1. Module 16 – Decision Theory
Chapter 5 Supplement

2. 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

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

4. 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

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

6. 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

7. 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

8. 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

9. 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