5s-1 Decision Theory

Chapter 5 Supplement

Decision Theory

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin 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

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin 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

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin 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

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin 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

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin 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

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin 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

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin 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:

capacity product
product and
and
planning service
service design
design

location equipment
planning selection

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin 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

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin 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

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-11 Decision Theory

Format of a Decision Tree

Decision Point
Chance Event a t u re 1 Payoff 1
t e o fn
Sta
seA ’1 Payoff 2
C h oo
’
A State
s e of n a 2
o o ture 2
C h C h o o se Payoff 3
A’2
B
1
oo se A’ 3 Payoff 4
Ch
a t ure 1
Ch

of n 2
State
oo
se

C h o o se Payoff 5
A’4
A
’2

State
of natur Payoff 6
e2
Operations Management, Seventh Edition, by William J. Stevenson
McGraw-Hill/Irwin 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

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-13 Decision Theory

Sensitivity Analysis
Example 8
#1 Payoff #2 Payoff
16 B 16
14 14
12 A 12
C
10 10
8 8
6 6
4 4
2 B best C best A best 2
0 0
Sensitivity analysis: determine the range of
probability for which an alternative has the best
expected payoff

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5s-14 Decision Theory

Solved Problem 5

Operations Management, Seventh Edition, by William J. Stevenson

McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.