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Decision Theory

Decision Theory

A general approach to decision making

that is suitable to a wide range of

operations management decisions

Capacity planning

Product and service design

Equipment selection

Location planning

Characteristics of Suitable

Problems

Characteristics of decisions that are

suitable for using decision theory

A set of possible future conditions that will

have a bearing on the results of the decision

A list of alternatives from which to choose

A known payoff (Profit) for each alternative

under each possible future condition

Process for Using Decision

Theory

1. Identify the possible future states of nature

2. Develop a list of possible alternatives

3. Estimate the payoff for each alternative for each

possible future state of nature

4. If possible, estimate the likelihood of each possible

future state of nature

5. Evaluate alternatives according to some decision

criterion and select the best alternative

Payoff Table

A table showing the expected payoffs for each

alternative in every possible state of nature

Possible Future Demand

Alternatives Low Moderate High

Medium facility 7 12 12

should be constructed

The present value (in millions) for each alternative under

each state of nature is expressed in the body of the above

payoff table

Causes of Poor Decisions

More frequently poor decisions are the result

of a combination of

Mistakesin the decision process

Bounded rationality

The limitations on decision making caused by costs,

human abilities, time, technology, and availability of

information

Sub-optimization

The results of different departments each attempting

to reach a solution that is optimum for that department

Decision Process

Steps:

1. Identify the problem

2. Specify objectives and criteria for a solution

3. Develop suitable alternatives

4. Analyze and compare alternatives

5. Select the best alternative

6. Implement the solution

7. Monitor to see that the desired result is achieved

Decision Environments

There are three general environment categories:

Certainty

Environment in which relevant parameters (such as;

capacity, demand, costs) have known values.

e.g. Profit per unit is $5. You have an order for 200 units.

Risk

Environment in which certain future events have probable

outcomes.

e.g. Profit is $5 per unit. 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.

Uncertainty

Environment in which it is impossible to assess the likelihood

of various possible future events

e.g. Profit is $5 per unit. The probabilities of potential

demands are unknown.

Decision Making Under

Uncertainty

Decisions are sometimes made under complete uncertainty

No information is available on how likely the various states

of nature are.

Decision Criteria:

Maximin (pessimistic approach)

Choose the alternative with the best of the worst possible payoffs

Maximax (optimistic approach)

Choose the alternative with the best possible payoff

Laplace

Choose the alternative with the best average payoff

Minimax regret

Choose the alternative that has the least of the worst regrets (min. of

the max. regrets)

Example Maximin Criterion

Possible Future Demand

Alternatives Low Moderate High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

Small facility: $10 million

Medium facility $7 million

Large facility -$4 million

Choose to construct a small facility

(the best of the worst possible payoffs)

Example Maximax Criterion

Possible Future Demand

Alternatives Low Moderate High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

Small facility $10 million

Medium facility $12 million

Large facility $16 million

Choose to construct a large facility

(the best possible payoff)

Example Laplace Criterion

Possible Future Demand

Alternatives Low Moderate High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

Small facility: (10+10+10)/3 = $10 million

Medium facility (7+12+12)/3 = $10.33 million

Large facility (-4+2+16)/3 = $4.67 million

Choose to construct a medium facility

(the best average payoff)

Example Minimax Regret

Possible Future Demand

Alternatives Low Moderate High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

The difference between a given payoff and the best payoff for a state of

nature

Regrets

Alternatives Low Moderate High

Small Facility $0 $2 $6

Medium 3 0 4

Facility

Large Facility 14 10 0

Example Minimax Regret

Regrets

Alternatives Low Moderate High

Small Facility $0 $2 $6

Medium Facility 3 0 4

Large Facility 14 10 0

Small facility $6 million

Medium facility $4 million

Large facility $14 million

Select the alternative with the minimum of the maximum regrets

Build a medium facility

Decision Making Under Risk

Decisions made under the condition that the probability

of occurrence for each state of nature can be estimated

A widely applied criterion is expected monetary value

(EMV)

EMV

Determine the expected payoff of each alternative, and

This approach is most appropriate when the decision maker is

neither risk averse nor risk seeking

Probability of

Example EMV occurrence

Alternatives Low (.30) Moderate (.50) High (.20)

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

EMVmedium = .30(7) + .50(12) + .20(12) = 10.5

EMVlarge = .30(-4) + .50(2) + .20(16) = $3

Decision Tree

Decision tree

A schematic representation of the available alternatives and

their possible consequences

Useful for analyzing sequential decisions

Decision Tree

Nodes

Decisions

represented by square

nodes

Chance events

represented by circular

nodes

Branches

Alternatives branches

leaving a square node

Chance events

branches leaving a

circular node

Decision Tree

Analyze from right to left

Start with the last decision that might be made.

For each decision, choose the alternative that will

yield the greatest return (or the lowest cost).

If chance events follow a decision, choose the

alternative that has the highest expected monetary

value (or lowest expected cost).

Example Decision Tree

A manager must decide on the size of a video arcade to construct. The

manager has narrowed the choices to two: large or small. Information has

been collected on payoffs, and a decision tree has been constructed.

Analyze the decision tree and determine which initial alternative (build small

or build large) should be chosen in order to maximize expected monetary

value.

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Example Decision Tree

Determine which alternative would be selected for each possible second

decision.

For a small facility with high demand, the choice (expand) has the highest payoff.

For a large facility with low demand, the choice (reduce prices) has the higher

payoff.

Example Decision Tree

Determine the expected value of each initial alternative

EMVSmall = .40(40) + .60(55) = $49

EMVLarge = .40(50) + .60(70) = $62

The choice should be to build the large facility because it has a

larger expected value than the small facility.

Expected Value of Perfect

Information

Expected value of perfect information (EVPI)

The difference between the expected payoff with perfect

information and the expected payoff under risk

Two methods for calculating EVPI

EVPI = expected payoff under certainty expected payoff under risk

EVPI = minimum expected regret

Example EVPI

Possible Future Demand

Alternatives Low (.30) Moderate (.50) High (.20)

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

EMV = $10.5

EVPI = EVwith perfect information EMV

= $12.2 10.5

= $1.7

You would be willing to spend up to $1.7 million to obtain perfect

information

Example EVPI

Regrets

Alternatives Low (.30) Moderate (.50) High (.20)

Small Facility $0 $2 $6

Medium Facility 3 0 4

Large Facility 14 10 0

EOLSmall = .30(0) + .50(2) + .20(6) = $2.2

EOLMedium = .30(3) + .50(0) + .20(4) = $1.7

EOLLarge = .30(14) + .50(10) + .20(0) = $9.2

The minimum EOL is associated with the building the medium size

facility. This is equal to the EVPI, $1.7 million

Sensitivity Analysis

Since the payoffs and the probabilities are

estimated values, it can be useful to have some

indication of how sensitive the choice of an

alternative is to changes in one or more of these

values.

Sensitivity Analysis

provides a range of probability over which the

choice of alternatives would remain the same.

Sensitivity Analysis Example

For two states of nature only

State of nature

#1 #2

A 4 12

Alternatives B 16 2

C 12 8

for which each alternative is optimal

Sensitivity Analysis Example

Plot each alternative relative to P(2).

Sensitivity Analysis Example

Obtain the equation of each line.

Straight line equation y = a + bx

where

a the y-intercept value at the left axis

b the slope of the line (the change in y for a one-unit change in x)

x P(2).

State of nature

Slope Equation

#1 #2

A 4 12 12-4 = 8 4 + 8 P(2)

Alternatives B 16 2 2-16 = -14 16 14 P(2)

C 12 8 8-12 = -4 12 4 P(2)

Sensitivity Analysis Example

Find the points of intersection,

Solve for the value of P(2) at each intersections.

For B & C intersection

16 14 P(2) = 12 4 P(2)

P(2) = 0.4

Thus, alternative B is best from P(2) = 0 up to P(2)= 0.40.

For C & A intersection

12 4 P(2) = 4 + 8 P(2)

P(2) = 0.67

Thus, alternative C is best from P(2)= 0.4 up to P(2) = 0.67

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