Chapter 5S - Decision Theory

Decision Theory

A general approach to decision-making that is suitable for a wide range of operations management decisions

• Capacity planning

• Produt and service design

• Equipment selection

• Location planning

Characteristics of Suitable Problems

Characteristics of decisions that are suitable for using decision theory
For Example:

• A set of possible future conditions that will have a bearing on the results of the decision

• A list of alternatives under each possible future condition

• A known payoff for each alternative under each possible future condition

Process for Using Decision Theory

1. Identify the possible future states of nature

2. Develop a list of possible alternatives

3. Estimate the payoff for each alternative for each possible future state of nature

4. if possible, estimate the likelihood of each possible future state of nature

5. Evaluate alternatives according to some decision criterion and select the best alternative

Payoff Table

A table showing the expected payoffs for each alternative in every possible state of nature

Steps in the Decision Process

1. Identify the problem

2. Specify objectives and criteria for a solution

3. Develop suitable alternatives

4. Select the best alternative

5. Implement the solution

6. monitor to see that the desired result is achieved

Causes of Poor Decisions

• Sometimes due to unforeseeable circumstances (not the norm)

• More frequently poor decisions are the result of a combination of

  • Mistakes in the decision process

  • bounded rationality

  • suboptimization

Errors in the Decision Process

• Failure to recognize the importance of each step

• Skipping a step

• Failure to complete a step before jumping to the next step

• Failure to admit mistakes

• Inability to make a decision

Bounded Rationality

The limitations on decision making caused by costs, human abilities, time, tech, and avalibility of information

Suboptimization

The results of different departments each attempting to reach a solution that is optimal for that department

Decision Environments

• Certainty

• Risk

• Uncertainty

Certainty

Environment in which relevant parameters have known values

Risk

Environment in which certain future events have probabilistic outcomes

Uncertainty

Environment in which it is imporssible to assess the likelihood of various possible future events

Decision Criteria

• Maximin

• Maximax

• Laplace

• Minimax Regret

Maximin

Choose the alternative with the best of the worst possible payoffs

Maximax

Choose the alternative with the best possible payoff

Laplace

Choose the alternative with the best average payoff

Minimax Regret

Choose the alternative that has been the least of the worst regrets

Expected Monetary Value (EVM)

Widely applied criterion that addresses the monetary value of the predicted case decision under risk

Decision Tree

A schematic representation of the available alternatives and their possible consequences (should I cheat on my spouse tonight?) (analyze from right to left, choosing the alternative that will yield the greatest return)

Nodes in a Decision Tree

Decisions - Represented by squares

Chance events - represented by circles

Branches in a Decision Tree

Alternatives - branches leaving square nodes

Chance events - branches leaving a circular node