10th ed.
Decision Making
A General Overview
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Why study decision making?
-It is the most fundamental task performed by managers.
-It is the underlying theme of the course. The techniques and
tools employed in the text are intended to improve our
decision making skills as managers.
-It is assumed that a better understanding of decision making
will lead to better decision by managers.
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The Decision Process (Descriptive Model)
 Identify the Problem
 Specify objectives and the
criteria for choosing a solution
 Develop alternatives
 Analyze and compare alternatives
 Select the best
alternative
 Implement the chosen
alternative
 Monitor the results
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Some Key Elements which Managers Must
Cope with in Their Decision Environment
Uncertainty/Risk (and even
luck)
Complexity
Change (including technological
change)
Behavioral/Political Considerations
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Pareto Phenomenon
• A vital few things are important for reaching
an objective or solving a problem.
• 80/20 Rule - 80% of problems are caused by
20% of the activities.
How do we identify the vital few?
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Models
•
A model is an abstraction of reality.
– Physical
– Schematic
– Mathematical
What are the pros and cons of models?
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7
8
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Systems Approach
“The whole is greater than the sum of the parts.”
Suboptimization
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Causes of Poor Decisions (Cont’d)
Suboptimization
The result of different
departments each
attempting to reach a
solution that is
optimum for that
department
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Causes of Poor Decisions
Bounded Rationality
The limitations on decision
making caused by costs,
human abilities, time,
technology, and
availability of information
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Some Very Basic
Approaches to
Decision Making
Based on
Decision Theory
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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
product and
service design
location
planning
equipment
selection
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Decision Making Conditions
 Certainty – Condition in which relevant
parameters have known values
 Uncertainty – Condition in which it is
impossible to assess the likelihood of
various future events
 Risk – Condition in which certain future
events have probable outcomes
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Decision Making Under Certainty
Examples of a criterion:
Break Even Analysis:
Decide to produce items if they lead to a profit
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Example BE analysis
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Decision Making under Uncertainty
Examples of three criteria:
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
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Try to do homework problem 1(a,b,c)
on page 229 in the textbook
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Decision Making under Risk
Examples of two criteria:
•Expected monetary value: calculate the
expected value (average or mean) of each
alternative, choosing the alternative with the
best expected value
•Expected value of perfect information:
calculate the difference between the expected
payoff under certainty and the expected payoff
under risk
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Format of a Decision Tree
Decision Point
Chance Event
Payoff 1
Payoff 2
2
Payoff 3
1
B
Payoff 4
2
Payoff 5
Payoff 6
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Try to do homework problems 2(b,a,c),
10, and 11 on pp. 229-232.
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Solutions to Homework
Partial solutions are on the slides that
follow. Be sure to try the problems before
you look at the solutions.
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1.
1.
a
.
Maximax:
Expand [$80 is the highest payoff]
b
.
Maximin:
Worst payoffs:
c
.
Laplace:
Do
Nothing:
$50
Expand:
$20
Subcontract:
$40
[best of the worst
payoffs]
Average
Payoff
Do Nothing
$55
[Indifferent between Do
Nothing
Expand
$50
And Subcontract]
Subcontract
$55
Comments on the above: Part (a) is simply the highest return of all possibilities in the
table. Part (b) shows 50, 20, and 40 as the worst return for each of the three alternatives. Hence,
the best of the worst is 50, and the answer is “Do Nothing.” Note that Part (c) simply finds the
average for each alternative, l. Leading to a tie between Do Nothing and Subcontract. In a sentence
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two, could you find a method to break the tie?
2.
Now that we have probabilities for High (.7) and Low (.3) demand, our problem
changes from decision making under uncertainty (as in Problem 1) to decision
making under risk (which allows us to build a decision tree as shown below).
Low
High
2 b.
Low
High
Low
act
High
2a.
The following gives the Expected Values (or Expected Payoffs) of the three alternatives
for the above decision tree (this allows us to solve the above decision tree):
EV(Do Nothing) = EVDN = (.3) (50) + (.7) (60) = 57
EV(Expand) = EVEXP = (.3) (20) + (.7) (80) = 62
EV(Sub-Contract) = EVSC = (.3) (40) + (.7) (70) = 61
Since EVEXP is the largest, we cut the branches for Do Nothing and Subcontract, and our
solution is to “EXPAND.” Note that EVEXP is also our Expected Value (EVr) under 25
conditions of risk, which we will use in the problem for finding the EV of perfect information.
2.
2 b.
act
Note that we had three probability distributions on the tree in the previous slide, and
replaced each distribution with its expected value (or average), allowing us to
simplify the tree as shown above. Hence, as stated in the previous slide, our solution
to the tree was to Expand since its payoff of $62 is larger than the payoffs of the other
two alternatives. Note the cuts that we made on the above tree used the symbol “║”.
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50
2c
Low
.3
.7
Do Nothing
EVc = (.3) (50) + (.7) (80) = 71
High
Expand
80
We draw the above tree which represents what we would do if we knew
for certain that demand was to be Low (upper branch) or High (lower
branch). The EV of the above tree would have to be our Expected Value
under conditions of certainty. Hence,
EVPI = EVc - EVr = 71 - 62 = 9,
Or:
Expected Value under conditions of certainty = EVc = (.3) (50) + (.7) (80) = $71
Expected Value under conditions of risk = EVr =
-$62
EVPI (Expected Value of Perfect Information) =
$ 9
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10.
.70 high
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11.
=EV5
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In-Class Assignment (You will be asked in class how this problem could be
solved. However, you need NOT solve this problem for class. We will do it
together during the lecture. All you should do, at the minimum, is to read this
problem carefully, and go to the next slide.)
It is suggested that you make a hardcopy of this slide and the next slide, and
bring the hardcopy to the next class.
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(a) This is the structure of the decision
tree for the problem above. Try to
complete this tree (i.e., print out this slide
and add the payoffs and the probabilities).
(b) For a greater challenge, try to
solve this tree using the monetary
expected value criterion, and write
a brief statement on what Joe should
do.
(c) Based on your answer in part (b),
What is the probability that Joe could
go bankrupt if bankruptcy occurs from
a loss of $75,000? What is the probability
of bankruptcy for a loss of $150,000?
For even a greater challenge,
and assuming that you were able to
answer the above questions,
write a sentence
or two on how Joe could do
something unethical in order to
get a better return, if he later found
the market test to be unfavorable.
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Discussion Problem: Do not try to solve this problem. Simply read through it a
few times. This problem will be solved in class as a computer application.
Please make a hardcopy of this slide, and bring it to class. .
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End of Session. See
you during our next
class meeting.
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