SUPPLEMENT TO CHAPTER 5:

DECISION THEORY
INTRODUCTION
Decision theory represents a general
approach to decision making-capacity
planning, product and service design,
equipment selection, and location
planning. Characterized by the
following 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 the
manager to choose from.
3. A known payoff for each alternative
under each possible future condition.
To use this approach, a decision maker
would employ this process:
1. Identify the possible future (states
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.
4. If possible, estimate the likelihood
of each possible future condition.
5. Evaluate alternatives according to
some decision criterion and select the
best alternative.
Payoff table Table showing the
expected payoffs for each alternative
in every possible state of nature.
CAUSES OF POOR DECISIONS
Despite the best efforts of a manager,
a decision occasionally turns out
poorly due to unforeseeable
circumstances. Luckily, such

occurrences are not common. Often,

failures can be traced to a
combination of mistakes in the
decision process, to bounded
rationality, or to
suboptimization.
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 desired result is
achieved.
In many cases, managers fail to
appreciate the importance of each
step in the decision-making
process. They may skip a step or not
devote enough effort to completing it
before jumping
to the next step. Sometimes this
happens owing to a managers style of
making quick decisions or a failure
to recognize the consequences of a
poor decision. The managers ego
can be a factor.
This sometimes happens when the
manager has experienced a series of
successesimportant decisions that
turned out right. Some managers then
get the impression that they can
do no wrong. But they soon run into
trouble, which is usually enough to
bring them back down to earth. Other
managers seem oblivious to
negative results and continue the
process they associate with their
previous successes, not recognizing
that some of that success may have

been due more to luck than to any

special abilities of their own. A part of
the problem may be the managers
unwillingness to admit a mistake.
Yet other managers demonstrate an
inability to make a decision; they
stall long past the time when the
decision should have been rendered.
Bounded rationality - the limits
imposed on decision making by costs,
human abilities, time, technology, and
the availability of information. Because
of these limitations, managers cannot
always expect to reach decisions that
are optimal in the sense of providing
the best possible outcome. Instead,
they must often resort to achieving a
satisfactory solution.
Still another cause of poor decisions is
that organizations typically
departmentalize decisions.
Naturally, there is a great deal of
justification for the use of departments
in terms of overcoming span-of-control
problems and human limitations
Suboptimization - a result of
different departments attempts to
reach a solution that is optimum for
each. Unfortunately, what is optimal
for one department may not be
optimal for the organization as a
whole.
DECISION ENVIRONMENTS
Three basic categories:
Certainty means that relevant
parameters such as costs, capacity,
and demand have known values.
Risk means that certain parameters
have probabilistic outcomes.

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
usually relatively straightforward:
Simply choose the alternative that has
the best
payoff under that state of nature.
Although complete certainty is rare in
such situations, this kind of exercise
provides some perspective on the
analysis. Moreover, in some instances,
there may be an opportunity to
consider allocation of funds to
research efforts, which may reduce or
remove some of the uncertainty
surrounding the states of nature,
converting uncertainty to risk or to
certainty.

The actual outcome may not be as bad

as that, but this approach establishes
a guaranteed
minimum.
Maximax Determine the best
possible payoff, and choose the
alternative with that payoff.
The maximax approach is an
optimistic, go for it strategy; it does
not take into account any payoff other
than the best.
Laplace Determine the average
payoff for each alternative, and
choose the alternative
with the best average. The Laplace
approach treats the states of nature as
equally likely.
Minimax regret Determine the
worst regret for each alternative, and
choose the alternative
with the best worst. This approach
seeks to minimize the difference
between the
payoff that is realized and the best
payoff for each state of nature.

DECISION MAKING UNDER

UNCERTAINTY
No information is available on how
likely the
various states of nature are.
Four possible decision criteria:
Maximin Determine the worst
possible payoff for each alternative,
and choose the
alternative that has the best worst.
The maximin approach is essentially a
pessimistic
one because it takes into account only
the worst possible outcome for each
alternative.

The first step in this approach is to

prepare a table of regrets (or
opportunity losses ). To do
this, subtract every payoff in each
column from the best payoff in that
column. The second step is to identify
the worst regret for each
alternative. The best of these worst
regrets would be chosen using
minimax regret. The main weakness of
these approaches (except for Laplace)
is that they do not take into account
all of the payoffs. Instead, they focus
on the worst or best, and so they lose
some information.

DECISION MAKING UNDER RISK

The probability of occurrence for each
state of nature is known.
Expected monetary value (EMV)
criterion Determine the expected
payoff of each alternative, and choose
the alternative that has the best
expected payoff.
The expected monetary value
approach is most appropriate when a
decision maker is neither
risk averse nor risk seeking, but is risk
neutral. Typically, well-established
organizations with numerous decisions
of this nature tend to use expected
value because it provides an indication
of the long-run, average payoff. That
is, the expected-value amount is not
an actual payoff but an expected or
average amount that would be
approximated if a large number of
identical decisions were to be made
DECISION TREES
A decision tree is a schematic
representation of the alternatives
available to a decision maker and their
possible consequences.
*useful for analyzing situations that
involve sequential decisions.

Analyze the decisions from right to

left:
1. Determine which alternative would
be selected for each possible second
decision. For a
small facility with high demand, there
are three choices: do nothing, work
overtime, and
expand. Because expand has the
highest payoff, you would choose it.
Indicate this by
placing a double slash through each of
the other alternatives. Similarly, for a

large facility with low demand, there

are two choices: do nothing and
reduce prices. You would choose
reduce prices because it has the
higher expected value, so a double
slash is placed on the other branch.
2. Determine the product of the
chance probabilities and their
respective payoffs for the
remaining branches:
3. Determine the expected value of
each initial alternative

Expected value of perfect

information (EVPI) The difference
between the expected payoff with
perfect information and the expected
payoff under risk.
Sensitivity analysis
Determining the range of probability
for which an alternative has the best
expected payoff.

ALFORTE, IRISH
PEARL A
N2 BMTM321
Reference: Operations Management by William Stevenson, 11 th
Edition (page 212-232)