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McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Decision Theory

Chapter 5 Supplement

Decision Theory

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McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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

5s-3

McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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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McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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

5s-5

McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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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McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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

5s-7

McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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

5s-8

McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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

product andservice design

product andservice design

equipment selection

location planning

5s-9

McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Decision Theory

Payoff Table

Alternatives Low Moderate High

Small facility $10 $10 $10

Medium facility 7 12 12

Large facility (4) 2 16

Possible future demand*

*Present value in $ millions

5s-10

McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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

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McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Decision Theory

Format of a Decision Tree

State of nature 1

B

Payoff 1

State of nature 2

Payoff 2

Payoff 3

2

Choose A’1

Choose A’2

Payoff 6State of nature 2

2

Payoff 4

Payoff 5

Choose A’3

Choose A’4

State of nature 1

Choose A

’

Choose A’2

1

Decision PointChance Event

5s-12

McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 payoffperfect information under certainty under risk

=_

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McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Decision Theory

Sensitivity Analysis

16141210 86420

16141210 86420

A

B

C

A bestC bestB best

#1 Payoff #2 Payoff

Sensitivity analysis: determine the range of probability for which an alternative has the best expected payoff

Example 8

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McGraw-Hill/IrwinOperations Management, Seventh Edition, by William J. StevensonCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Decision Theory

Solved Problem 5