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5s-1

Decision Theory

Operations Management

William J. Stevenson

6th

edition

5s-2

Decision Theory

CHAPTER

2s

Decision Making

McGraw-Hill/Irwin

Operations Management, Eighth Edition, by William J. Stevenson


Copyright 2005 by The McGraw-Hill Companies, Inc. All rights

5s-3

Decision Theory

Decision Theory
Decision Theory represents a general
approach to decision making which is suitable for a
wide range of operations management decisions,
including:

Capacity
planning
location
planning

product
product and
and
service
service design
design
equipment
selection

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Decision Theory

Decision Theory Elements

A set of possible future conditions exists that


will have a bearing on the results of the
decision

A list of alternatives for the manager to


choose from

A known payoff for each alternative under


each possible future condition

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Decision Theory

Decision Theory Process

Identify possible future conditions called


states of nature

Develop a list of possible alternatives, one


of which may be to do nothing

Determine the payoff associated with each


alternative for every future condition

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Decision Theory

Decision Theory Process (Contd)

If possible, determine the likelihood of each


possible future condition

Evaluate alternatives according to some


decision criterion and select the best
alternative

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Decision Theory

Causes of Poor Decisions


Bounded Rationality
The limitations on decision
making caused by costs,
human abilities, time, technology,
and availability of information

5s-8

Decision Theory

Causes of Poor Decisions (Contd)


Suboptimization
The result of different
departments each
attempting to reach a
solution that is
optimum for that
department

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Decision Theory

Decision Environments
Certainty - Environment in which
relevant parameters have known
values
Risk - Environment in which certain
future events have probable
outcomes
Uncertainty - Environment in which
it is impossible to assess the
likelihood of various future events

5s-10 Decision Theory

Decision Making under Uncertainty


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 of
any of the alternatives
Minimax Regret - Choose the alternative that has the least of
the worst regrets

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Payoff Table
Possible future demand*
Alternatives Low Moderate High
Small facility

$10

$10

$10

Medium facility

12

12

Large facility

(4)

16

*Present value in $ millions

5s-12 Decision Theory

Format of a Decision Tree


Figure 5S.1
Decision Point
Chance Event
A
e
s
o
o
h
C

State

re 1
u
t
a
of n

State
of

natur 2
e2

C
ho
os

State

1
e
r
u
t
2
of na

e
A 2
State

of n a
ture 2

Payoff 1
A1
e
s
o
o
Ch

Payoff 2

C h o o se

A2

Payoff 3

A3
e
s
o
o
Ch

Payoff 4

C h o o se

Payoff 5

A4

Payoff 6

5s-13 Decision Theory

A manager must decide on the size of a video arcade to construct. The


manager has narrowed the choices to two: large or small. Information has
been collected on payoffs, and a decision tree has been constructed. Analyze
the decision tree and determine which initial alternative (build small or build
large) should be chosen in order to maximize expected monetary value.

5s-14 Decision Theory

Expected Value of Perfect Information


Approach I : Expected value of perfect information:
the difference between the expected payoff under
certainty and the expected payoff under risk

Expected value of
Expected payoff
perfect information = under certainty

Expected payoff
under risk

5s-15 Decision Theory

5s-16 Decision Theory

5s-17 Decision Theory

5s-18 Decision Theory

5s-19 Decision Theory

Sensitivity Analysis
Example S-8
#1 Payoff

16
14
12
10
8
6
4
2
0

#2 Payoff

B best

C best

A best

Sensitivity analysis: determine the range of


probability for which an alternative has the best
expected payoff

16
14
12
10
8
6
4
2
0