Module 16 – Decision Theory

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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

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