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Decision Theory

Operations Management

William J. Stevenson

8th edition

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Decision Theory

CHAPTER

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Decision Theory

McGraw-Hill/Irwin

Operations Management, Eighth Edition, by William J. Stevenson Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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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 and service 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 Process (Contd)

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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Causes of Poor Decisions (Contd)

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

Decision Theory

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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 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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Format of a Decision Tree

Payoff 1 Payoff 2
2

Figure 5S.1
Decision Point Chance Event

Payoff 3
1

B
Payoff 4
2

Payoff 5 Payoff 6

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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

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Sensitivity Analysis
#2 Payoff

Example S-8
#1 Payoff
B A C

16 14 12 10 8 6 4 2 0

B best

C best

A best

16 14 12 10 8 6 4 2 0

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

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Solved Problem 5