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Decision Theory

Decision Theory

McGraw-Hill/Irwin

Operations Management, Eighth Edition, by William J. Stevenson

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

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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

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

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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

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Decision Theory

Decision Theory Process (Contd)

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

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Decision Theory

Example
ABC Inc. has acquired a new textile company
and is contemplating on the future of this new
acquisition. The alternative decisions presented
below are being considered with its
corresponding payoffs. Determine the best
decision using the different decision criteria.
States of Nature
Alternative

Good ($)

Bad ($)

Expand

800,000

500,000

1,300,000

-150,000

320,000

320,000

Maintain Status Quo

Sell now

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Decision Making under Uncertainty

Maximax is an optimistic approach in
decision making. It looks at the best that
could happen under each action and then
chooses the action with the largest value.
The maximum of the maximums or best
of the best
States of Nature
Alternative

Good ($)

Bad ($)

Expand

800,000

500,000

1,300,000

-150,000

320,000

320,000

Maintain Status Quo

Sell now

Choose: Maintain Status Quo = $1,300,000

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Decision Making under Uncertainty

Maximin is a pessimist approach in
decision making. It looks at the worst that
could happen under each action and then
choose the action with the largest payoff.
The maximum of the minimums or the
best of the worst.
States of Nature
Alternative

Good ($)

Bad ($)

Expand

800,000

500,000

1,300,000

-150,000

320,000

320,000

Maintain Status Quo

Sell now

Choose: Expand = $500,000

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Decision Making under Uncertainty

Hurwicz is an approach in decision making
that represents a compromise between
Maximax and Maximin criteria. It makes use
of the Hurwicz criterion of Realism. It puts
weight on the different states of nature and
chooses the alternative with the best payoff.
States of Nature
Alternative
Expand
Maintain Status Quo
Sell now

Good ($); 55%

Bad ($); 45%

Payoff

800,000

500,000

665,000

1,300,000

-150,000

647,500

320,000

320,000

320,000

Choose: Expand = $665,000

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Decision Making under Uncertainty

Laplace (Equal Likehood) is an approach
that gives equal weight to each state of nature
and then chooses the alternative with the best
payoff.
States of Nature
Alternative
Expand
Maintain Status Quo
Sell now

Good ($); 50%

Bad ($); 50%

Payoff

800,000

500,000

650,000

1,300,000

-150,000

575,000

320,000

320,000

320,000

Choose: Expand = $650,000

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Decision Making under Uncertainty

Minimax determine the worst regret for
each alternative, and choose the alternative
with the best worst. This approach seeks to
minimize the difference between the payoff
that is realized and the best payoff for each
state of nature.
States of Nature
Alternative

Good ($)

Bad ($)

Expand

800,000

500,000

1,300,000

-150,000

320,000

320,000

Maintain Status Quo

Sell now

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Decision Making under Uncertainty

Minimax determine the worst regret for
each alternative, and choose the alternative
with the best worst. This approach seeks to
minimize the difference between the payoff
that is realized and the best payoff for each
state of nature.
States of Nature
Alternative

Good ($)

Bad ($)

Expand

500,000

500,000

-150,000

980,000

320,000

Maintain Status Quo

Sell now

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Decision Making under Uncertainty

Minimax determine the worst regret for
each alternative, and choose the alternative
with the best worst. This approach seeks to
minimize the difference between the payoff
that is realized and the best payoff for each
state of nature.
States of Nature
Alternative

Good ($)

Bad ($)

Expand

500,000

650,000

980,000

180,000

Maintain Status Quo

Sell now

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Decision Making under Uncertainty

Minimax determine the worst regret for
each alternative, and choose the alternative
with the best worst. This approach seeks to
minimize the difference between the payoff
that is realized and the best payoff for each
state of nature.
States of Nature
Alternative

Good ($)

Bad ($)

Worst

Expand

500,000

500,000

650,000

650,000

980,000

180,000

980,000

Maintain Status Quo

Sell now

Choose: Expand = $500,000

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Decision Making Under Certainty

Expected Monitary Value (EMV) computed by
multiplying each decision outcome under each
state of nature by the probability of its occurrence.
The best decision is the one with the greatest
expected value. Computed without perfect
information.
- same as the Hurwicz approach

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Decision Making Under Certainty

Expected Value with (given) Perfect Information
(EVw/PI) Information maximum amount a
decision maker would pay for additional
information.
EVw/PI summation of the product of the best
outcome in each state of nature and its
corresponding probabilities of occurrence.

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Decision Making Under Certainty

Expected Value of Perfect Information (EVPI)
the average/expected value of information if it
were completely accurate. The information is
perfect.
EVPI = EVw/PI EMV

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