DECISION

THEORY
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Decision Theory

represents a general approach to decision making which is suitable for a wide

range of operations management decisions, including:

Product
Capacity and Equipment Location
Planning Service Selection Planning
Design

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Decision Theory Elements

▸ A set of ▸ A list of ▸ A known

possible alternatives payoff for
future for the each
conditions manager to alternative
exists that choose from under each
will have a possible
bearing on future
the results of condition
the decisions
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Decision Theory Process

▸ Identify the possible future conditions (e.g., demand will be low,

medium, or high; the competitor will or will not introduce a new
product). These are called states of nature.
▸ Develop a list of possible alternatives, one of which may be to do
nothing.
▸ Determine or estimate the payoff associated with each alternative
for every possible future condition.
▸ If possible, estimate the likelihood of each possible future condition.
▸ Evaluate alternatives according to some decision criterion (e.g.,
maximize expected profit), and select the best alternative.
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Payoff Table

POSSIBLE FUTURE DEMAND

Alternatives
Low Moderate High

Small Facility 10 10 10

Medium Facility 7 12 12

Large Facillity (4) 2 16

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Steps in Decision Process

MONITOR TO SEE THAT

DESIRED RESULT IS IDENTIFY THE PROBLEM
ACHIIEVED 07 01
SPECIFY OBJECTIVES AND
CRITERIA FOR A SOLUTION
IMPLEMENT THE SOLUTION
06 02
DEVELOP SUITABLE
ALTERNATIVES

SELECT THE BEST 05 03

ALTERNATIVES. ANALYZE AND COMPARE
04 ALTERNATIVES
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Causes of Poor Decision

Mistake in Decision Process

Bounded Rationality
▸ The limitations on decision making caused by costs, human abilities,
time, technology, and availability of information.
Suboptimization
▸ The result of different departments each attempting to reach a solution
that is optimum for that department.
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Decision Environment

▸ Certainty means that relevant parameters such as

costs, capacity, and demand have known values.
▸ Risk means that certain parameters have probabilistic
outcomes.
▸ Uncertainty means that it is impossible to assess the
likelihood of various possible future events
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Decision making under Certainty

When it is known for certain POSSIBLE FUTURE DEMAND

which of the possible future Alternatives
Low Moderate High
conditions will actually
happen, the decision is Small
10 10 10
usually relatively Facility
straightforward: Simply
choose the alternative that Medium
7 12 12
has the best payoff under Facility
that state of nature Large
(4) 2 16
Facillity
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Decision making under Uncertainty

Decisions are sometimes made under complete uncertainty. No information

is available on how likely the various states of nature are:

Maximin- Choose the alternative with the best of the worst possible payoff
Maximax- Choose the alternative with the best possible payoff
Laplace- Choose the alternative with best average period of any of the
alternatives
Minimax Regret- Choose the alternative that has the least of worst regrets
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Payoff Table

POSSIBLE FUTURE DEMAND

Alternatives
Low Moderate High

Small Facility 10 10 10

Medium Facility 7 12 12

Large Facillity (4) 2 16

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Row in Total Row Average Regrets

Alternatives
Low Moderate High Worst
30 10
Small
0 2 6 6
Facility
31 10.33
Medium
3 0 4 4
Facility
14 4.67 Large
14 10 0 14
Facillity
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Decision Making under Risk

Expected monetary POSSIBLE FUTURE DEMAND

Alternatives
value (EMV) criterion Low Moderate High
—Determine the
expected payoff of Small Facility 10 10 10
each alternative, and
choose the alternative Medium Facility 7 12 12
that has the best
expected payoff.
Large Facillity (4) 2 16

Using the EMV Criterion, identify the best alternatives for these probabilities: Low= 30, Moderate=
50, and High= 20

EMVsmall= .30(10) + .50(10) + .20(10) = 10

EMVmedium= .30(7) + .50(12) + .20(12) = 10.5
EMVhigh= .30(4) + .50(2) + .20(16) = 3
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Decision Tree
A schematic representation of the
available alternatives and their possible
consequences

Useful for analyzing sequential

decisions

Composed of Nodes and Branches

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Example

A manager must decide on

the size of a video arcade to
construct. The manager has
narrowed the choices 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
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Product of chance probabilities and Expected value of each initial

their respective payoffs for the alternative:
remaining branches:
Build small
Build small 16+33= 49
Low Demand .4(40) = 16
High Demand .6(55) = 33 Build large
20+42= 62
Build large
Low Demand .4(50) = 20
Hence, the choice should be to build the large
High Demand .6(70) = 42
facility because it has a larger expected
value than the small facility.
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Expected Value of Perfect Information (EVPI)

•The difference between the expected payoff with perfect information and the expected payoff under risk
•Two ways to determine EVPI:

Expected
Payoff Under
Certainty
- Expected
Payoff Under
Risk
= EVPI

OR

EVPI = Minimax Regret

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Examples

1st Method 2nd Method

.30(10) + .50(12) + .20(16) =
12.2
The expected payoff risk based
on Example is 10.5
EVPI = 12.2 – 10.5 = 1.7
Small Facility .30(0) + .50(2) + .20(6)
= 2.2
Medium Facility .30(3) + .50(0) +
.20(4) = 1.7
Large Facility .30(14) + .50(10) +
.20(0) = 9.2

The lowest expected regret is 1.7.

Therefore, EVPI = 1.7
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Thank You
