5s-1

Decision Theory

Decision Theory

McGraw-Hill/Irwin

Operations Management, Eighth Edition, by William J. Stevenson
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights

5s-2

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
planning
location
planning

product
product and
and
service
service design
design
equipment
selection

5s-3 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 .

5s-4 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 .

5s-5 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 .

human abilities. time.5s-6 Decision Theory Causes of Poor Decisions Bounded Rationality The limitations on decision making caused by costs. and availability of information . technology.

5s-7 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 .

Environment in which relevant parameters have known values  Risk .Environment in which it is impossible to assess the likelihood of various future events  .5s-8 Decision Theory Decision Environments Certainty .Environment in which certain future events have probable outcomes  Uncertainty .

000 -150.000 1.5s-9 Decision Theory Example ABC Inc.000 320.000 500.300. States of Nature Alternative Good ($) Bad ($) Expand 800. Determine the best decision using the different decision criteria.000 Maintain Status Quo Sell now .000 320. has acquired a new textile company and is contemplating on the future of this new acquisition. The alternative decisions presented below are being considered with its corresponding payoffs.

000 500.300. The maximum of the maximums or “best of the best” States of Nature Alternative Good ($) Bad ($) Expand 800.000 Maintain Status Quo Sell now Choose: Maintain Status Quo = $1.000 1.000 320.000 -150.5s-10 Decision Theory Decision Making under Uncertainty Maximax – is an optimistic approach in decision making.000 320.300.000 . It looks at the best that could happen under each action and then chooses the action with the largest value.

The maximum of the minimums or the “best of the worst”.5s-11 Decision Theory Decision Making under Uncertainty Maximin – is a pessimist approach in decision making.000 -150.000 500. It looks at the worst that could happen under each action and then choose the action with the largest payoff.000 320.300. States of Nature Alternative Good ($) Bad ($) Expand 800.000 .000 1.000 320.000 Maintain Status Quo Sell now Choose: Expand = $500.

5s-12 Decision Theory Decision Making under Uncertainty Hurwicz – is an approach in decision making that represents a compromise between Maximax and Maximin criteria.300. 55% Bad ($).000 320. It makes use of the “Hurwicz criterion of Realism”. States of Nature Alternative Expand Maintain Status Quo Sell now Good ($).500 320.000 Choose: Expand = $665.000 500.000 320.000 1.000 647. 45% Payoff 800. It puts weight on the different states of nature and chooses the alternative with the best payoff.000 .000 665.000 -150.

000 Choose: Expand = $650.000 320.000 -150.000 1.000 320.000 650.000 575. 50% Bad ($).000 .5s-13 Decision Theory Decision Making under Uncertainty Laplace (Equal Likehood) – is an approach that gives equal weight to each state of nature and then chooses the alternative with the best payoff.000 500.000 320. 50% Payoff 800. States of Nature Alternative Expand Maintain Status Quo Sell now Good ($).300.

000 320.000 320.5s-14 Decision Theory Decision Making under Uncertainty Minimax – determine the worst regret for each alternative. and choose the alternative with the “best worst”.000 1.300. This approach seeks to minimize the difference between the payoff that is realized and the best payoff for each state of nature.000 500.000 Maintain Status Quo Sell now .000 -150. States of Nature Alternative Good ($) Bad ($) Expand 800.

States of Nature Alternative Good ($) Bad ($) Expand 500.000 980.000 500.5s-15 Decision Theory Decision Making under Uncertainty Minimax – determine the worst regret for each alternative. This approach seeks to minimize the difference between the payoff that is realized and the best payoff for each state of nature.000 Maintain Status Quo Sell now .000 0 -150. and choose the alternative with the “best worst”.000 320.

000 980. States of Nature Alternative Good ($) Bad ($) Expand 500.5s-16 Decision Theory Decision Making under Uncertainty Minimax – determine the worst regret for each alternative.000 Maintain Status Quo Sell now . This approach seeks to minimize the difference between the payoff that is realized and the best payoff for each state of nature.000 0 0 650.000 180. and choose the alternative with the “best worst”.

States of Nature Alternative Good ($) Bad ($) Worst Expand 500.5s-17 Decision Theory Decision Making under Uncertainty Minimax – determine the worst regret for each alternative.000 650. This approach seeks to minimize the difference between the payoff that is realized and the best payoff for each state of nature.000 980. and choose the alternative with the “best worst”.000 .000 Maintain Status Quo Sell now Choose: Expand = $500.000 0 500.000 180.000 0 650.000 980.

5s-18 Decision Theory Decision Making Under Certainty Expected Monitary Value (EMV) – computed by multiplying each decision outcome under each state of nature by the probability of its occurrence. The best decision is the one with the greatest expected value.  . Computed without perfect information.same as the Hurwicz approach  .

 .  EVw/PI – summation of the product of the best outcome in each state of nature and its corresponding probabilities of occurrence.5s-19 Decision Theory Decision Making Under Certainty Expected Value with (given) Perfect Information (EVw/PI) Information – maximum amount a decision maker would pay for additional information.

5s-20 Decision Theory Decision Making Under Certainty Expected Value of Perfect Information (EVPI) – the average/expected value of information if it were completely accurate. The information is perfect.  EVPI = EVw/PI – EMV  .

5s-21 Decision Theory .