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Decision Environment
Decision Environment
- Operation management decision environments are classified according to degree of certainty present:
3 BASIC CATEGORIES
1) CERTAINTY
- Environment in which relevant parameters have known values.
- Means that relevant parameters such as cost, capacity, and demand have known values
- The decision maker knows which state of nature will occur
- E.g. profit/unit is P50. You have an order for 200 units. How much profit will you make? (profits and total
demand are known)
2) RISK
- Environment in which certain future events have probable outcomes
- Means that certain parameters have probabilistic outcomes
- The decision maker does not know which state of nature will occur but can estimate the probability that
any one state will occur.
- E.g profit/ unit is P50. Based on previous experience there is a 50% chance of an order for 100 units and
a 50% chance of an order for 200 units. What is expected profit? (demand outcome are probabilistic)
3) UNCERTAINTY
- Environment in which it is impossible to assess the likelihood of various future events
- Means that it is impossible to assess the likelihood of various future events
- The decision maker lacks sufficient information even to estimate the probabilities of the possible states of
nature
- E.g. profit is to P50/unit. The probabilities of potential demand are unknown.
NOTE: These three decision environments require different analysis techniques. Some techniques are
better suited for one category than for others.
DECISION THEORY
- Suitable for a wide range of operations management decisions, e.g. capacity planning, product and
service design, equipment selection and location planning and inventory, because these are about an
uncertain future.
- General approach to decision making when the outcomes associated with alternatives are often in
doubt.
ELEMENTS OF DECISION MAKING
1. A set of possible future conditions exist that will have a bearing on the results of the decision.
2. A list of alternatives for the manager to choose from.
3. A known payoff for each alternative under each possible future condition.
PROCESS OF DECISION MAKING
1. List the feasible alternatives
- One alternative that should always be considered as a basis for reference is to do nothing or to maintain
Status Quo.
Ex.: where to locate a new retail store in a certain part of the city
2. List the events (chance events or states of nature) that have an impact on the outcome of the choice but
aren’t under the managers’ control
States of Nature- possible future conditions; these events must be mutually exclusive and exhaustive-
they don’t overlap and that they cover all eventualities.
Ex.:
a) Number of contracts awarded will be one, two or three
b) Competitors will or will not introduce a new product
c) Demand experienced by the new facility could be: low, medium or high
Location
Depending on Competition then group events into reasonable
General retail/ trends categories*
*e.g. average of sales per day could be from 1 to from 500 units. The manager can represent demand
with just 3 events: 100 units/day, 300 units/day or 500/day.
Payoffs are in terms of present values which represent equivalent current peso
values of expected future income
4. Estimate the likelihood of each event using past data, executive opinion and other forecasting methods.
- express it as probability, making sure that the probabilities sum to 1.0; develop probability estimates from
past data if the past is considered a good indicator of the future.
5. Select a decision rule or criterion to evaluate the alternatives and select the best alternative
e.g. choosing the alternative with the lowest expected cost
Solution:
a. Maximin
1. Select the column with minimum payoff.
2. Identify the worst payoff.
Alternative Payoffs Worst Payoffs
Small Facility 200
Large Facility 160
The best of these worst numbers is 200, so the pessimist would build a small facility.
b. Maximax
1. Highest number in its row
Alternative Payoffs Best Payoffs
Small Facility 270
Large Facility 800
The best of these numbers is 800, so the optimist would build a large facility.
c. Laplace
1. With two events, we assign each a probability of 0.5.
Alternative Payoffs Weighted Payoffs
Small Facility 0.5(200) +0.5(270) = 235
Large Facility 0.5(160) + 0.5(800) = 480
The best of these payoffs is 480, so the realist would build a large facility.
d. Minimax Regret
1. Determine the largest element in both columns.
2. Subtract every element from the largest payoff in both columns.
3. Select the largest amount in each row.
4. Identify the maximum regrets.
Alternative Payoffs Low Demand High Demand Maximum Demand
Small Facility 200-200=0 800-270=530 530
Large Facility 200-160=40 800-800=0 40
The column on the right shows the worst regret for each alternative. To minimize the maximum regret,
pick a large facility. The biggest regret is associated with having only a small facility and high demand.
The best of these worst numbers is 270, so the pessimist would build a small facility.
b. Minimin
1. lowest number in its row
Alternative Payoffs Best Payoffs
Small Facility 200
Large Facility 160
The worst of these numbers is 160, so the optimist would build a large facility.
c. Laplace
1. With two events, we assign each a probability of 0.5.
Alternative Payoffs Weighted Payoffs
Small Facility 0.5(200) +0.5(270) = 235
Large Facility 0.5(160) + 0.5(800) = 480
The worst of these payoffs is 235, so the realist would build a small facility.
d. Minimax Regret
1. Determine the lowest element in both columns.
2. Subtract every element from the lowest payoff in both columns.
3. Select the largest amount in each row.
4. Identify the lowest payoff.
Alternative Payoffs Low Demand High Demand Maximum Demand
Small Facility 200-160=40 270-270=0 40
Large Facility 160-160=0 800-270=530 530
Maximax Profit – Choose the highest in each row and select the highest in the
column.
Minimin Cost – Choose the lowest in each row and select the lowest payoff in the
column.
Profit – get the average in each row and select the highest payoff in the column.
Laplace
Cost – get the average in each row and select the lowest payoff in the column.
Profit – Subtract highest PO in each column to each PO in each row, select the
highest in each row then select the lowest.
Minimax Regret
Cost – subtract lowest PO to each PO in each row, select the highest in each
row, and select the lowest.
EMV Criterion
- Determine the expected payoff of each alternative and choose the alternative that has the best
expected payoff
Note: This EMV approach is most appropriate when a decision maker is neither risk- averse nor
risk- seeking, but is risk- neutral.
The expected value is what the average payoff would be if the decision would be
repeated time after time.
The rule should not be used if the manager is inclined to avoid risk. This approach
provides an indication of the long run, average payoff that is, the expected value amount is not an
actual payoff but an expected or average amount that would be approximated if a large number of
identical decision, were to be made.
Example 1
Possible Future Demand
Alternative Low High
Small Faculty 200 270
Large Faculty 160 800
Do Nothing 0 0
Which is the best alternative if the probability of small demand is estimated to be .40 and
the probability of large demand is estimated to be .6?
Example 2 Using the expected monetary value criterion, identify the best alternative for previous
payoff table for these probabilities: low= .30, moderate= .50 and high= .20
Solution:
EV small= .30(P10) + .50(P10) + .2(P10) = P10
EV medium=. 30(P7) + .50(P12) + .2(P12) = P10.5
EV large= .30(-4) + .50(P2) + .2(P16) = P3
Choose the medium facility because it has the highest expected value
Note: suppose that a manager has a way of improving the forecasts- through more expensive
market research or studying past trends. Assume that the manager, although unable to affect the
probabilities of the events, can predict the future without error.
Example:
Possible Future Demand
Alternative Low High
Small Faculty 200 270
Large Faculty 160 800
Do Nothing 0 0
The probability of small demand is estimated to be .40 and the probability of large demand is
estimated to be .6
Expected Value of the Perfect Information= .6(270) +.6(800) = 642
Expected Value of the Imperfect Information= .4(200) + .4(160) = 144
Value of the Perfect Information= 642-144