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# 5s-1

Decision Theory

Operations Management

William J. Stevenson

8th edition

5s-2

Decision Theory

CHAPTER

5s

Decision Theory

McGraw-Hill/Irwin

## Operations Management, Eighth Edition, by William J. Stevenson

Copyright 2005 by The McGraw-Hill Companies, Inc. All rights

5s-3

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

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Decision Theory

## A set of possible future conditions exists that

will have a bearing on the results of the
decision

choose from

## A known payoff for each alternative under

each possible future condition

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Decision Theory

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

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Decision Theory

## If possible, determine the likelihood of each

possible future condition

## Evaluate alternatives according to some

decision criterion and select the best
alternative

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Decision Theory

## Causes of Poor Decisions

Bounded Rationality
The limitations on decision
making caused by costs,
human abilities, time, technology,
and availability of information

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Decision Theory

## Causes of Poor Decisions (Contd)

Suboptimization
The result of different
departments each
attempting to reach a
solution that is
optimum for that
department

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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

## 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

Figure 5S.1
Decision Point
Chance Event
A
e
s
o
o
h
C

State

re 1
u
t
a
of n

State
of

natur 2
e2

C
ho
os

State

1
e
r
u
t
2
of na

e
A 2
State

of n a
ture 2

Payoff 1
A1
e
s
o
o
Ch

Payoff 2

C h o o se

A2

Payoff 3

A3
e
s
o
o
Ch

Payoff 4

C h o o se

Payoff 5

A4

Payoff 6

## 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
perfect information = under certainty

Expected payoff
under risk

## 5s-13 Decision Theory

Sensitivity Analysis
Example S-8
#1 Payoff

16
14
12
10
8
6
4
2
0

#2 Payoff

B best

C best

A best

## Sensitivity analysis: determine the range of

probability for which an alternative has the best
expected payoff

16
14
12
10
8
6
4
2
0

Solved Problem 5