DECISION THEORY

Decision theory represents a general approach to decision making. It is suitable

for a wide range of operations management decisions. Among them are capacity
planning, product and service design, equipment selection, and location planning.
Decisions that lend themselves to a decision theory approach tend to be characterized
by the following elements:

1. A set of possible future conditions that will have a bearing on the results of
the decision.
2. A list of alternatives for the manager to choose from.
3. A known payoff for each alternative under each possible future condition.

To use this approach, a decision maker would employ this process:

1. Identify the possible future conditions (e.g., demand will be low, medium, or
high; the competitor will or will not introduce a new product). These are called
states of nature.
2. Develop a list of possible alternatives, one of which may be to do nothing.
3. Determine or estimate the payoff associated with each alternative for every
possible future condition.
4. If possible, estimate the likelihood of each possible future condition.
5. Evaluate alternatives according to some decision criterion (e.g., maximize
expected profit), and select the best alternative.

The information for a decision is often summarized in a payoff table, which

shows the expected payoffs for each alternative under the various possible states of
nature. These tables are helpful in choosing among alternatives because they facilitate
comparison of alternatives. The problem for the decision maker is to select one of the
alternatives, taking the present value into account. Evaluation of the alternatives differs
according to the degree of certainty associated with the possible future conditions.

DECISION MAKING UNDER CERTAINTY

 When it is known for certain which of the possible future conditions will actually
happen, the decision is usually relatively straightforward: Simply choose the alternative
that has the best payoff under that state of nature. Example 5S–1 illustrates this.

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. Choose the alternative with the highest payoff. Thus, if we know demand will be
low, we would elect to build the small facility and realize a payoff of $10 million. If we
know demand will be moderate, a medium factory would yield the highest payoff ($12
million versus either $10 million or $2 million). For high demand, a large facility would
provide the highest payoff.

Although complete certainty is rare in such situations, this kind of exercise

provides some perspective on the analysis. Moreover, in some instances, there may be
an opportunity to consider allocation of funds to research efforts, which may reduce or
remove some of the uncertainty surrounding the states of nature, converting uncertainty
to risk or to certain.

DECISION MAKING UNDER UNCERTAINTY

At the opposite extreme is complete uncertainty: No information is available on

how likely the various states of nature are. Under those conditions, four possible
decision criteria are maximin, maximax, Laplace, and minimax regret. These
approaches can be defined as follows:

 Maximin — Determine the worst possible payoff for each alternative, and choose
the alternative that has the “best worst.” The maximin approach is essentially a
pessimistic one because it takes into account only the worst possible outcome for
each alternative. The actual outcome may not be as bad as that, but this
approach establishes a “guaranteed minimum.”
 Maximax — Determine the best possible payoff, and choose the alternative with
that payoff. The maximax approach is an optimistic, “go for it” strategy; it does
not take into account any payoff other than the best.
  Laplace — Determine the average payoff for each alternative, and choose the
alternative with the best average. The Laplace approach treats the states of
nature as equally likely.
 Minimax regret — Determine the worst regret for each alternative, and choose
the alternative with the “best worst.” This approach seeks to minimize the
difference between the payoff that is realized and the best payoff for each state
of nature.

DECISION MAKING UNDER RISK

Between the two extremes of certainty and uncertainty lies the case of risk: The
probability of occurrence for each state of nature is known. (Note that because the
states are mutually exclusive and collectively exhaustive, these probabilities must add
to 1.00.) A widely used approach under such circumstances is the expected monetary
value criterion. The expected value is computed for each alternative, and the one with
the best expected value is selected. The expected value is the sum of the payoffs for an
alternative where each payoff is weighted by the probability for the relevant state of
nature. Thus, the approach is:

 Expected monetary value (EMV) criterion — Determine the expected payoff of

each alternative, and choose the alternative that has the best expected payoff.

The expected monetary value approach is most appropriate when a decision

maker is neither risk averse nor risk seeking, but is risk neutral. Typically, well-
established organizations with numerous decisions of this nature tend to use expected
value because it provides an indication of the long-run, average payoff. That is, the
expected-value amount (e.g., $10.5 million in the last example) is not an actual payoff
but an expected or average amount that would be approximated if a large number of
identical decisions were to be made. Hence, if a decision maker applies this criterion to
a large number of similar decisions, the expected payoff for the total will approximate
the sum of the individual expected payoffs.
DECSIION TREES

In health care the array of treatment options and medical costs makes tools such
as decision trees particularly valuable in diagnosing and prescribing treatment plans.
For example, if a 20-year-old and a 50-year-old both are brought into an emergency
room complaining of chest pains, the attending physician, after asking each some
questions on family history, patient history, general health, and recent events and
activities, will use a decision tree to sort through the options to arrive at the appropriate
decision for each patient.

Decision trees are tools that have many practical applications, not only in health
care but also in legal cases and a wide array of management decision making, including
credit card fraud; loan, credit, and insurance risk analysis; decisions on new product or
service development; and location analysis.

A decision tree is a schematic representation of the alternatives available to a

decision maker and their possible consequences. The term gets its name from the
treelike appearance of the diagram. The figure below is an example of a decision tree.

Although tree diagrams can be used in place of a payoff table, they are
particularly useful for analyzing situations that involve sequential decisions. For
instance, a manager may initially decide to build a small facility only to discover that
demand is much higher than anticipated. In this case, the manager may then be called
upon to make a subsequent decision on whether to expand or build an additional
facility.

A decision tree is composed of a number of nodes that have branches emanating

from them. Square nodes denote decision points, and circular nodes denote chance
events. Read the tree from left to right. Branches leaving square nodes represent
alternatives; branches leaving circular nodes represent chance events (i.e., the possible
states of nature). After the tree has been drawn, it is analyzed from right to left; that is,
starting with the last decision that might be made. For each decision, choose the
alternative that will yield the greatest return or the lowest cost. If chance events follow a
decision, choose the alternative that has the highest expected monetary value or lowest
expected cost.

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. For example:

EXPECTED VALUE OF PERFECT INFORMATION

In certain situations, it is possible to ascertain which state of nature will actually

occur in the future. For instance, the choice of location for a restaurant may weigh
heavily on whether a new highway will be constructed or whether a zoning permit will be
issued. A decision maker may have probabilities for these states of nature; however, it
may be possible to delay a decision until it is clear which state of nature will occur. This
might involve taking an option to buy the land. If the state of nature is favorable, the
option can be exercised; if it is unfavorable, the option can be allowed to expire. The
question to consider is whether the cost of the option will be less than the expected gain
due to delaying the decision (i.e., the expected payoff above the expected value). The
expected gain is the expected value of perfect information, or EVPI.

Other possible ways of obtaining perfect information depend somewhat on the

nature of the decision being made. Information about consumer preferences might
come from market research, additional information about a product could come from
product testing, or legal experts might be called on.

There are two ways to determine the EVPI. One is to compute the expected
payoff under certainty and subtract the expected payoff under risk. That is,

Expected value of Expected payoff Expected payoff

= -
perfect information under certainty under risk