Chapter 5

Decision Theory

To accompany
Quantitative Analysis for Management, Tenth Edition,
by Render, Stair, and Hanna © 2008 Prentice-Hall, Inc.
Power Point slides created by Jeff Heyl © 2009 Prentice-Hall, Inc.
 Learning Objectives
After completing this chapter, students will be able to:

1. List the steps of the decision-making

process
2. Describe the types of decision-making
environments
3. Make decisions under uncertainty
4. Use probability values to make decisions
under risk
5. Develop accurate and useful decision
trees

© 2009 Prentice-Hall, Inc. 3–2

 Introduction

 What is involved in making a good

decision?
 Decision theory is an analytic and
systematic approach to the study of
decision making
 A good decision is one that is based
on logic, considers all available data
and possible alternatives, and the
quantitative approach described here

© 2009 Prentice-Hall, Inc. 3–3

 Decision Theory

Decision theory problems are

characterized by the following:
1. A list of alternatives.
2. A list of possible future states of nature.
3. Payoffs associated with each
alternative/state of nature combination.
4. An assessment of the degree of certainty
of possible future events.
5. A decision criterion.

© 2009 Prentice-Hall, Inc. 3–4

 Thompson Lumber Company

STATE OF NATURE

FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 200,000 –180,000

Construct a small plant 100,000 –20,000

Do nothing 0 0

Table 5.1

© 2009 Prentice-Hall, Inc. 3–5

 Types of Decision-Making
Environments

Type 1: Decision making under certainty

 Decision maker knows with certainty the
consequences of every alternative or
decision choice
Type 2: Decision making under uncertainty
 The decision maker does not know the
probabilities of the various outcomes
Type 3: Decision making under risk
 The decision maker knows the
probabilities of the various outcomes

© 2009 Prentice-Hall, Inc. 3–6

 Decision Making Under
Uncertainty
There are several criteria for making decisions
under uncertainty

1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret

© 2009 Prentice-Hall, Inc. 3–7

 Maximax
Used to find the alternative that maximizes
the maximum payoff
 Locate the maximum payoff for each alternative
 Select the alternative with the maximum
number
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
200,000 –180,000 200,000
plant
Maximax
Construct a small
100,000 –20,000 100,000
plant
Do nothing 0 0 0

Table 3.2
© 2009 Prentice-Hall, Inc. 3–8
 Maximin
Used to find the alternative that maximizes
the minimum payoff
 Locate the minimum payoff for each alternative
 Select the alternative with the maximum
number
STATE OF NATURE
FAVORABLE UNFAVORABLE MINIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
200,000 –180,000 –180,000
plant
Construct a small
100,000 –20,000 –20,000
plant
Do nothing 0 0 0

Table 5.3
Maximin
© 2009 Prentice-Hall, Inc. 3–9
 Criterion of Realism (Hurwicz)
A weighted average compromise between
optimistic and pessimistic
 Select a coefficient of realism 
 Coefficient is between 0 and 1
 A value of 1 is 100% optimistic
 Compute the weighted averages for each
alternative
 Select the alternative with the highest value

Weighted average = (maximum in row)

+ (1 – )(minimum in row)

© 2009 Prentice-Hall, Inc. 3 – 10

 Criterion of Realism (Hurwicz)
 For the large plant alternative using  = 0.8
(0.8)(200,000) + (1 – 0.8)(–180,000) = 124,000
 For the small plant alternative using  = 0.8
(0.8)(100,000) + (1 – 0.8)(–20,000) = 76,000
STATE OF NATURE
CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) ( = 0.8)$
Construct a large
200,000 –180,000 124,000
plant
Realism
Construct a small
100,000 –20,000 76,000
plant
Do nothing 0 0 0
Table 3.4
© 2009 Prentice-Hall, Inc. 3 – 11
 Equally Likely (Laplace)
Considers all the payoffs for each alternative
 Find the average payoff for each alternative
 Select the alternative with the highest average

STATE OF NATURE
FAVORABLE UNFAVORABLE ROW
ALTERNATIVE MARKET ($) MARKET ($) AVERAGE ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Equally likely
Do nothing 0 0 0
Table 3.5

© 2009 Prentice-Hall, Inc. 3 – 12

 Minimax Regret
Based on opportunity loss or regret,
regret the
difference between the optimal profit and
actual payoff for a decision
 Create an opportunity loss table by determining
the opportunity loss for not choosing the best
alternative
 Opportunity loss is calculated by subtracting
each payoff in the column from the best payoff
in the column
 Find the maximum opportunity loss for each
alternative and pick the alternative with the
minimum number

© 2009 Prentice-Hall, Inc. 3 – 13

 Minimax Regret
STATE OF NATURE
FAVORABLE UNFAVORABLE
 Opportunity MARKET ($) MARKET ($)
Loss Tables 200,000 – 200,000 0 – (–180,000)
200,000 – 100,000 0 – (–20,000)
200,000 – 0 0–0
Table 3.6

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 0 180,000
Construct a small plant 100,000 20,000
Do nothing 200,000 0
Table 3.7
© 2009 Prentice-Hall, Inc. 3 – 14
 Minimax Regret
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
0 180,000 180,000
plant
Construct a small
100,000 20,000 100,000
plant
Minimax
Do nothing 200,000 0 200,000

Table 3.8

© 2009 Prentice-Hall, Inc. 3 – 15

Summary of Methods for Decision Making under Complete
Uncertainty

© 2009 Prentice-Hall, Inc. 3 – 16

 Decision Making Under Risk
 Decision making when there are several possible
states of nature and we know the probabilities
associated with each possible state
 Most popular method is to choose the alternative
with the highest expected monetary value (EMV)

native i) = (payoff of first state of nature)

x (probability of first state of nature)
+ (payoff of second state of nature)
x (probability of second state of nature)
+ … + (payoff of last state of nature)
x (probability of last state of nature)

© 2009 Prentice-Hall, Inc. 3 – 17

 EMV for Thompson Lumber
 Each market has a probability of 0.50
 Which alternative would give the highest EMV?
 The calculations are

rge plant) = (0.50)($200,000) + (0.50)(–$180,000)

= $10,000
mall plant) = (0.50)($100,000) + (0.50)(–$20,000)
= $40,000
o nothing) = (0.50)($0) + (0.50)($0)
= $0

© 2009 Prentice-Hall, Inc. 3 – 18

 EMV for Thompson Lumber

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Do nothing 0 0 0
Probabilities 0.50 0.50

Table 3.9 Largest EMV

© 2009 Prentice-Hall, Inc. 3 – 19

 Expected Opportunity Loss

 Expected opportunity loss (EOL) is the

cost of not picking the best solution
 First construct an opportunity loss table
 For each alternative, multiply the
opportunity loss by the probability of that
loss for each possible outcome and add
these together
 Minimum EOL will always result in the
same decision as maximum EMV
 Minimum EOL will always equal EVPI

© 2009 Prentice-Hall, Inc. 3 – 20

 Expected Opportunity Loss
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EOL
Construct a large plant 0 180,000 90,000
Construct a small
100,000 20,000 60,000
plant
Do nothing 200,000 0 100,000
Probabilities 0.50 0.50
Table 3.10 Minimum EOL
arge plant) = (0.50)($0) + (0.50)($180,000)
= $90,000
mall plant) = (0.50)($100,000) + (0.50)($20,000)
= $60,000
o nothing) = (0.50)($200,000) + (0.50)($0)
= $100,000
© 2009 Prentice-Hall, Inc. 3 – 21
 Expected Value of Perfect
Information (EVPI)
 EVPI places an upper bound on what you should
pay for additional information
EVPI = EVwPI – Maximum EMV
 EVwPI is the long run average return if we have
perfect information before a decision is made

EVwPI = (best payoff for first state of nature)

x (probability of first state of nature)
+ (best payoff for second state of nature)
x (probability of second state of nature)
+ … + (best payoff for last state of nature)
x (probability of last state of nature)

© 2009 Prentice-Hall, Inc. 3 – 22

 Expected Value of Perfect
Information (EVPI)
 Scientific Marketing, Inc. offers analysis
that will provide certainty about market
conditions (favorable)
 Additional information will cost $65,000
 Is it worth purchasing the information?

© 2009 Prentice-Hall, Inc. 3 – 23

 Expected Value of Perfect
Information (EVPI)
1. Best alternative for favorable state of nature is
build a large plant with a payoff of $200,000
Best alternative for unfavorable state of nature is
to do nothing with a payoff of $0
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $100,000
2. The maximum EMV without additional
information is $40,000
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000

© 2009 Prentice-Hall, Inc. 3 – 24

 Expected Value of Perfect
Information (EVPI)
1. Best alternative for favorable state of nature is
build a large plant with a payoff of $200,000
So the maximum Thompson
Best alternative for unfavorable
should pay for the state of nature is
additional
to do nothinginformation
with a payoff
is of $0
$60,000
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $100,000
2. The maximum EMV without additional
information is $40,000
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000

© 2009 Prentice-Hall, Inc. 3 – 25

 Decision Trees
 Any problem that can be presented in a
decision table can also be graphically
represented in a decision tree
 Decision trees are most beneficial when a
sequence of decisions must be made
 All decision trees contain decision points
or nodes and state-of-nature points or
nodes
 A decision node from which one of several
alternatives may be chosen
 A state-of-nature node out of which one state
of nature will occur
© 2009 Prentice-Hall, Inc. 3 – 26
 Five Steps to
Decision Tree Analysis

1. Define the problem

2. Structure or draw the decision tree
3. Assign probabilities to the states of
nature
4. Estimate payoffs for each possible
combination of alternatives and states of
nature
5. Solve the problem by computing
expected monetary values (EMVs) for
each state of nature node

© 2009 Prentice-Hall, Inc. 3 – 27

 Structure of Decision Trees
 Trees start from left to right
 Represent decisions and outcomes in
sequential order
 Squares represent decision nodes
 Circles represent states of nature nodes
 Lines or branches connect the decisions
nodes and the states of nature

© 2009 Prentice-Hall, Inc. 3 – 28

 Thompson’s Decision Tree
A State-of-Nature Node
Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
r
n st Pla
e
Co a r g
L Favorable Market
Construct
2
Small Plant Unfavorable Market
Do
No
th
in
g
Figure 3.2

© 2009 Prentice-Hall, Inc. 3 – 29

 Thompson’s Decision Tree
EMV for Node = (0.5)($200,000) + (0.5)(–$180,000)
1 = $10,000
Payoffs
Favorable Market (0.5)
$200,000
Alternative with best
EMV is selected 1
Unfavorable Market (0.5)
ct nt –$180,000
r u
n st Pla
e
Co a r g
L Favorable Market (0.5)
$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000
Do
No
th EMV for Node = (0.5)($100,000)
in
g 2 = $40,000 + (0.5)(–$20,000)
Figure 3.3
$0
© 2009 Prentice-Hall, Inc. 3 – 30
 Example
 The owner of a Restaurant, has determined that she needs to
expand her facility. The decision is whether to expand now with a
large facility, incurring additional costs and taking the risk that
demand will not materialize, or expand now on a smaller scale,
knowing that she will have to consider expanding again in three
years. She has estimated the following chances for demand:
 The likelihood of demand being high is 0.70.
 The likelihood of demand being low is 0.30.
 She has also estimated profits for each alternative:
 Large expansion has an estimated profitability of either $300,000 or
$50,000, depending on whether demand turns out to be high or low.
 Small expansion has a profitability of $80,000, assuming that demand is
low.
 Small expansion with an occurrence of high demand would require
considering whether to expand further. If she expands at that point, her
profitability is expected to be $200,000. If she does not expand further,
profitability is expected to be $150,000.

© 2009 Prentice-Hall, Inc. 3 – 31

From the decision tree, it can be inferred
that the large expansion gives the higher
expected value.

© 2009 Prentice-Hall, Inc. 3 – 32

 Example 2
 Monica is considering the possibility of starting a company to produce
small sailboats for the recreational market. Unlike other mass-produced
sailboats, however, these boats will be made specifically for children
between the ages of 10 and 15. The boats will be of the highest quality and
extremely stable, and the sail size will be reduced to prevent problems of
capsizing.
 Her basic decision is whether to build a large manufacturing facility, a
small manufacturing facility, or no facility at all. With a favorable market,
Monica can expect to make $90,000 from the large facility or $60,000 from
the smaller facility. If the market is unfavorable, however, Monica
estimates that she would lose $30,000 with a large facility, and she would
lose only $20,000 with the small facility. Because of the expense involved
in developing the initial molds and acquiring the necessary equipment to
produce fiberglass sailboats for young children, Monica has decided to
conduct a pilot study to make sure that the market for the sailboats will be
adequate. She estimates that the pilot study will cost her $10,000.
Furthermore, the pilot study can be either favorable or unfavorable.
Monica estimates that the probability of a favorable market given a
favorable pilot study is 0.8. The probability of an unfavorable market given
an unfavorable pilot study result is estimated to be 0.9. Monica feels that
there is a 0.65 chance that the pilot study will be favorable. Of course,
Monica could bypass the pilot study and simply make the decision as to
whether to build a large plant, small plant, or no facility at all. Without
doing any testing in a pilot study, she estimates that the probability of a
favorable market is 0.6. What do you recommend? Compute the EMV.
© 2009 Prentice-Hall, Inc. 3 – 33
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