Decision Theory

2014
2014
Pearson
Pearson
Education,
Education,
Inc.Inc.

MA - 1

The Decision Process in

Operations
1. Clearly define the problem and the
factors that influence it
2. Develop specific and measurable
objectives
3. Develop a model
4. Evaluate each alternative solution
5. Select the best alternative
6. Implement the decision and set a
timetable for completion
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Fundamentals of
Decision Making
1. Terms:
a. Alternative a course of action or
strategy that may be chosen by the
decision maker
b. State of nature an occurrence or a
situation over which the decision
maker has little or no control

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Fundamentals of
Decision Making
2. Symbols used in a decision tree:
aa Decision node from which one of
several alternatives may be selected
aa A state-of-nature node out of
which one state of nature will occur

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Application of Decision Trees

to Product Design

Particularly useful when there are a

series of decisions and outcomes
which lead to other decisions and
outcomes

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Application of Decision Trees

to Product Design
Procedure
1. Include all possible alternatives and
states of nature - including doing
nothing
2. Enter payoffs at end of branch
3. Determine the expected value of each
branch and prune the tree to find the
alternative with the best expected value
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Decision Tree Example

(.4)

Purchase CAD

High sales

(.6) Low sales

Hire and train engineers

(.4)
High sales

(.6)
Low sales

Do nothing

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Decision Tree Example

(.4)

Purchase CAD

High sales

(.6) Low sales

Hire and train engineers

$2,500,000
1,000,000
500,000
$1,000,000
$800,000
320,000
500,000
$20,000

Revenue
Mfg cost ($40 x 25,000)
CAD cost
Net
Revenue
Mfg cost ($40 x 8,000)
CAD cost
Net loss

(.4)
High sales

EMV (purchase CAD system)

= (.4)($1,000,000) + (.6)( $20,000)

(.6)
Low sales

Do nothing

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Decision Tree Example

(.4)

Purchase CAD
$388,000

High sales

(.6) Low sales

Hire and train engineers

$2,500,000
1,000,000
500,000
$1,000,000
$800,000
320,000
500,000
$20,000

Revenue
Mfg cost ($40 x 25,000)
CAD cost
Net
Revenue
Mfg cost ($40 x 8,000)
CAD cost
Net loss

(.4)
High sales

EMV (purchase CAD system)

= (.4)($1,000,000) + (.6)( $20,000)

= $388,000

(.6)
Low sales

Do nothing

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Decision Tree Example

(.4)

Purchase CAD
$388,000

High sales

(.6) Low sales

Hire and train engineers

$365,000
(.4)

High sales

(.6)
Low sales

Do nothing $0

$2,500,000
1,000,000
500,000
$1,000,000
$800,000
320,000
500,000
$20,000
$2,500,000
1,250,000
375,000
$875,000
$800,000
400,000
375,000
$25,000

Revenue
Mfg cost ($40 x 25,000)
CAD cost
Net
Revenue
Mfg cost ($40 x 8,000)
CAD cost
Net loss
Revenue
Mfg cost ($50 x 25,000)
Hire and train cost
Net
Revenue
Mfg cost ($50 x 8,000)
Hire and train cost
Net

$0 Net
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 2014 Pearson Education, Inc.

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Decision Tree Example

A decision node

A state of nature node

Favorable market

ew
N
lop uct
e
v
De Prod
Redesign
Existing Product

Do
n

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ot h

Unfavorable market
Favorable market

Unfavorable market

ing

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Decision Table Example

Decision Table with Conditional Values for Getz Products
STATES OF NATURE
ALTERNATIVES

FAVORABLE MARKET

UNFAVORABLE MARKET

Develop New Product

$200,000

$180,000

Redesign Existing
Product

$100,000

$ 20,000

Do nothing

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Decision-Making Environments
Decision making under uncertainty
Complete uncertainty as to which state of
nature may occur

Decision making under risk

Several states of nature may occur
Each has a probability of occurring

Decision making under certainty

State of nature is known
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Uncertainty
1. Maximax
Find the alternative that maximizes the
maximum outcome for every alternative
Pick the outcome with the maximum
number
Highest possible gain
This is viewed as an optimistic decision
criteria

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Uncertainty
2. Maximin
Find the alternative that maximizes the
minimum outcome for every alternative
Pick the outcome with the minimum
number
Least possible loss
This is viewed as a pessimistic decision
criteria

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Uncertainty
3. Equally-likely
Find the alternative with the highest
average outcome
Pick the outcome with the maximum
number
Assumes each state of nature is equally
likely to occur

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Uncertainty Example
Decision Table for Decision Making Under Uncertainty
STATES OF NATURE
FAVORABLE
MARKET

UNFAVORABLE
MARKET

MAXIMUM
IN ROW

MINIMUM
IN ROW

Develop New
Product

$200,000

$180,000

$200,000

$180,000

$10,000

Redesign
Existing Product

$100,000

$ 20,000

$100,000

$ 20,000

$40,000

Do nothing

ALTERNATIVES

Maximax

ROW
AVERAGE

Maximin

$
0
Equally
likely

1. Maximax choice is to Develop New Product

2. Maximin choice is to do nothing
3. Equally likely choice is to Redesign Current Product
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Decision Making Under Risk

Each possible state of nature has an
assumed probability
States of nature are mutually exclusive
Probabilities must sum to 1
Determine the expected monetary
value (EMV) for each alternative

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Expected Monetary Value

EMV (Alternative i) = (Payoff of 1st state of nature)
x (Probability of 1st state of
nature)
+ (Payoff of 2nd state of nature)
x (Probability of 2nd state of
nature)
+ + (Payoff of last state of
nature) x (Probability of
last state of nature)

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EMV Example
Decision Table for Getz Products
STATES OF NATURE
FAVORABLE
MARKET

UNFAVORABLE
MARKET

Develop New Product(A1)

$200,000

$180,000

Redesign Existing Product

(A2)

$100,000

$ 20,000

Do nothing (A3)

ALTERNATIVES

Probabilities

0
0.6

0
0.4

1. EMV(A1) = (.6)($200,000) + (.4)($180,000) = $48,000

2. EMV(A2) = (.6)($100,000) + (.4)($20,000) = $52,000
3. EMV(A3) = (.6)($0) + (.4)($0) = $0
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Best Option
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Decision Making Under Certainty

Is the cost of perfect information
worth it?
Determine the expected value of
perfect information (EVPI)

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Expected Value of
Perfect Information
EVPI is the difference between the payoff
under certainty and the payoff under risk
Expected value
EVPI =
Maximum
with perfect
EMV
information
Expected value with = (Best outcome or consequence for 1st state
perfect information
of nature) x (Probability of 1st state of
(EVwPI)
nature)
+ Best outcome for 2nd state of nature)
x (Probability of 2nd state of nature)
+ + Best outcome for last state of nature)
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x (Probability of last state of nature)

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EVPI Example
1. The best outcome for the state of nature
favorable market is Develop New Product
with a payoff of $200,000. The best outcome
for unfavorable is do nothing with a payoff
of $0.
Expected value
with perfect = ($200,000)(.6) + ($0)(.4) = $120,000
information

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EVPI Example
2. The maximum EMV is $52,000, which is the
expected outcome without perfect
information. Thus:
EVPI = EVwPI Maximum
EMV
= $120,000 $52,000 = $68,000
The most the company should pay for perfect
information is $68,000
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Decision Trees
Information in decision tables can be
displayed as decision trees
A decision tree is a graphic display of the
decision process that indicates decision
alternatives, states of nature and their
respective probabilities, and payoffs for each
combination of decision alternative and state
of nature
Appropriate for showing sequential decisions
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Decision Trees
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 decision alternatives and
states of nature
5. Solve the problem by working backward
through the tree computing the EMV for
each state-of-nature node
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Decision Tree Example

EMV for node 1
= $48,000

= (.6)($200,000) + (.4)($180,000)
Payoffs
Favorable market (.6)

ve
De

N
l op

Do

no

wP

uc
d
o
r

ng

Unfavorable market (.4)

Favorable market (.6)

Redesign
Existing
Product
th
i

EMV for node 2

= $52,000

Unfavorable market (.4)

$200,000
$180,000
$100,000
$20,000

= (.6)($100,000) + (.4)($20,000)

$0
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Decision Theory

2014
2014
Pearson
Pearson
Education,
Education,
Inc.Inc.

MA - 29