Supplement 5

Decision Theory

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 Learning Objectives
You should be able to:
5S.1 Outline the steps in the decision process
5S.2 Name some causes of poor decisions
5S.3 Describe and use techniques that apply to
decision making under uncertainty
5S.4 Describe and use the expected-value approach
5S.5 Construct a decision tree and use it to analyze a
problem
5S.6 Compute the expected value of perfect
information
5S.7 Conduct sensitivity analysis on a simple decision
problem

© McGraw-Hill Education. 5S-2

 Decision Theory

• A general approach to decision making that is

suitable to a wide range of operations
management decisions
– Capacity planning
– Product and service design
– Equipment selection
– Location planning

© McGraw-Hill Education. 5S-3

Characteristics of Suitable Problems
• Characteristics of decisions that are suitable
for using decision theory
– A set of possible future conditions that will
have a bearing on the results of the decision
– A list of alternatives from which to choose
– A known payoff for each alternative under
each possible future condition

© McGraw-Hill Education. 5S-4

 Process for Using Decision Theory
1. Identify the possible future states of nature
2. Develop a list of possible alternatives
3. Estimate the payoff for each alternative for
each possible future state of nature
4. If possible, estimate the likelihood of each
possible future state of nature
5. Evaluate alternatives according to some
decision criterion and select the best
alternative

Learning Objective 5S.1

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 Payoff Table (1 of 2)
• A table showing the expected payoffs for each
alternative in every possible state of nature

Possible Future Possible Future Possible Future

Alternatives
Demand: Low Demand: Moderate Demand: High
Small facility $10 $10 $10
Medium
7 12 12
facility
Large facility (4) 2 16

Learning Objective 5S.1

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 Payoff Table (2 of 2)

• A decision is being made concerning which size

facility should be constructed
• The present value (in millions) for each
alternative under each state of nature is
expressed in the body of the above payoff table

Learning Objective 5S.1

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 Decision Process
• Steps:
1. Identify the problem
2. Specify objectives and criteria for a solution
3. Develop suitable alternatives
4. Analyze and compare alternatives
5. Select the best alternative
6. Implement the solution
7. Monitor to see that the desired result is
achieved

Learning Objective 5S.1

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 Causes of Poor Decisions

• Decisions occasionally turn out poorly due to

unforeseeable circumstances; however, this is
not the norm
• More frequently poor decisions are the result
of a combination of
– Mistakes in the decision process
– Bounded rationality
– Suboptimization

Learning Objective 5S.2

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 Mistakes in the Decision Process

• Errors in the Decision Process

– Failure to recognize the importance of each step
– Skipping a step
– Failure to complete a step before jumping to the
next step
– Failure to admit mistakes
– Inability to make a decision

Learning Objective 5S.2

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 Bounded Rationality &
Suboptimization
• Bounded rationality
– The limitations on decision making caused by
costs, human abilities, time, technology, and
availability of information
• Suboptimization
– The results of different departments each
attempting to reach a solution that is optimum
for that department

Learning Objective 5S.2

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 Decision Environments
• There are three general environment
categories:
– Certainty
 Environment in which relevant parameters have
known values
– Risk
 Environment in which certain future events have
probabilistic outcomes
– Uncertainty
 Environment in which it is impossible to assess
the likelihood of various possible future events

Learning Objective 5S.3

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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.
• Decision criteria:
– 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
– Minimax regret
 Choose the alternative that has the least of the worst
regrets

Learning Objective 5S.3

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 Example – Maximin Criterion
Possible Future Possible Future Possible Future
Alternatives
Demand: Low Demand: Moderate Demand: High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

• The worst payoff for each alternative is

– Small facility: $10 million
– Medium facility: $7 million
– Large facility: -$4 million
• Choose to construct a small facility

Learning Objective 5S.3

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 Example – Maximax Criterion
Possible Future Possible Future Possible Future
Alternatives
Demand: Low Demand: Moderate Demand: High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

• The best payoff for each alternative is

– Small facility: $10 million
– Medium facility: $12 million
– Large facility: $16 million
• Choose to construct a large facility
Learning Objective 5S.3

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 Example – Laplace Criterion
Possible Future Possible Future Possible Future
Alternatives
Demand: Low Demand: Moderate Demand: High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

• The average payoff for each alternative is

– Small facility: (10+10+10)/3 = $10 million
– Medium facility: (7+12+12)/3 = $10.33 million
– Large facility: (-4+2+16)/3 = $4.67 million

• Choose to construct a medium facility

Learning Objective 5S.3

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 Example – Minimax Regret (1 of 2)

Possible Future Possible Future Possible Future

Alternatives
Demand: Low Demand: Moderate Demand: High

Small Facility $10 $10 $10

Medium Facility 7 12 12

Large Facility (4) 2 16

• Construct a regret (or opportunity loss)

table
– The difference between a given payoff and the
best payoff for a state of nature

Learning Objective 5S.3

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 Example – Minimax Regret (2 of 2)
Alternatives Regrets: Low Regrets: Moderate Regrets: High

Small Facility $0 $2 $6

Medium Facility 3 0 4

Large Facility 14 10 0

• Identify the worst regret for each alternative

– Small facility: $6 million
– Medium facility: $4 million
– Large facility: $14 million
• Select the alternative with the minimum of
the maximum regrets
– Build a medium facility
Learning Objective 5S.3

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 Decision Making Under Risk
• Decisions made under the condition that the
probability of occurrence for each state of
nature can be estimated
• A widely applied criterion is expected
monetary value (EMV)
– EMV
 Determine the expected payoff of each alternative,
and choose the alternative that has the best expected
payoff
– This approach is most appropriate when the
decision maker is neither risk averse nor risk
seeking

Learning Objective 5S.4

© McGraw-Hill Education. 5S-19
 Example – EMV
Possible Future Possible Future Demand: Possible Future Demand:
Alternatives
Demand: Low (.30) Moderate (.50) Moderate (.20)
Small Facility $10 $10 $10
Medium Facility 7 12 12
Large Facility (4) 2 16

EMV  .30(10)  .50(10)  .20(10)  10

small
EMV  .30(7)  .50(12)  .20(12)  10.5
medium
EMV  .30(-4)  .50(2)  .20(16)  $3
large

Build a medium facility

Learning Objective 5S.4

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 Decision Tree (1 of 2)
• Decision tree
– A schematic representation of the available
alternatives and their possible consequences
– Useful for analyzing sequential decisions
• Composed of
– Nodes
 Decisions – represented by square nodes
 Chance events – represented by circular nodes
– Branches
 Alternatives – branches leaving a square node
 Chance events – branches leaving a circular node

Learning Objective 5S.5

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 Decision Tree (2 of 2)
• Analyze from right to left
– For each decision, choose the alternative that
will yield the greatest return
– If chance events follow a decision, choose the
alternative that has the highest expected
monetary value (or lowest expected cost)

Learning Objective 5S.5

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 Example – Decision Tree (1 of 3)

• 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.

Learning Objective 5S.5

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 Example – Decision Tree (2 of 3)

Learning Objective 5S.5

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 Example – Decision Tree (3 of 3)

EV  .40(40)  .60(55)  $49

Small
EV  .40(50)  .60(70)  $62
Large
Build the large facility
Learning Objective 5S.5
© McGraw-Hill Education. 5S-25
 Expected Value of Perfect
Information
• Expected value of perfect information
(EVPI)
– The difference between the expected payoff
with perfect information and the expected
payoff under risk
– Two methods for calculating EVPI
 EVPI = expected payoff under certainty –
expected payoff under risk
 EVPI = minimum expected regret

Learning Objective 5S.6

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 Example – EVPI (1 of 4)

Alternatives Possible Future Possible Future Demand: Possible Future Demand:

Demand: Low (.30) Moderate (.50) Moderate (.20)

Small Facility $10 $10 $10

Medium Facility 7 12 12
Large Facility (4) 2 16

Learning Objective 5S.6

© McGraw-Hill Education. 5S-27
 Example – EVPI (2 of 4)
EV  .30(10)  .50(12)  .20(16)  $12.2
with perfect information
EMV  $10.5
EVPI  EV – EMV
with perfect information
 $12.2 – 10.5
 $1.7

You would be willing to spend up to $1.7 million

to obtain perfect information

Learning Objective 5S.6

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 Example – EVPI (3 of 4)

Alternatives Possible Future Possible Future Demand: Possible Future Demand:

Demand: Low (.30) Moderate (.50) Moderate (.20)

Small Facility $0 $2 $6
Medium Facility 3 0 4
Large Facility 14 10 0

Expected Opportunit y Loss

EOL  .30(0)  .50(2)  .20(6)  $2.2

Small
EOL  .30(3)  .50(0)  .20(4)  $1.7
Medium
EOL  .30(14)  .50(10)  .20(0)  $9.2
Large

Learning Objective 5S.6

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 Example – EVPI (4 of 4)

• The minimum EOL is associated with the

building the medium size facility. This is
equal to the EVPI, $1.7 million.

Learning Objective 5S.6

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 Sensitivity Analysis (1 of 2)
• Sensitivity analysis
– Determining the range of probability for which
an alternative has the best expected payoff
– The approach illustrated is useful when there
are two states of nature
 It involves constructing a graph and then using
algebra to determine a range of probabilities
over which a given solution is best

Learning Objective 5S.7

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 Sensitivity Analysis (2 of 2)
Alternative State of Nature: #1 State of Nature: #2 Slope Equation
A 4 12 12 – 4 = +8 4 + 8P(2)
B 16 2 2 – 16 = -14 16 – 14P(2)
C 12 8 8 - 12 = -4 12 – 4P(2)

Learning Objective 5S.7

© McGraw-Hill Education. 5S-32
 End of Presentation

© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No
reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education. 5S-33