Decision making under certainty uncertainty and risk

Decision Theory LEARNING OBJECTIVES SUPPLEMENT OUTLINE 5S.5 Decision Making under Uncertainty, 219 After completing this supplement, you 5S.6 Decision Making under Risk, 220 5S.1 Introduction, 216 should be able to: 5S.7 Decision Trees, 2215S.2 The Decision Process and Causes of L05S.1 Outline the steps in the decision Poor Decisions, 217 5S.8 Expected Value of Perfect

process. Information, 2235S.3 Decision Environments, 218 L05S.2 Name some causes of poor 5S.9 Sensitivity Analysis, 224

decisions. 5S.4 Decision Making under Certainty, 218

L05S.3 Describe and use techniques that apply to decision making under uncertainty.

L05S.4 Describe and use the expected- value approach.

L05S.5 Construct a decision tree and use it to analyze a problem.

L05S.6 Compute the expected value of perfect information.

L05S.7 Conduct sensitivity analysis on a simple decision problem.

55.1 INTRODUCTION -

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. t

3. Determine or estimate the payoff associated with each alternative for every possible future condition.

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217 Supplement to Chapter Five Decision Theory

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. Consider the following payoff table, which illustrates a capacity planning problem.

POSSIBLE FUTURE DEMAND

Alternatives Low Moderate High Small facility $10* $10 $10 Medium facility 7 12 12 Large facil ity (4) 2 16 'Present value in $ millions.

The payoffs are shown in the body of the table. 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 moder- ate, and a present value of $16 million if demand is high.

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.

5S.2 THE DECISION PROCESS AND CAUSES OF POOR DECISIONS

Despite the best efforts of a manager, a decision occasionally turns out poorly due to unfore- seeable circumstances. Luckily, such occurrences are not common. Often, failures can be traced to a combination of mistakes in the decision process, to bounded rationality, or to suboptimization.

The decision process consists of these steps:

1. Identify the problem.

2. Specify objectives and criteria for a solution.

3. Develop suitable alternatives.

4. Analyze and compare alternatives.

5. Select the best alternative.

6. Implement the solution.

7. Monitor to see that desired result is achieved.

In many cases, managers fail to appreciate the importance of each step in the decision- making process. They may skip a step or not devote enough effort to completing it before jumping to the next step. Sometimes this happens owing to a manager's style of making quick decisions or a failure to recognize the consequences of a poor decision. The manager's ego can be a factor. This sometimes happens when the manager has experienced a series of successes- important decisions that turned out right. Some managers then get the impression that they can do no wrong. But they soon run into trouble, which is usually enough to bring them back down

Payoff table Table showing the expected payoffs for each alternative in every possible state of nature.

L05S.1 Outline the steps in the decision process.

L05S.2 Name some causes of poor decisions.

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

Suboptimization The result of different departments each attempting to reach a solu- tion that is optimum for that department.

Certainty Environment in which relevant parameters have known values.

Risk Environment in which cer- tain future events have probable outcomes.

Uncertainty Environment in which it is impossible to assess the likelihood of various future events.