5s-1
Decision Theory
Chapter 5 Supplement
Decision Theory
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-2
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
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-3
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
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-4
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
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-5
Decision Theory
Causes of Poor Decisions
Bounded Rationality
The limitations on decision
making caused by costs,
human abilities, time,
technology, and availability of
information
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-6
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
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-7
Decision Theory
Decision Environments
• Certainty - Environment in which
relevant parameters have known
values
• Risk - Environment in which
certain future events have
probable outcomes
• Uncertainty - Environment in
which it is impossible to assess
the likelihood of various future
events
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-8
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:
McGraw-Hill/Irwin
capacity
planning
product and
service design
location
planning
equipment
selection
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-9
Decision Theory
Payoff Table
Possible future demand*
Alternatives Low Moderate High
Small facility
$10
$10
$10
Medium facility
7
12
12
Large facility
(4)
2
16
*Present value in $ millions
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-10
Decision Theory
Decision Making under Uncertainty
Maximin - Choose the alternative with the
best of the worst possible payoffs
Maximax - Choose the alternative with the
best possible payoff
Laplace - Choose the alternative with the
best average payoff of any of the
alternatives
Minimax Regret - Choose the alternative
that has the least of the worst regrets
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-11
Decision Theory
Format of a Decision Tree
Decision Point
Chance Event
Payoff 1
Payoff 2
2
Payoff 3
1
B
Payoff 4
2
Payoff 5
Payoff 6
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-12
Decision Theory
Expected Value of Perfect Information
Expected value of perfect information the
difference between the expected payoff under
certainty and the expected payoff under risk
Expected value of Expected payoff
Expected payoff
_
=
perfect information
under certainty
under risk
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-13
Decision Theory
Sensitivity Analysis
Example 8
#1 Payoff
16
14
12
10
8
6
4
2
0
#2 Payoff
B
A
C
B best
C best
A best
16
14
12
10
8
6
4
2
0
Sensitivity analysis: determine the range of
probability for which an alternative has the best
expected payoff
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-14
Decision Theory
Solved Problem 5
McGraw-Hill/Irwin
Operations Management, Seventh Edition, by William J. Stevenson
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.