# Module 16 – Decision Theory

## Presentation on theme: "Module 16 – Decision Theory"— Presentation transcript:

Module 16 – Decision Theory
Chapter 5 Supplement

What is decision theory?
Definition Payoff table (certainty) POSSIBLE FUTURE DEMAND Alternatives Low Moderate High Small facility \$10 Medium facility 7 12 Large facility (4) 2 16

What is decision theory?
Basic concepts Certainty vs uncertainty Utility values Expected utility

Expected utility example
Outcome 1: Utility = 100, probability = 75% Outcome 2: Utility = -40, probability = 25% Expected utility = 100 X .75 = 75 -40 X .25 = -10 75 + (-10) = 65

Decision making under uncertainty
4 possible decision criteria Maximin Maximax Laplace Minimax regret

Decision making under uncertainty
Problem 1 Maximax 80, Expand Maximin 50, Do nothing NEXT YEAR’S DEMAND Alternatives Low HIGH Do nothing \$50 \$60 Expand 20 80 Subcontract 40 70

Decision making under uncertainty
Problem 1 Laplace Now we have problem! NEXT YEAR’S DEMAND Alternatives Low HIGH Do nothing \$50 \$60 Expand 20 80 Subcontract 40 70 (\$50+\$60)/2 = \$55 (\$20+\$80)/2 = \$50 (\$40+\$70)/2 = \$55

Decision making under uncertainty
Problem 1 Minimax regrets (opportunity losses) NEXT YEAR’S DEMAND Alternatives Low HIGH Do nothing \$50 \$60 Expand 20 80 Subcontract 40 70

Decision making under uncertainty
Problem 1 Minimax regrets subcontract NEXT YEAR’S DEMAND Alternatives Low HIGH WORST Do nothing \$50 - \$50 = 0 \$80 – 60 = 20 \$20 Expand 50 – 20 = 30 80 – 80 = 0 30 Subcontract 50 – 40 = 10 80 – 70 = 10 10