Decision Theory

Introduction
Causes of Poor Decision Decision Environments

Payoff Table
Decision Tree

Decision Theory
Definition: Decision theory represents a general

approach to decision making. Decision theory provides a framework for the analysis of decisions. It includes a number of techniques that can be classified according to the degree of uncertainty associated with a particular decision problem. 1. It is suitable for a wide a range of operation management decisions. 2. Decision making is an integral part of operations management.

Decision Theory (Continued)

Decisions that lend themselves to a decision theory

approach tend to be characterized by these elements: 1. A set of possible future conditions that will have a bearing on the results of the decision. 2. A list of alternatives for managers to choose from. 3. A known payoff for each alternative under each possible future condition.

Decision Theory (Continued)

To use that approach, a decision maker would employ this process: 1. Identify the possible future conditions. (e.g., demand will be low, medium, or high; the competitor will or will not introduce a new product). These are called state of nature. 2. Develop a list of possible alternatives, one of which may be to do nothing. 3. Determine or estimate the payoff associated with each alternative for every possible future condition.

Decision Theory (Continued)

4. If possible, estimate the likelihood of each possible future condition. 5. Evaluate alternatives according to some decision criterion. (e.g., maximize expected profit) and select the best alternatives.

Causes of Poor Decision

Despite of best efforts of a manager, a decision occasionally turns out poorly due to unforeseeable circumstances. 1. Natural disaster. 2. Unstable economic condition 3. Over confidence of a manager. 4. Skipping the steps of making decision. Bounded Rationality: The limitations on decision making caused by costs, human abilities, time, technology, and availability of information.

Decision Environments
OM decision environments are classified according to the degree of certainty present. There are three basic categories: 1. Certainty 2. Risk 3. Uncertainty

Decision Environments
Certainty: Means that relevant parameters such as

costs, capacity, and demand have known values. From the below table choose the highest pay off if the demand is low.
Possible Future Demand Alternatives Low Moderate High

Small Facility
Medium Facility Large Facility

$10
$7 $ (4)

$12
$12 $2

$10
$12 $15

Decision Environments (Contd.)

Risk- Means the certain parameters have probabilistic outcome. Between the two extremes uncertainty and certainty lies the case of risk: The probability of occurrence for each state of nature is known. These probabilities must add to 1.00 Expected Monetary value (EMV) Criterion: Determine the expected payoff of each alternative, and choose the alternative that has the best expected payoff. Using the expected monetary value criterion, identify the best alternative for the previous table for these probabilities: Low-0.30, Moderete-0.50, High-0.20. EV (small) = 0.30($10) + 0.50($10) + 0.20($10) = $10 EV (medium) = 0.30($7) + 0.50($12) + 0.20($12) = $10.5 EV (High) = 0.30(-$4) + 0.50($2) + 0.20($16) = $3
So, Choose the medium facility because it has the highest expected value.

Decision Environments (Contd.)

Uncertainty: means that is impossible to assess the likelihood of various possible future events. Under those conditions, four possible decision criteria are given below: 1. Maximin 2. Maximax 3. Laplace 4. Minimax Regret

Decision Environments (Contd.)

Maximin: Choose the alternative with the best of the worst possible payoffs. Maximin: 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 Environments (Contd.)

Referring the previous payoff table which alternative would be chosen under each of strategies: a. Minimax: Using minimax, the worst payoffs for the alternatives are: Small Facility: $10 Medium Facility: $7 Large Facility: -$4 Hence, since $10 is the best, choose to build the small facility using the maximin strategy. b. Maximax: The best payoffs are: SF: $10 MF: $12 LF: $16 Hence, the best payoff is the $16 in the third row. So, the maximax criterion leads us to build the large facility.

Decision Environments (Contd.)

c. Laplace: Choose the alternative with the best average payoff of any of the alternatives. - For Laplace criterion, first find the row totals, and then divide each of those amounts by the number of states of nature (according to previous table, three in this case). Thus we have,
Row Total Small Facility Medium Facility Large Facility $30 $31 $14 Row Average $10 $10.33 $4.67

Because the medium facility has the highest average, it would be chosen under the Laplace criterion.

Decision Environments (Contd.)

. Minimax Regret: Choose the alternative that has the least of the worst regret. - Regret: The difference between a given payoff and the best payoff for a state of nature. - For Minimax regret criterion first step is to prepare a regret table by subtract every payoff in each column from the best payoff in that column. If we take the previous table as an example we get the regret table as below: The best of these worst regrets would be chosen using minimax regret. The lowest regret is 4, which is a medium facility. We chose that alternative.
Regrets
Alternatives Small Facility Medium Facility Large Facility Low $0 $3 $14 Moderate $2 $0 $10 High $6 $4 $0 Worst $6 $4 $14