# SUPPLEMENT TO CHAPTER 5 DECISION THEORY

Answers to Discussion and Review Questions
1. 2. The chief role of the operations manager is that of decision maker. Decision making consists of the following steps: (1) Specify objectives and criteria for making a decision. (2) Develop alternatives. (3) Analyze and compare alternatives. (4) Select the best alternative. (5) Implement the chosen alternative. (6) Monitor the results. Bounded rationality is a term that refers to the limits imposed on decision making because of costs, human abilities, time, technology, and availability of information. 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. 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 departmentalizing decisions (which often leads to interdepartment conflicts and suboptimization). A payoff table shows the expected payoffs for each alternative in every possible state of nature. 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. 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. 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). 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, and/or where utilities are nonlinear, 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. 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 opportunity loss, or regret, associated with choosing a decision. c. Expected value is an approach to decision making under risk: the probabilities of states of nature are assumed to be known.
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" 79 Operations Management. Thus.11. a list of states of nature. it may not be necessary for a decision maker to pinpoint a probability. In order to use an expected value approach to decision making. it may only be necessary to decide if a probability is in this "ballpark. Sensitivity analysis could be used to show the range of probability for which a particular alternative would be optimal. or adopting an approach which does not call for probabilities. 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. and a set of payoffs). either additional resources can be used to attempt to ascertain the probabilities. 7/e . If probabilities are unknown. d. rather. a decision maker must have state of nature probabilities (in addition to a list of alternatives.

Chapter 5 Supplement 80 .Solutions Instructor’s Manual.

70(80) = \$71 Exp. a.67 1. EPC: . Expected profit Do Nothing \$57 Expand 62 Subcontract 61 \$57 Do Nothing \$62 Expand \$61 Subcontr. Maximax: Best payoffs: Do Nothing: Expand: Subcontract: Worst payoffs: Do Nothing: Expand: Subcontract: Average Payoff Do Nothing Expand Subcontract Low 0 30 10 High 20 0 10 60 80 70 50 20 40 55 50 55 [best of the best payoffs] b.1.67 Low Payoff Do Nothing 80 70 60 High Payoff 50 40 20 Subcontract Expand 0 .67 to 1. [Best] .30(50) + .00 Subcontract: > .7 .3 .7 c. Minimax Regret Do Nothing Expand Subcontract 2. 7/e .0 81 Operations Management. Maximin: [best of the worst payoffs] c.7 \$50 \$60 \$20 \$80 \$40 \$70 . Laplace: [Indifferent between Do Nothing And Subcontract] d.3 . Profit: 62 EVPI: \$9 3.50 to < . Equations: Do Nothing: 50 + 10P Expand: 20 + 60P Subcontract: 40 + 30P Optimal ranges: Do nothing: 0 to < 50 Expand: > . Worst 20 30 10 [best of worst] a.50 .3 .

000 = \$270.000 (expected value if Build large is chosen) (4) Since the expected value of building a large plant has the higher expected value. \$50.4) Build Small Maintain Demand High (.000 = \$160. b.000 (2) (eliminated) \$430.000 Expected value of perfect information: \$164.54 0 Instructor’s Manual.000 vs. select the large plant alternative. For instance begin with decision 2 and choose expansion because it has a higher present value (\$450.000 Expected payoff under risk: 476. work backwards from the end of the tree towards the root).000).000) + . and then determine the expected value for the two initial alternatives.000 (5) (2) Analyze decisions from right to left (i.Solutions (continued) 4. (1) .4 x \$400.e.6 x \$450.000 (2) Expand \$450.0 P (low) .000 (4) Demand High (. (1) Draw the tree diagram: Demand Low (.4(400.000 (1) \$50.6 (800. a.000 (expected value if (3) . Low 800 High Payoff Build Large 400 Build Large Build Small 450 -10 1.000 (3) 1 Build Large Demand Low (. (3) Compute the expected value of the ends of the remaining branches (numbered 1 to 5 in the diagram).000) = \$640. Expected payoff under certainty: ..000 5. Chapter 5 Supplement 82 .4) \$-10.000 = \$-4.4 x -\$10.6 x \$800.000 = \$480.000 (5) .6) 2 \$400.6) \$800.000 Build small is chosen) (4) .000 \$476.

65) \$5.000* \$3.000.35) Reject (. a.000(.815. build.000.000 .000 Yes. EVsubcontract= (.000(1 .Solutions (continued) 5.3.000) + .4) = 1.4)(1.23 EVexpand = (. Decision: Renew lease EVPI = EPC – EMV = .000 + 4. b.000 \$1.x) = 100. 6.000(.900.3. 83 Operations Management.000 Approve (. Payoff (c) Average (d) Regret \$4.65) = \$1.6) + (..5)(1.5)(1.x) = 4.000x The two alternatives are equally good when 4.V. \$2. From 7(a) 500.4) + (.575.000 Renew Reject (. 7/e .000* Relocate Renew Relocate Relocate Expected Value 500.900.000 \$2.000(.000 \$5. Let P (application is approved) = x.815.000* \$100.35 Since 1. when x + 3.000 c.000 E.5) + (.000 = \$1.7) = 1.250.000 since it is less than the EVPI of \$1.000. Payoff (b) Min.4643 8.000* 7.000 \$500. Renew Relocate MaxiMax MaxiMin Laplace Minimax (a) Max.57 > 1.000(.35) + 100.5)(1.65(4.000.x.000 + 4.000) .35) \$500.35) + 4.35 > 1.400. the manager should sign the lease for \$24.000.000.000 = 0.500.3) + (.775.1) + (.000* 5.550.8) = 1. Relocate Approve (.000 .4)(1.2.000.500.000 \$4.000x + 4.000 \$100.000x i.775.65) \$4. Then P (application rejected) = 1 .57 EVbuild = (.775.000.1)(1.0) + (.23.500.575.900.900.1)(2.000.35(5.000x + 100.000.000x and 5.65) = \$2.000x = 100.000* \$2.000 8.4)(1.1)(1.000. Alternative Renew Relocate Decision: Alternative a.e.000(1 .000.000.

Chapter 5 Supplement 84 .4 Instructor’s Manual.22.6 = 12.775.5 P (application approved) Renewal better than Relocation Renew Relocate 5 4 3 100.523.2(-20) + .000 = .2 Low .500. Max (42. Decision: Build a large facility.65D D = \$1.523.000 – 3. .Solutions (continued) Exp.6 = \$66.8(50) .900.-20) = \$42 million.8(72) 46. D = am't of decrease in \$4.0 .8 1 44. Value (millions) 5 4 3 2 1 Relocate 4.6 a.4 + 57.000 – \$1.53.000.000 Range is \$2.2 Low .000 – \$1.476.8 High 72 Do Nothing Expand Expand Greatly 48 22 46 50 (20) .000 + 4.020 \$4. 9.2(42) .476.8 High 2 Large .000.2(22) + .920 = \$2.000.2) + 72(.000 in order that EV= EV EV– EV= \$2.080 or more. c.000 = \$960.8 High 42 + .8) = 8.000 \$960.4643 .4 53. EVPI = EPC – EMV EPUC = 42(. b.8(48) . Decision: Build a small facility.000x 2 1 x = .815.2 Low \$ 42 Subcontract 2 Small Medium .000x For 8(a) and 8(b) the decision should be to renew the 10 year lease. c.

30 low buy 2 .3(75) + . 42 + 6x = -20 + 92x => 86x = 62 => x = 0.3(90) \$104 Decision: Buy 2 machines. . 85 Operations Management.721 P (High) 1.7(130) \$113. Large: 42(1-x) + 48x => 42 + 6x -20(1-x) + 72x => -20 + 92x II.0 10. Medium: 22(1-x) + 50x => 22 + 28x Value of x where expected value for I and III are the same. 7/e .7209 72 Small 42 22 0 -20 Medium 50 48 Large . Let P(high) = x P(low) = 1-x I.70 high 110 100 75 130 + .5 (optimum) \$90 .7(110) .Solutions (continued) d. Small: III.30 low do nothing buy 1 2 90 subcontract buy 2nd .

5)(50) + (.Solutions (continued) 11.4) \$-10.000 (5) (2) Analyze decisions from right to left (i. choose alternative A.6) \$800.3)(40) + (.50 1 1/3 1/3 1/3 0 60 90 40 44 .3)(50) + (.6) 2 Build Large Demand Low (.2)(60) = 49 EV1 = (. 50 .000 vs.4) Build Small 1 \$400.5)(44) + (.000 (1) Maintain \$50.000 (4) Demand High (.20 60 49 2 Alternative B 40 . \$50.50 . (1) Draw the tree diagram: Demand Low (. For instance begin with decision 2 and choose expansion because it has a higher present value (\$450.000 (2) Expand \$450.. 12.30 4 Alternative A .20 45 1/3 1/3 1/3 (45) 45 99 40 50 30 1/2 3 1/2 40 50 EV1 = (1/3)(0) + (1/3)(60) + (1/3)(90) = 50 EV2 = (1/3)(-45) + (1/3)(45) + (1/3)(99) = 33 EV3 = (1/2)(40) + (1/2)(50) = 45 EV4 = (.2)(45) = 46 Since 49 > 46.000 (3) Demand High (.000). work backwards from the end of the tree towards the root). Instructor’s Manual.e.30 5 . Chapter 5 Supplement 86 .

Solutions (continued) (3) Compute the expected value of the ends of the remaining branches (numbered 1 to 5 in the diagram).10 Moderate Redesign 73 .10(40) + . Maximax: Redesign c.000 \$476.60 Very High 50 60 85 60 60 60 40 50 90 87 Operations Management.000 = \$270.60 Very High .000 (2) (eliminated) \$430. 13.000 (expected value if (3) .4 x -\$10. Maximin: New staff b. Regret table: Moderate Reassign 10 New Staff 20 Redesign 0 High 10 10 0 Very High 25 0 30 Worst 25 20* 30 d.4 x \$400.30(60) + . . select the large plant alternative.000 Build small is chosen) (4) .6 x \$450.000 = \$480. Insufficient reason: (tie) New Staff or Redesign 14.30(60) + .000 (5) .60(85) = \$74 New Staff: . (1) .30 High .6 x \$800.10 Moderate 60 New Staff 60 . Reassign: . and then determine the expected value for the two initial alternatives.000 (expected value if Build large is chosen) (4) Since the expected value of building a large plant has the higher expected value.000 = \$160.10 Moderate Reassign 74 .30 High .10(60) + . Reassign New Staff Redesign Moderate 50 60 40 High 60 60 50 Very High 85 60 90 Worst 85 60* 90 Best 50 60 40* Average 65 60 (tie) 60 a.30(50) + .30 High . 7/e .60 Very High .60(90) = 73 b. a.60(60) = 60 * Redesign: .000 = \$-4.10(50) + .

30 High (Hire 1) . 140 120 B d.625).Solutions (continued) c.625.e.10 Moderate EOL 19 5* 18 50 60 85 60 60 60 40 75 80 40 50 90 15.30 High .30 High .000 . EV = 120 . choose Alternative A if P(#2) is greater than .10 Moderate 73 . so it would Payoff never be appropriate. EV= 20 + 120P. #1 #2 16. c.60 Very High .375 (i.60 V.3) Very High 25 0 30 (.40P.0 88 . 1. Opportunity loss table: Moderate Reassign 10 New Staff 20 Redesign 0 (. Reassign Hire 2 Initially 60 New Staff 60 74 . if P(#1) isAless than . 100 C C A 40 B 80 Instructor’s Manual. Solving. High (Hire 1) . choose Alternative A. For P(#1)..60 Very High Solution continued b.30 High .1) High 10 10 0 (.. Therefore. Chapter 5 Supplement 0 P(#2) 1.10 Moderate Hire 1 Initially Redesign 74.6) . Alternative Payoff C is lower than Alternative B for all values of P(#2).10 Moderate 60 .5 .625.60 Very High . P = .

EV= 20 + 120P. EV= 120 – 100P EV= 60 – 20p EV= 10 + 100p EV = 90 Payoff #1 120 A . .60P. 89 Operations Management. c. In terms of P(#1). 7/e . and choose Alternative C for P(#2) greater than .417 becomes . Therefore.30 becomes .25.70. P = .75 becomes .30 Profits . Solving. . .286 .556.3 > 1. and .556 and C for P(#1) less than .714 19.444.75 1. choose Alternative A for P(#2) less than . choose A for P(#1) greater than .80 Payoff #2 110 C 90 D 90 Note that in terms of P(#1).444.0 P (#2) 2. C B Costs A 40 20 10 0 .80 becomes .5.60 . Alternative B is now the one that is never appropriate.Solutions (continued) 17. 18. 60 20. hire no additional employees when the probability of rain is 20%.583. d. EV= 10 – 12P EV= 8 – 5P EV= 5 – 0P EV= 0 + 7P Payoff for contract 10 #1 8 #2 #2 5 #3 #4 7 5 Payoff for no contract 3 #4 0 1.0 -2 . [Refer to the diagram in the previous solution] b.417 . EV= 100 .444.