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.

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Operations Management, 2/ce

Conversely. a payoff of $2 has twice the utility of a payoff of $1) and risk-neutral attitude towards risk.. 67 Operations Management. the approach cannot be used. when a series of on-going decisions on projects.. d. The manager can also look at other criteria such as maximin. expected value can be useful. 10. It treats the states of nature as equally likely. the expected payoff approach is often used. i. It seeks to minimize the maximum opportunity loss. where utilities are nonlinear. The expected monetary value approach implies a linear utility for payoff (e. c. Thus. are to be made. either additional resources can be used to attempt to ascertain the probabilities. If these are not available.e. and a set of payoffs). 2/ce . First using sensitivity analysis. associated with decisions. expected value would not be appropriate. Expected monetary value is an approach to decision making under risk: the probabilities of states of nature are assumed to be known. the expected value approach requires probabilities for states of nature. or an approach can be adopted which does not call for probabilities. and for people with risk aversion and risk lovers. etc. it may not be necessary for a decision maker to pinpoint a probability. When multiple decisions are to be made. a. it may only be necessary to decide if a probability is in this "ballpark. If probabilities are unknown. 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. new equipment. similarly. rather. The Laplace criterion is an approach to decision making under uncertainty." 12. will result in highest EMV under varied probabilities for future conditions. In order to use an expected monetary value approach to decision making. b. Minimax regret is an approach to decision making under uncertainty. or regret. Finally.9. one-time type decision. It involves choosing that decision that has the highest expected payoff value. Of course. the manager can find out which decision is more robust. a list of states of nature. for unique. a decision maker must have state of nature probabilities (in addition to a list of alternatives.g. other non-monetary operations factors such as space availability can be used to break the tie. 11. Sensitivity analysis could be used to show the range of probability for which a particular alternative would be optimal.

3 Subcontr. Minimax Regret Low High Worst = maximum regret Do Nothing 0 20 20 Expand 30 0 30 Subcontract 10 10 10 [best of worst] 2. $40 . Maximin: Worst payoffs: Do Nothing: 50 [best of the worst payoffs] Expand: 20 Subcontract: 40 c.3 $20 Expand .50 Expand: . Expected profit Do Nothing .7 (60) = $57 Expand .7 (70) = $61 b. . a.Solutions 1.67 Instructor’s Manual.P) + 80P = 20 + 60P 40 Subcontract Subcontract: 40 (1 .67 to 1.3 (40) + .3 (20) + .0 Subcontract: . 80 3.7 $80 $61 .00 P 0 .70(80) = $71 Expected profit under risk: 62 EVPI: $9 Any market research is at most worth $9000 to the contractor.7 $70 c.67 1.50 . Let P = P (high) 70 Equations: Do Nothing 60 Do Nothing: 50 (1 .3 (50) + .P) + 60P = 50 + 10P 50 Expand: 20 (1 .3 $50 $57 .P) + 70P = 40 + 30P 20 Expand Optimal ranges: ___P___ Do nothing: 0 to < . Chapter 5 Supplement 68 .30(50) + .7 (80) = $62 [Best] Subcontract .50 to . a. Maximax: Expand [$80 is the highest payoff] b. Expected profit under certainty: . Laplace: Average Payoff Do Nothing 55 [Indifferent between Do Nothing Expand 50 And Subcontract] Subcontract 55 d.7 Do Nothing $60 $62 .

46 1 P (low) -10 69 Operations Management.46 Build Large Build small if P(low) ≥ .000 (1) Maintain $50. 2/ce .000 (2) Build Small 2 Demand High (.4) $-10.000) = $640. select the large plant alternative. Solutions (continued) 4.000 (3) Demand Low (.000 vs.000 = $160. Expected payoff under certainty: .000 (5) (2) Analyze decisions from right to left (i. work backwards from the end of the tree towards the root). (1) .000 (expected value if (3) .4 x $400.000 = $-4. (3) Compute the expected value of the ends of the remaining branches (numbered 1 to 5 in the diagram).000 (expected value if Build large is chosen) (4) Since the expected value of building a large plant has the higher expected value.000).6 x $800. a. b.000 $476.e.6 (800. $50. and then determine the expected value for the two initial alternatives.6) $800.000 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 = .000) + .000 (4) Build Large Demand High (.6 x $450.4(400.000 = $270. For instance begin with decision 2 and choose expansion because it has a higher present value ($450.000 Expected payoff under risk: 476.6) Expand 1 $450.000 = $480.4) $400..000 Build small is chosen) (4) . (1) Draw the tree diagram: Demand Low (.46 Build large if P(low) < .000 (5) .000 (2) (eliminated) $430.4 x -$10.46 0 .000 Expected value of perfect information: $164.

35) Approved 100.000) .2.35) + 4. when x = 3.900.4) + (.000 = 0.000.000(.815.3. Let P (application is approved) = x.7) = 1.815.775.x.400. 6. $500.000 $2.65) Renew $4.000 . EVPI = EPC – EMV Motel Approved (.900.3. Renew: 500.000 8.000x = 100.900.000(1 .000(.V.1)(1.000x $1.000(.65(4.000 since it$2.000(.1) + (. EVsubcontract= (.000.000.000* is less than the EVPI of $1.900.000x The two alternatives are equally good when Relocate $5.000.1)(1.35 Since 1.e.500.000x Relocate: 5.000* $100.000 4.250.4643 8.4) = 1. Chapter 5 Supplement 70 .57 is the maximum build.1)(2. the manager should sign the lease for $24.775.35) = .000.000.65) i.000 Decision: Renew lease c.23 EVexpand = (. Regret Renew $4.000.6) + (.000(1 .8) = 1.000. Alternative Expected Value a.57 EVbuild = (.000 Rejected (.000 $500.x) = 4. Renew 500. MaxiMax MaxiMin Laplace Minimax Alternative (a) Max.5)(1.500.x) =(.000.500.575.5) + (.000.000E.000 Relocate $5. Then P (application rejected) = 1 .000* Decision: Relocate Renew Relocate Relocate 7. Payoff (c) Average (d) Max.000 $100.4)(1.65) = $1.000.4)(1.Solutions (continued) 5.000 = $1.5)(1.575.4)(1.000. From Problem 6.550.5)(1.35) + 100. Payoff (b) Min.000 + 4.000 Instructor’s Manual.0) + (.000 $4.000.000) + .000 .3) + (.000x + 4.000 + 4.35(5.775.000* $3.000x + 100.000 Yes.000* Relocate 5.65) = $2.000* $2. Rejected (.

000 in order that EV= EV EV– EV= $2.8(72) a. EMV 9.8 High Subcontract 42 + 46. c.4 + 2 Expand 50 Large .6 max.22. 2/ce .5 0. Not sensitive (i. Very sensitive because .000 + 4.-20) = $42 million.775.000 $960.077 Range is $2.923 $4.Solutions (continued) Exp.e.523.000 = $960. 72 . at which point decision should be changed.000 – $1.000x 2 2 Relocate 1 1 . p (approve) can increase to .476. D = amount of decrease in $4.1 x = .6m b.000.8 High Do Nothing 46 44.923 = $2.8 High + 53.464.000.000 = .000 – $1.523.2 Low .2(42) .000x 4 Renew Relocate 4 3 3 4.8 2 Expand 48 . Demand $ 42 .077 or more. Decision: Build a large facility (see the tree). Value 5 (millions) Renewal better than 5 Relocation 100.900.8(48) Small .2 Low 22 .8(50) . 71 Operations Management.2 Low (-20) . Max (42.2(22) Medium 1 .46 and still the decision remains renew.65D D = $1.500.000 – 3.2(-20) .. EMV = $53.45 is very close to . b.476.4643 P (application approved)=x a.000.815.

0 EVPI = $66. Decision: Build a small facility.30 low 75 .4 Would be willing to pay up to $12. Instructor’s Manual.3(90) do nothing 90 + $104 buy 1 . Let P(high) = x P(low) = 1-x I. Large: -20(1-x) + 72x => -20 + 92x Value of x where expected value for I and III are the same.5 (optimum) . EVPI = EPC – EMV EPC = 42(.6 = $12.7(130) Decision: Buy 2 machines (initially).8) = $66. Medium: 22(1-x) + 50x => 22 + 28x III.0 – 53.721 10.4 million to find out the demand.7(110) buy 2nd 100 . .2) + 72(. c.70 high 130 . 42 + 6x = -20 + 92x => 86x = 62 => x = 0. and Large if p(high) >.721.0 -20 P (High) Choose Small if p(high) <. d. Chapter 5 Supplement 72 . Small: 42(1-x) + 48x => 42 + 6x II.721 1.30 low demand $90 .70 high demand subcontract 2 110 .721 72 50 Small 42 48 Medium 22 Large 0 .3(75) buy 2 + $113.

12. 2/ce .20 49 1/3 (45) 1/3 2 45 1/3 99 Alternative B 40 .3)(50) + (.2)(60) = 49 EV5 = (. 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. Minimin: Redesign c.5)(44) + (.30 40 .3)(40) + (.50 5 50 . 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.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 = (.50 4 44 Alternative A 60 .30 40 .5)(50) + (. New Staff or Redesign (tie).Solutions (continued) 1/3 0 1/3 60 11. 1 1/3 90 50 . 73 Operations Management. Minimax: New staff b. choose alternative A.2)(45) = 46 Since 49 > 46.

10 Moderate Hire 2 60 Initially . Reassign: .30(60) + .10 Moderate 40 Redesign .10 Moderate 50 Reassign .60 Very High 60 .60(85) = $74 New Staff: .60(60) = 60 * Redesign: . High (Hire 1 more) Initially 80 .30 High (Hire 1 more) 74.1) (. 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) (.60 Very High 85 .30(50) + . . a.60 V.30 High 60 60 60 .60(90) = 73 b.60 Very High 90 c.30 High 74 60 .60 Very High 90 Hire 2 initially. Solutions (continued) 13.3) (.10 Moderate 60 New Staff .60 Very High 85 .6) 14. Chapter 5 Supplement 74 . Instructor’s Manual.10 Moderate 40 .5 75 Hire 1 .30 High 73 50 .10 Moderate 50 Reassign .30 High 74 60 .10 Moderate 40 Redesign .10(60) + .30(60) + .30 High 60 60 . .10(50) + .30 High 73 50 .60 Very High New Staff 60 60 60 .10(40) + .

d. EV= 20 + 120P..60P.60 => Choose 0 1. P = . c. Therefore. 16.556 = 1 .625.286 .6 #4 EV3 = EV4 => 5 = 7P => P = .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 = = .625 1. [Refer to the diagram in the previous solution] b.444.000 . Solving.60 . 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 . Alternative B is now the one that is never appropriate. choose Alternative A if P(#2) is greater than .286 => Choose #1.625. For P(#1).6 ≤ P < .285 7 3 EV2 = EV3 => 8-5P = 5 => 5P = 3 => P = .444. Alternative C is lower than Alternative B for all values of P(#2).714 If P < . Solving. choose Alternative A. if P ≥ .0 P b.286 ≤ P < .714 #2.444. if P(#1) is less than .0 . Therefore.375 (i. if .714 => Choose #4 -2 75 Operations Management. P = .625).40P. a. choose A for P(#1) greater than . Solutions (continued) 15. so it would never be appropriate.714 => Choose #3. In terms of P(#1). EV= 20 + 120P. and choose Alternative C for P(#2) greater than . 1. c. EV= 100 .. 2/ce .e. d. if . choose Alternative A for P(#2) less than . EV = 120 .

3 ≤ P(2) < . EV= 120 (1-P) + 20P = 120 – 100P . Chapter 5 Supplement 76 .8 EV= 60 (1-P) + 40P = 60 – 20p A Profits 110 D: . A: never 90 90 EV 90 (1-P) + 90P = 90 B: . A: P(2) < .0 EV= EV => 120 – 100P = 90 => P =.3 P (#2) EV= EV => 90 = 10 + 100P => P = 80 EV= EV => 10 + 100P = 60 – 20P => P = .80 a.75 1.417 EV= EV => 60 – 20P = 120 – 100P => P =.417 D: P(2) ≥ . Solutions (continued) 18.30 .417 ≤ P(2) < .417 .75 60 B C 40 Costs A 20 10 0 .75 Instructor’s Manual.8 EV= 10 (1-P) + 110P = 10 + 100p C D b.30 B: never 120 C: P(2) ≥ .75 C: P(2) < .