5s-1Decision Theory McGraw-Hill/Irwin Operations Management, Eighth Edition, by William J. Stevenson Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

5s-2Decision Theory Decision Theory represents a general approach to decision making which is suitable for a wide range of operations management decisions, including: product and service design equipment selection location planning Decision Theory Capacity planning

5s-3Decision Theory  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 Decision Theory Elements

5s-4Decision Theory  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 Decision Theory Process

5s-5Decision Theory  If possible, determine the likelihood of each possible future condition  Evaluate alternatives according to some decision criterion and select the best alternative Decision Theory Process (Cont’d)

5s-6Decision Theory Bounded Rationality The limitations on decision making caused by costs, human abilities, time, technology, and availability of information Causes of Poor Decisions

5s-7Decision Theory Suboptimization The result of different departments each attempting to reach a solution that is optimum for that department Causes of Poor Decisions (Cont’d)

5s-8Decision Theory  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 Decision Environments

5s-9Decision Theory 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 Decision Making under Uncertainty

5s-10Decision 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 6 State 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 Point Chance Event Figure 5S.1

5s-11Decision 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 perfect information Expected payoff under certainty Expected payoff under risk = -

5s-12Decision Theory Solved Problem 5