DECISION THEORY

 By the end of this topic, the student

should be able to:
 Define decision theory.
 Identify some POM decisions for
which decision theory is suitable.
 Apply the decision making process
using decision theory under conditions
of certainty, risk, and uncertainty.
A. Ll. Areola
 What Is Decision Theory?

 A general approach
to decision making
Suitable for a wide range of
POM decisions such as:
 Capacity planning
 Product and service design
 Equipment selection
 Location planning
 Suitable for decisions with the
following elements:
1. A set of possible future conditions
exists that will have a bearing on the
results of the decision.
2.A list of alternative decisions for the
manager to choose from.
3.A known payoff for each alternative
under each possible future condition.
 Decision making Process using
Decision Theory
Identify the possible Develop a list Determine or
future conditions or of possible estimate the
states of nature alternatives payoff
associated with
If possible, each alternative
Evaluate the estimate the for every
alternatives likelihood of possible future
according to some each possible condition
decision criterion state of nature
and select the best
alternative
The information for a decision are
summarized in a Payoff Table

The payoffs are in terms of net present

values, which represent equivalent
current peso values of expected future
income less costs.
Evaluation of the alternatives differs
according to the degree of certainty
associated with the possible future
conditions. There are three possibilities:

• Decision making under certainty

• Decision making under risk
• Decision making under uncertainty
 Decision making Under
Certainty
• The future possible condition
that will actually happen is known
for certain.
 Decision: Simply choose the
alternative that has the best payoff
under the state of nature that is
certain to happen.
Decision making Under Certainty
POSSIBLE FUTURE DEMAND
ALTERNATIVES
Low Moderate High

Small facility $10M $10M $10M

Medium facility 7M 12M 12M
Large facility (4M) 2M 16M

If low demand is expected: build small facility.

If moderate demand: build medium facility.
If high demand: build large facility.
 Decision making Under
Uncertainty
• No information is available on
the likelihood of the various states
of nature.
Decision Criteria:
1. Maximin
2. Maximax
3. Laplace
4. Minimax regret
 • Maximin
Decision making Under Uncertainty

– a pessimistic approach
– takes into account only the
worst possible outcome for
each alternative
 Decision: Choose the alternative
with the best of the worst possible
payoffs.
Decision making Under Uncertainty

7M
(4M)
Worst
Decision making Under Uncertainty
• Maximax
– an optimistic approach
– takes into account only the
best possible outcome for
each alternative
 Decision: Choose the alternative
with the best possible payoff.
Decision making Under Uncertainty
Best

16M
12M
Decision making Under Uncertainty
• Laplace
– treats the states of nature as
equally likely.
 Decision: Choose the alternative
with the best average payoff.
Decision making Under Uncertainty
Average

10.33M
4.67M

Small facility: ( 10 + 10 + 10 ) = 10
3
( 7 + 12 + 12 ) = 10.33
Medium facility:
3
Large facility: ( -4 + 2 + 16 ) = 4.67
3
Decision making Under Uncertainty
• Minimax regret
– seeks to minimize the difference
between the payoff that is realized
and the best payoff for each state
of nature.
 Decision: Choose the alternative
with the least of the worst regrets.
Decision making Under Uncertainty

1. Decision:
Step 3.
2. Prepare the
Identify a Build
Table ofregret
worst
theOpportunity
medium Losses
for each
facility;
or Regrets
alternative.
this would minimize the worst regret.

Worst

4M
14M
 Decision making Under
Risk
• Lies between the two extreme cases
of certainty and uncertainty.
• The likelihood (probability) of
occurrence for each state of nature is
known.
• In this case, the expected monetary
value (EMV) criterion is used.
 • The EMV is the sum of the
Decision making Under Risk

payoffs for an alternative where

each payoff is weighted by the
probability for the relevant state of
nature.
 Decision: Choose the alternative
with the highest EMV.
Decision making Under Risk

EMV

10.5M
3M

EMVsmall = 0.30($10) + 0.50($10) + 0.20($10) = $10

EMVmedium = 0.30($7) + 0.50($12) + 0.20($12) = $10.5
EMVl arg e = 0.30(-$4) + 0.50($2) + 0.20($16) = $3

Hence, choose to build the medium facility,

because it has the highest EMV.
 Decision Trees
• A decision tree is a schematic
representation of the alternatives
available to a decision maker and
their possible consequences.

• Particularly useful for analyzing

situations that involve sequential
decisions.
 Decision Trees
• Composed of a number of nodes
that have branches emanating
from them. Square nodes denote
decision points, and circular
nodes denote chance events.

• Read the tree from left to right.

 Decision Trees
• Branches leaving square nodes
represent alternatives; branches
leaving circular nodes represent
chance events (i.e., the possible
states of nature).
 Decision Trees
• After the tree has been drawn, it is
analyzed from right to left; that is,
starting with the last decision that
might be made.
 Decision Trees
• 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 the lowest expected cost).
 • A manager must decide on the size
of a video arcade to construct. The
manager has narrowed the choices
Decision Tree Exercise

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.
 $40M
a nd (0.4)
em
Decision Tree Exercise

Low d
Hig ing
$40M
th
no
al l
hd o
em D
sm

an Overtime
d (0. $50M
ild

6)
Bu

Exp
and
$55M
Bu

g
o nothin ($10M)
ild

(0.4) D
a nd
em
lar

Low d
ge

Redu
c e pr
High ices $50M
dema
nd (0
.6)
$70M
 $40M
nd (0.4)
ema
Low d
Hig ing
$40M
th
no

al l
hd o
em D
sm
Decision Tree Exercise

an Overtime
d (0. $50M
ild
6)
Bu

Exp
and
$55M
Bu

nothing ($10)M
Do
ild

a nd (0.4)
em
lar

Low d
ge

Redu
ce pr
High ices $50M
dema
nd (0
.6)
$70M
Build small Build large
Low demand: (0.4)(40) = $16M Low demand: (0.4)(50) = $20M
High demand: (0.6)(55) = $33M High demand: (0.6)(70) = $42M

Build small: $16M + $33M = $49M Build large: $20M + $42M = $62M