000,000x + 100,000(1 - x) =(.35)
Approved 100,000 + 4,900,000x
The two alternatives are equally good when
Relocate $5,000,000
4,000,000 - 3,500,000x = 100,000 + 4,900,000x $1,815,000
Rejected (.65)
i.e. when x = 3,900,000 $100,000
= 0.4643
8,400,000

Instructors Manual, Chapter 5 Supplement 70


Solutions (continued)
Exp.
Value
5
(millions) Renewal better than 5
Relocation 100,000 + 4,900,000x
4
Renew Relocate 4

3 3
4,000,000 3,500,000x
2 2
Relocate

1 1
.5
0.1 x = .4643 P (application approved)=x

a. Not sensitive (i.e., p (approve) can increase to .46 and still the decision remains renew.
b. Very sensitive because .45 is very close to .464, at which point decision should be
changed.

c. D = amount of decrease in $4,000,000 in order that EV= EV


EV EV= $2,775,000 $1,815,000 = $960,000
$960,000 = .65D
D = $1,476,923
$4,000,000 $1,476,923 = $2,523,077
Range is $2,523,077 or more.

EMV
9. Demand $ 42 .2(42)
.2 Low

.8 High Subcontract
42 + 46.8
2
Expand
48 .8(48)
Small

.2 Low 22 .2(22)
Medium
1 .8 High Do Nothing
46 44.4
+
2
Expand 50
Large .8(50)

.2 Low (-20) .2(-20)

.8 High + 53.6 max.


72 .8(72)

a. Decision: Build a large facility (see the tree), EMV = $53.6m


b. Max (42;22;-20) = $42 million.

71 Operations Management, 2/ce


Decision: Build a small facility.
c. EVPI = EPC EMV
EPC = 42(.2) + 72(.8) = $66.0
EVPI = $66.0 53.6 = $12.4
Would be willing to pay up to $12.4 million to find out the demand.
d. Let P(high) = x P(low) = 1-x
I. Small: 42(1-x) + 48x => 42 + 6x
II. Medium: 22(1-x) + 50x => 22 + 28x
III. Large: -20(1-x) + 72x => -20 + 92x
Value of x where expected value for I and III are the same.
42 + 6x = -20 + 92x => 86x = 62 => x = 0.721

72

50
Small
42 48
Medium

22
Large

0 .721 1.0
-20 P (High)

Choose Small if p(high) <.721, and Large if p(high) >.721

10.

.30 low demand $90 .3(90)


do nothing
90 + $104
buy 1 .70 high demand
subcontract
2 110 .7(110)

buy 2nd
100
.30 low
75 .3(75)
buy 2
+ $113.5 (optimum)
.70 high 130 .7(130)

Decision: Buy 2 machines (initially).

Instructors Manual, Chapter 5 Supplement 72


Solutions (continued) 1/3
0
1/3 60
11. 1
1/3
90
50
.30 40
.50
4 44
Alternative A 60
.20

49 1/3
(45)
1/3
2 45
1/3 99
Alternative B 40
.30
40
.50
5 50

.20 30
1/2
45 40
3
EV1 = (1/3)(0) + (1/3)(60) + (1/3)(90) = 50 1/2
50
EV2 = (1/3)(-45) + (1/3)(45) + (1/3)(99) = 33
EV3 = (1/2)(40) + (1/2)(50) = 45
EV4 = (.3)(50) + (.5)(44) + (.2)(60) = 49
EV5 = (.3)(40) + (.5)(50) + (.2)(45) = 46

Since 49 > 46, choose alternative A.

12. Moderate High Very High Worst Best Average


(max) (min)
Reassign 50 60 85 85 50 65
New Staff 60 60 60 60* 60 60 (tie)

Redesign 40 50 90 90 40* 60
a. Minimax: New staff
b. Minimin: Redesign
c. Regret table:

Moderate High Very High Worst (max)


Reassign 10 10 25 25
New Staff 20 10 0 20*
Redesign 0 0 30 30
d. New Staff or Redesign (tie).

73 Operations Management, 2/ce


Solutions (continued)

13. a. Reassign: .10(50) + .30(60) + .60(85) = $74


New Staff: .10(60) + .30(60) + .60(60) = 60 *
Redesign: .10(40) + .30(50) + .60(90) = 73
b.
.10 Moderate
50
Reassign .30 High
74 60
.60 Very High 85
.10 Moderate
60
New Staff .30 High
60 60 60
.60 Very High 60
.10 Moderate
40
Redesign .30 High
73 50
.60 Very High 90

c. Opportunity loss table:


Moderate High Very High Expected
Regret
Reassign 10 10 25 19
New Staff 20 10 0 5* (min)
Redesign 0 0 30 18
EVPI=$5(000) (.1) (.3) (.6)

14. .10 Moderate


50
Reassign .30 High
74 60
.60 Very High
85
.10 Moderate
Hire 2 60
Initially .30 High
60 60
.60 Very High
New Staff 60
60 60 .10 Moderate
40
.30 High (Hire 1 more)
74.5 75
Hire 1 .60 V. High (Hire 1 more)
Initially 80
.10 Moderate
40
Redesign .30 High
73 50
.60 Very High
90

Hire 2 initially.

Instructors Manual, Chapter 5 Supplement 74


Solutions (continued)
15. a. Let P = p (#2)

Payoff Payoff
#1 #2
A: 20 (1-P) + 140 P = 20 + 120 P
B: 120 (1-P) + 80P = 120 40 P
C: 100 (1-P) + 40P = 100 60P 140
120 B A
100
C B
80
C
A
40

0 .625 1.0 P
b. Alternative C is lower than Alternative B for all values of P(#2), so it would
never be appropriate.
c. EV = 120 - 40P; EV= 20 + 120P. Solving, P = .625.
Therefore, choose Alternative A if P(#2) is greater than .625.
d. For P(#1), choose Alternative A, if P(#1) is less than .375 (i.e., 1.000 - .625).

16. [Refer to the diagram in the previous solution]


b. Alternative B is now the one that is never appropriate.
c. EV= 20 + 120P; EV= 100 - 60P. Solving, P = .444.
Therefore, choose Alternative A for P(#2) less than .444, and choose
Alternative C for P(#2) greater than .444.
d. In terms of P(#1), choose A for P(#1) greater than .556 = 1 - .444

17. Let P = P (not receiving contract)


10
EV1 = 10 (1 P) + (-2) P = 10 12P #1
EV2 = 8 (1 P) + 3P = 8 5P 8 #2
7
EV3 = 5 (1 P) + 5P = 5 0P #2 #4

EV4 = 0 (1 P) + 7P = 0 + 7P #3 5
5
2
EV1 = EV2 => 10-12P = 8-5P => P = = .285
7
3
EV2 = EV3 => 8-5P = 5 => 5P = 3 => P = .6
#4
EV3 = EV4 => 5 = 7P => P = .714
If P < .286 => Choose #1; if .286 P < .60 => Choose 0 1.0
.286 .60 .714
#2; if .6 P < .714 => Choose #3; if P .714 => Choose #4
-2

75 Operations Management, 2/ce


Solutions (continued)

18. EV= 120 (1-P) + 20P = 120 100P .30 .80 a. A: P(2) < .30
B: never
120 C: P(2) .8
EV= 60 (1-P) + 40P = 60 20p
A Profits 110 D: .3 P(2) < .8
EV= 10 (1-P) + 110P = 10 + 100p C
D b. A: never
90 90
EV 90 (1-P) + 90P = 90 B: .417 P(2) < .75
C: P(2) < .417
D: P(2) .75
60
B

C 40
Costs A

20
10

0 .417 .75 1.0


EV= EV => 120 100P = 90 => P =.3
P (#2)
EV= EV => 90 = 10 + 100P => P = 80

EV= EV => 10 + 100P = 60 20P => P = .417

EV= EV => 60 20P = 120 100P => P =.75

Instructors Manual, Chapter 5 Supplement 76