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BM2-Chapter-3-Decision-Theory

Decision Theory provides a structured approach to decision-making in operations management, involving the identification of future conditions, alternatives, payoffs, and likelihoods. It distinguishes between decision-making under certainty, risk, and uncertainty, employing various criteria such as Maximin, Maximax, and Laplace to evaluate alternatives. Additionally, it introduces concepts like Expected Monetary Value (EMV) and Expected Value of Perfect Information (EVPI) to assess the value of information in decision-making.

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12 views

BM2-Chapter-3-Decision-Theory

Decision Theory provides a structured approach to decision-making in operations management, involving the identification of future conditions, alternatives, payoffs, and likelihoods. It distinguishes between decision-making under certainty, risk, and uncertainty, employing various criteria such as Maximin, Maximax, and Laplace to evaluate alternatives. Additionally, it introduces concepts like Expected Monetary Value (EMV) and Expected Value of Perfect Information (EVPI) to assess the value of information in decision-making.

Uploaded by

anonymousehedgehog
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Decision

Theory
CHAPTER 3
Decision Theory

∙ Represents a general
approach to decision
making that is suitable for
a wide range of operations
management decision.
1. Identify the possible
2. Develop a list of possible
future conditions (chance 1
alternatives.
event or state of nature)

THE DECISION 3. Determine or estimate


the payoff associated with 3
4. If possible, estimate the
likelihood of each possible
each alternative for every
PROCESS possible future conditions.
future condition.

5. Evaluate alternatives
according to some decision
criterion (maximize
expected profit) and select
the best alternative.
PAYOFF TABLE
∙ Table showing the expected payoff for each alternative in every possible state of nature.

Alternatives .30 .50 .20


Low Demand Moderate High
Demand Demand
Small $ 10 $ 10 $ 10
Facility
Medium 7 12 12
Facility
Large -4 2 16
Facility
DECISION ENVIRONMENT

1. Certainty – means that relevant parameters such as


cost, capacity and demand have known value.
2. Risk – means that certain parameters have
probabilistic outcomes.
3. Uncertainty – means that it is impossible to assess
the likelihood of various possible future events.
Decision Making Under CERTAINTY

When it is known for certain which of the possible


future conditions will actually happen, the decision is
relatively straightforward. Alternatives .30 .50 .20
Low Moderate High
Small $ 10 $ 10 $ 10
Facility
Medium 7 12 12
Facility
Large -4 2 16
Facility
Decision Making Under UNCERTAINTY
Four possible decision criteria:
1. Maximin – choose the alternative with theAlt .30 .50 .20 Maxi Maxi Lapla
best of the worst possible payoffs. min max ce
SF = $ 10; MF = $7; LF = $ -4 LD MD HD
Best worst = $ 10 to build SF
2. Maximax – choose the alternative with SF $ 10 $ 10 $ 10 10 10 10
the best possible payoff.
SF = $ 10; MF = $12; LF = $ 16
Best overall payoff = $16, to build LF. MF 7 12 12 7 12 10.33
3. Laplace – choose the alternative with the
best average payoff of any of the alternatives.
SF= (10+10+10)/3= $ 10 LF -4 2 16 -4 16 4.7
MF= (7+12+12)/3= $ 10.33
LF= (-4+2+16)/3= $ 4.67
Best average payoff is to build a MF.
Decision Making Under UNCERTAINTY
(cont.)
4. Minimax Regret – choose the alternative that has the least of the worst regrets.
a. prepare a table of opportunity losses or regret. (subtract every payoff in each column
from the best payoff in that column)
Alt .30 .50 .20 Worst
b. identify the worst regret for each Regret
alternative. Low Moderat High
e
SF= 6; MF= 4; LF= 14 Small 0 2 6 6
Lowest regret is 4 which is for MF. Facility
Medium 3 0 4 4
Facility
Large 14 10 0 14
Facility
Decision Making Under RISK
The probability of occurrence of each state of nature is known, these probabilities
must add to 1.00
Expected Monetary Value (EMV) criterion - the best expected value among the
alternatives.
Probabilities: low=.30; medium=.50; high=.20
EMV(SF)= $10(.30) + $10(.50) + $10(.20) = $10
EMV(MF)= $7(.30) + $12(.50) + $12(.20) = $10.5
EMV(LF)= $-4(.30) + 2(.50) + $16(.20) = $ 3
The highest expected value is $10.5, to build a medium facility.
EXPECTED VALUE OF PERFECT INFORMATION
(Using Formula)
The difference between the expected payoff with perfect information and the
expected payoff under risk.
EVPI = Expected payoff under certainty – Expected payoff under risk
Expected payoff under certainty:
∙ $10(.30) + $12(.50) + $16(.20) = $ 12.2
Expected payoff under risk is computed in EMV as $ 10.5.
EVPI (sol.1) = $12.2 - $10.5 = $ 1.7
EXPECTED VALUE OF PERFECT
INFORMATION (Using Expected Regret)

Use the table of regret, compute for the expected regret for each
alternative using the given probabilities. Alternati .30 .50 .20
SF= 0(.30) + 2(.50) + 6(.20) = 2.2 ves Low Moderate High
MF=3(.30) + 0(.50) + 4(.20) = 1.7 Small $ 0 $ 2 $ 6
Facility
LF=14(.30) + 10(.50) + 0(.20) = 9.2
Medium 3 0 4
The lowest expected regret is 1.7
Facility
Large 14 10 0
Facility
DECISION TREE
∙ A schematic representation of the available alternatives and
their possible consequences. The term gets its name from the
treelike appearance. Although tree diagrams can be used in
place of a payoff table, they are particularly useful for analyzing
situations that involve sequential decisions.

∙ A decision tree is composed of a number of nodes that have


branches emanating from them. Square nodes denote decision
points, and circular nodes denote chance events.
Formative assessment using the previous decision
tree:

Alternatives .40 .60


Low High Maximin Maximax Laplace
Demand Demand
Build 40 55 40 55 47.5
Small
Build Large 50 70 50 70 60
Regret Table
Alternatives .4 .60
Low High Worst
Demand Demand Regret
Build 10 15 15
Small
Build 0 0 0
Medium
EMV
Builds Small = (40*.40) + (55*.60) = 49

Build Large = (50*.40) + (70*.60)= 62


EVPI (sol. 1)
= certainty – risk
= ( 50*.40) + (70*.60) = 62 - 62
=0
EVPI (sol.2)
BS = (10*.40) + (15*.60) = 13

BL = (0*.40) + (0*.60) = 0

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