Decision

Theory
 Decision Theory
represents general approach
to decision making

CAPACITY
PLANNING

PRODUCT & SERVICE

DESIGN
DECISION
IN EQUIPMENT
SELECTION
OPERATION LOCATION
S PLANNING

CHARACTERISTIC OF DECISIONS
UNDER DECISION THEORY
Set of possible
future
condition List of
alternatives
Pay off for
each
alternative
Identify 1 Decision
the
possible
Process
future
conditionse.g.
Future Develop a list
State
of
Demand
Low
2 of possible
alternatives
Nature Mediu
m one of which
High may be to do
nothing
Determine 3
or estimate
the payoff
associated
with each
alternative
4 estimate the
likelihood of
each possible
future
condition
Probabilit
Evaluate 5 y
alternatives
according to
some
decision
criterion
Payoff table The information for a decision is
Table showing the often summarized in a payoff table
expected payoffs
for each
alternative in
every possible
state of nature.

POSSIBLE FUTURE DEMAND

Alternatives Low Moderate High
Small Facility $10* 10 10
Medium 7 12 12
Facility
Large Facility (4) 2 16
*Present value in $ millions

Payoff
 CAUSES OF
POOR
BoundedDECISION
Rationality
MAKING
The limitations on
decision making
caused by costs,
human abilities, time,
technology, and
availability of
information
Bounded
Rationality

Suboptimization
The result of different
departments each
attempting to reach a
solution that is
optimum for that
department.
Suboptimization
STEPS IN
DECISION
MAKING
1 Identify the problem

Specify the objectives

2 and criteria for solution

Develop suitable
3 alternatives

Analyze and compare

4 alternatives

Select the best

5 alternative

6 Implement the solution

Monitor to see that

7 desired result is
achieved
 Decision
Environment
Certainty
means that relevant parameters
such as costs, capacity, and
demand have known values

Uncertaint
y
means that it is impossible to
assess the likelihood of various
possible future events

Risk
means that certain parameters
have probabilistic outcomes
Decision Making under
Certainty
In this instance, the payoffs are in terms of present
values, which represent equivalent current dollar values of
expected future income less costs. This is a convenient measure
because it places all alternatives on a comparable basis. If a
small facility is built, the payoff will be the same for all three
possible states of nature. For a medium facility, low demand will
have a present value of $7 million, whereas both moderate and
high demand will have present values of $12 million. A large
facility will have a loss of $4 million if demand is low, a present
value of $2 million if demand is moderate, and a present value of
$16 million if demand is high.

POSSIBLE FUTURE DEMAND

Alternatives Low Moderate High
Small Facility $10* 10 10
Medium 7 12 12
Facility
Large Facility (4) 2 16
*Present value in $ millions

Determine the best alternative in the payoff table

on the previous page for each of the cases:
It is known with certainty that demand will be
( a ) low,
( b ) moderate,
( c ) high.
Certain that the demand will be low
POSSIBLE FUTURE
DEMAND
Alternatives Low
Small Facility $10*
Medium Facility 7
Large Facility (4)
*Present value in $ millions

Identify if If profit = select highest

1 profit or cost If cost = select lowest

Evaluate the
2 column “Low”

Identify best
3 payoff

Select Best
4 Alternative Small Facility
Certain that the demand will be
moderate
POSSIBLE FUTURE
DEMAND
Alternatives Moderate
Small Facility 10
Medium Facility 12
Large Facility 2
*Present value in $ millions

Identify if If profit = select highest

1 profit or cost If cost = select lowest

Evaluate the
2 column
“Moderate”

Identify best
3 payoff

Select Best
4 Alternative Medium Facility
Certain that the demand will be high
POSSIBLE FUTURE
DEMAND
Alternatives High
Small Facility 10
Medium Facility 12
Large Facility 16
*Present value in $ millions

Identify if If profit = select highest

1 profit or cost If cost = select lowest

Evaluate the
2 column
“High”

Identify best
3 payoff

Select Best
4 Alternative Large Facility
 DECISION MAKING UNDER
UNCERTAINTY
No information is available on how likely the
various states of nature are.

MAXIMAX MAXIMIN

Choose the Choose the

alternative with the alternative with the
best possible payoff best of the worst
possible payoffs.

LAPLACE MINIMAX
REGRET
Choose the
Choose the
alternative with the
alternative that has
best average payoff
the least of the
of any of the
worst regrets.
alternatives.
Decision Making under
Uncertainty
In this instance, the payoffs are in terms of present
values, which represent equivalent current dollar values of
expected future income less costs. This is a convenient measure
because it places all alternatives on a comparable basis. If a
small facility is built, the payoff will be the same for all three
possible states of nature. For a medium facility, low demand will
have a present value of $7 million, whereas both moderate and
high demand will have present values of $12 million. A large
facility will have a loss of $4 million if demand is low, a present
value of $2 million if demand is moderate, and a present value of
$16 million if demand is high.

POSSIBLE FUTURE DEMAND

Alternatives Low Moderate High
Small Facility $10* 10 10
Medium 7 12 12
Facility
Large Facility (4) 2 16
*Present value in $ millions

determine which alternative would be chosen

under each of these strategies:
a. Maximin
b. Maximax
c. Laplace
d. Minimax Regret
Maximin
POSSIBLE FUTURE DEMAND
Alternative Low Moderat High Worst
s e
10
Small $10* 10 10
Facility 7
Medium 7 12 12
Facility (4)
Large (4) 2 16
Facility

Identify if profit If profit = select highest

1 or cost If cost = select lowest

Evaluate the
2 worst payoff for
each alternative

Identify best out

3 of worst payoff

Select Best
4 Alternative Small Facility
Maximax
POSSIBLE FUTURE DEMAND
Alternative Low Moderat High Best
s e
10
Small $10* 10 10
Facility 12
Medium 7 12 12
Facility 16
Large (4) 2 16
Facility

Identify if profit If profit = select highest

1 or cost If cost = select lowest

Evaluate the
2 best payoff for
each alternative

Identify best out

3 of best payoff

Select Best
4 Alternative Large Facility
Laplace
POSSIBLE FUTURE DEMAND
Alternative Low Moderat High Average
s e
10
Small $10* 10 10
Facility 10.33
Medium 7 12 12
Facility 4.67
Large (4) 2 16
Facility

Identify if profit If profit = select highest

1 or cost If cost = select lowest

Calculate the
2 average payoff for
each alternative

Identify best out

3 of average payoff

Select Best
4 Alternative Medium Facility
Minimax Regret
POSSIBLE FUTURE Regret
DEMAND Table
Alt Low Mod High Low Mo High Worst
d
Smal $10* 10 10 0 2 6 6
l
3 0 4 4
Med 7 12 12
14 10 0 14
Larg (4) 2 16
e
10 12 16

Identify if profit If profit = select highest

1 or cost If cost = select lowest

a. For each state of b. Subtract the

Create a regret
2 table
nature best payoff for
each payoff of
identify the best
their respective
payoff
nature
Evaluate the worst

3 regret for each

alternative and
identify best payoff

Select Best
4 Alternative Medium Facility
 Decision Making
under
Risk
The probability of occurrence for each
state of nature is known

Determine the expected

Expected monetary payoff of each alternative,
value (EMV) criterion and choose the alternative
that has the best expected
payoff.

EXAMPLE

In a toss coin game, the probability of winning is

0.5. For every round, you have to pay P50. If you
win, you will get P30 however if you lose, you lose
the P50. Compute the Expected monetary value

𝐸𝑉=∑ 𝑃𝑋 Where P = Probability

X = the
amount
Given
P(win) = 0.5 𝐸𝑉 =𝑃 30 ( 0.5 ) − 𝑃 50( 0.5)
P(Lose) = 0.5
Xwin = P30
Xlose = -P50
Decision Making under
Risk

POSSIBLE FUTURE DEMAND

Alternatives Low Moderate High
Small Facility $10* 10 10
Medium 7 12 12
Facility
Large Facility (4) 2 16
*Present value in $ millions

Using the expected monetary value criterion,

identify the best alternative for the previous payoff
table for these probabilities: low .30, moderate .50,
and high .20.
Expected Value
POSSIBLE FUTURE
DEMAND
Alt Low Mod High EV
EV
Smal $10* 10 10 10(.30)+10(.50)+1 10
l 0(.20)
7(.30)+12(.50)+12( 10.5
Med 7 12 12 .20)
- 3
Larg (4) 2 16 4(.30)+2(.50)+16(.
e
.30 .50 .20 20)

Identify if profit If profit = select highest

1 or cost If cost = select lowest

Calculate the EV
2 for every
alternative

Identify
3 best EV

Select Best
4 Alternative Medium Facility
THANKYOU