SUPPLEMENT TO CHAPTER 5 DECISION THEORY

Answers to Discussion and Review Questions

1. 2. The chief role of the operations manager is that of decision maker. Decision making consists of the following steps: (1) Specify objectives and criteria for making a decision. (2) Develop alternatives. (3) Analyze and compare alternatives. (4) Select the best alternative. (5) Implement the chosen alternative. (6) Monitor the results. Bounded rationality is a term that refers to the limits imposed on decision making because of costs, human abilities, time, technology, and availability of information. Suboptimization occurs as a result of different departments, each attempting to reach a solution that is optimum for that department but may not be optimum for the organization as a whole. Poor decisions can be due to bounded rationality, which refers to limits on decision making in terms of cost, technology, human abilities and availability of information; managerial style (including quick decisions, unwillingness to admit a mistake, and procrastination); and organization difficulties, which can be related to departmentalizing decisions (which often leads to interdepartment conflicts and suboptimization). A payoff table shows the expected payoffs for each alternative in every possible state of nature. Sensitivity analysis refers to examining how sensitive a given solution is to a change in one or more parameters of a problem. High sensitivity indicates to decision makers that a parameter must be carefully estimated or determined; low sensitivity would not require such careful estimation. Also, decision makers can use sensitivity analysis to explore how a change in the value of a parameter would effect a solution. Maximax is an optimistic approach that calls for selection of the alternative which has the best possible payoff; maximin is a conservative approach which seeks the alternative with the best "worst payoff. Thus, if the mood is "go for it" maximax would be used, while if the mood is cautious, maximin would be more appropriate. The expected monetary value approach implies a linear utility for payoff (e.g., a payoff of $2 has twice the utility of a payoff of $1). When multiple decisions are to be made, the expected payoff approach is often used; similarly, when a series of on-going decisions on projects, new equipment, etc. are to be made, expected value can be useful. Conversely, for unique, one-time type decision, and/or where utilities are nonlinear, expected value would not be appropriate. Of course, the expected value approach requires probabilities for states of nature. If these are not available, the approach cannot be used. a. The Laplace criterion is an approach to decision making under uncertainty. It treats the states of nature as equally likely. b. Minimax regret is an approach to decision making under uncertainty. It seeks to minimize the opportunity loss, or regret, associated with choosing a decision. c. Expected value is an approach to decision making under risk: the probabilities of states of nature are assumed to be known.
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3. 4. 5.

6. 7.

8.

9.

10.

11.

d. Expected value of perfect information is the maximum amount a decision maker should be willing to pay to move from a position of decision making under risk to a position of decision making under certainty. In order to use an expected value approach to decision making, a decision maker must have state of nature probabilities (in addition to a list of alternatives, a list of states of nature, and a set of payoffs). If probabilities are unknown, either additional resources can be used to attempt to ascertain the probabilities, or adopting an approach which does not call for probabilities. Sensitivity analysis could be used to show the range of probability for which a particular alternative would be optimal. Thus, it may not be necessary for a decision maker to pinpoint a probability; rather, it may only be necessary to decide if a probability is in this "ballpark."

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Solutions

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80

1.

a. Maximax:

Best payoffs: Do Nothing: Expand: Subcontract: Worst payoffs: Do Nothing: Expand: Subcontract: Average Payoff Do Nothing Expand Subcontract Low 0 30 10 High 20 0 10

60 80 70 50 20 40 55 50 55

[best of the best payoffs]

b. Maximin:

[best of the worst payoffs]

c. Laplace:

[Indifferent between Do Nothing And Subcontract]

d. Minimax Regret Do Nothing Expand Subcontract 2. Worst 20 30 10

[best of worst]

a. Expected profit Do Nothing $57 Expand 62 Subcontract 61

$57 Do Nothing $62 Expand $61 Subcontr.

[Best] .3
.7 $50 $60 $20 $80 $40 $70

.3
.7 .3 .7

c. EPC: .30(50) + .70(80) = $71 Exp. Profit: 62 EVPI: $9 3. Equations: Do Nothing: 50 + 10P Expand: 20 + 60P Subcontract: 40 + 30P Optimal ranges: Do nothing: 0 to < 50 Expand: > .67 to 1.00 Subcontract: > .50 to < .67
Low Payoff
Do Nothing

80 70 60

High Payoff

50 40 20
Subcontract

Expand

.50 .67

1.0

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Solutions (continued) 4. a. (1) Draw the tree diagram:

Demand Low (.4) Build Small Maintain Demand High (.6)
2

$400,000 (1) $50,000 (2) Expand $450,000 (3)

Build Large

Demand Low (.4)

$-10,000 (4)

Demand High (.6)

$800,000 (5)

(2) Analyze decisions from right to left (i.e., work backwards from the end of the tree towards the root). For instance begin with decision 2 and choose expansion because it has a higher present value ($450,000 vs. $50,000). (3) Compute the expected value of the ends of the remaining branches (numbered 1 to 5 in the diagram), and then determine the expected value for the two initial alternatives. (1) .4 x $400,000 = $160,000 (2) (eliminated) $430,000 (expected value if (3) .6 x $450,000 = $270,000 Build small is chosen) (4) .4 x -$10,000 = $-4,000 (5) .6 x $800,000 = $480,000 $476,000 (expected value if Build large is chosen) (4) Since the expected value of building a large plant has the higher expected value, select the large plant alternative. b. Expected payoff under certainty: .4(400,000) + .6 (800,000) = $640,000 Expected payoff under risk: 476,000 Expected value of perfect information: $164,000 5.
Low 800 High Payoff

Build Large 400 Build Large Build Small 450

-10 1.0 P (low) .54 0

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Solutions (continued) 5. EVsubcontract= (.4)(1.0) + (.5)(1.3) + (.1)(1.8) = 1.23 EVexpand = (.4)(1.5) + (.5)(1.6) + (.1)(1.7) = 1.57 EVbuild = (.4)(1.4) + (.5)(1.1) + (.1)(2.4) = 1.35

Since 1.57 > 1.35 > 1.23, build. 6. Alternative Renew Relocate Decision: Alternative a. Renew Relocate MaxiMax MaxiMin Laplace Minimax (a) Max. Payoff (b) Min. Payoff (c) Average (d) Regret $4,000,000 $500,000* $2,250,000 $4,500,000 $5,000,000* $100,000 $2,550,000* $3,900,000* Relocate Renew Relocate Relocate Expected Value 500,000(.35) + 4,000,000(.65) = $2,775,000* 5,000,000(.35) + 100,000(.65) = $1,815,000
Approve (.35) $500,000 Renew Reject (.65) $4,000,000 E.V. $2,775,000*

7.

Relocate

Approve (.35) Reject (.65)

$5,000,000 $1,815,000 $100,000

8.

Decision: Renew lease EVPI = EPC EMV = .35(5,000,000) + .65(4,000,000) - 2,775,000 = $1,575,000 Yes, the manager should sign the lease for $24,000 since it is less than the EVPI of $1,575,000. a., b. Let P (application is approved) = x. Then P (application rejected) = 1 - x. From 7(a) 500,000x + 4,000,000(1 - x) = 4,000,000 - 3,500,000x and 5,000,000x + 100,000(1 - x) = 100,000 + 4,900,000x The two alternatives are equally good when 4,000,000 - 3,500,000x = 100,000 + 4,900,000x i.e. when x + 3,900,000 = 0.4643 8,400,000 c.

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Solutions (continued)
Exp. Value (millions) 5 4 3 2 1 Relocate 4,000,000 3,500,000x 2 1 x = .4643 .5 P (application approved)

Renewal better than Relocation Renew Relocate

5 4 3

100,000 + 4,900,000x For 8(a) and 8(b) the decision should be to renew the 10 year lease.

c. D = am't of decrease in $4,000,000 in order that EV= EV EV EV= $2,775,000 $1,815,000 = $960,000 $960,000 = .65D D = $1,476,020 $4,000,000 $1,476,920 = $2,523,000 Range is $2,523,080 or more. 9.
.2 Low $ 42 Subcontract 2 Small Medium .2 Low .8 High 2 Large .2 Low .8 High 72 Do Nothing Expand Expand Greatly 48 22 46 50 (20) .2(42)

.8 High

42

+ .8(48) .2(22) + .8(50) .2(-20) + .8(72)

46.8

44.4

53.6

a. Decision: Build a large facility. b. Max (42;22;-20) = $42 million. Decision: Build a small facility. c. EVPI = EPC EMV EPUC = 42(.2) + 72(.8) = 8.4 + 57.6 = $66.0 - 53.6 = 12.4

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Solutions (continued) d. Let P(high) = x P(low) = 1-x I. Small: III. Large: 42(1-x) + 48x => 42 + 6x -20(1-x) + 72x => -20 + 92x II. Medium: 22(1-x) + 50x => 22 + 28x Value of x where expected value for I and III are the same. 42 + 6x = -20 + 92x => 86x = 62 => x = 0.7209
72 Small 42 22 0 -20
Medium

50 48

Large .721
P (High)

1.0

10.
.30 low do nothing buy 1 2 90 subcontract buy 2nd .30 low buy 2 .70 high 110 100 75 130 + .7(110) .3(75) + .7(130) $113.5 (optimum) $90 .3(90) $104

Decision: Buy 2 machines.

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Solutions (continued) 11.

50 .30 4 Alternative A .50 1

1/3 1/3 1/3

0 60 90 40 44

.20

60

49 2 Alternative B 40 .30 5 .50 .20 45

1/3 1/3 1/3

(45) 45 99 40 50 30

1/2 3 1/2

40 50

EV1 = (1/3)(0) + (1/3)(60) + (1/3)(90) = 50 EV2 = (1/3)(-45) + (1/3)(45) + (1/3)(99) = 33 EV3 = (1/2)(40) + (1/2)(50) = 45 EV4 = (.3)(50) + (.5)(44) + (.2)(60) = 49 EV1 = (.3)(40) + (.5)(50) + (.2)(45) = 46 Since 49 > 46, choose alternative A. 12. (1) Draw the tree diagram:
Demand Low (.4) Build Small
1

$400,000 (1) Maintain $50,000 (2) Expand $450,000 (3)

Demand High (.6)

Build Large

Demand Low (.4)

$-10,000 (4)

Demand High (.6)

$800,000 (5)

(2) Analyze decisions from right to left (i.e., work backwards from the end of the tree towards the root). For instance begin with decision 2 and choose expansion because it has a higher present value ($450,000 vs. $50,000).

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Solutions (continued) (3) Compute the expected value of the ends of the remaining branches (numbered 1 to 5 in the diagram), and then determine the expected value for the two initial alternatives. (1) .4 x $400,000 = $160,000 (2) (eliminated) $430,000 (expected value if (3) .6 x $450,000 = $270,000 Build small is chosen) (4) .4 x -$10,000 = $-4,000 (5) .6 x $800,000 = $480,000 $476,000 (expected value if Build large is chosen) (4) Since the expected value of building a large plant has the higher expected value, select the large plant alternative. 13. Reassign New Staff Redesign Moderate 50 60 40 High 60 60 50 Very High 85 60 90 Worst 85 60* 90 Best 50 60 40* Average 65 60 (tie) 60

a. Maximin: New staff b. Maximax: Redesign c. Regret table: Moderate Reassign 10 New Staff 20 Redesign 0 High 10 10 0 Very High 25 0 30 Worst 25 20* 30

d. Insufficient reason: (tie) New Staff or Redesign 14. a. Reassign: .10(50) + .30(60) + .60(85) = $74 New Staff: .10(60) + .30(60) + .60(60) = 60 * Redesign: .10(40) + .30(50) + .60(90) = 73 b.
.10 Moderate Reassign 74 .30 High .60 Very High .10 Moderate 60 New Staff 60 .30 High .60 Very High .10 Moderate Redesign 73 .30 High .60 Very High 50 60 85 60 60 60 40 50 90

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Solutions (continued) c. Opportunity loss table: Moderate Reassign 10 New Staff 20 Redesign 0 (.1)

High 10 10 0 (.3)

Very High 25 0 30 (.6)

.10 Moderate

EOL 19 5* 18

50 60 85 60 60 60 40 75 80 40 50 90

15.

Reassign Hire 2 Initially 60 New Staff 60

74

.30 High .60 Very High .10 Moderate

60

.30 High .60 Very High .10 Moderate

Hire 1 Initially Redesign

74.5

.30 High (Hire 1) .60 V. High (Hire 1) .10 Moderate

73

.30 High .60 Very High

Solution continued

b. Alternative Payoff C is lower than Alternative B for all values of P(#2), so it would Payoff never be appropriate. #1 #2 16. c. EV = 120 - 40P; EV= 20 + 120P. Solving, P = .625. Therefore, choose Alternative A if P(#2) is greater than .625. 140
120 B d. For P(#1), choose Alternative A, if P(#1) isAless than .375 (i.e., 1.000 - .625). 100 C C A 40 B 80

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0 P(#2) 1.0

88

Solutions (continued) 17. [Refer to the diagram in the previous solution] b. Alternative B is now the one that is never appropriate. c. EV= 20 + 120P; EV= 100 - 60P. Solving, P = .444. Therefore, choose Alternative A for P(#2) less than .444, and choose Alternative C for P(#2) greater than .444. d. In terms of P(#1), choose A for P(#1) greater than .556 and C for P(#1) less than .556. 18. EV= 10 12P EV= 8 5P EV= 5 0P EV= 0 + 7P
Payoff for contract 10 #1 8 #2 #2 5 #3 #4 7 5 Payoff for no contract

3 #4 0 1.0 -2

.286

.60 .714

19.

EV= 120 100P EV= 60 20p EV= 10 + 100p EV = 90

Payoff #1 120 A

.30 Profits

.80

Payoff #2 110

C 90 D 90

Note that in terms of P(#1), .30 becomes .70, .80 becomes . 60 20, .417 becomes .583, and .75 becomes .25.
C

B Costs A 40 20

10 0 .417 .75 1.0

P (#2) 2.3 > 1.5, hire no additional employees when the probability of rain is 20%.

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