Production and Project Management
Course code: ChEg 5104
Credit Hours: 3
Aregawi G/Eyesus (Assistant Professor)
Email: aregawig1974@[Link] Cellphone: +251968925386
April 07, 2025
Chapter 7: Decision Making
7.1 General Model for decision making - ayes’
Decision Rule
7.2 Decision Making under Certainty and
Uncertainty
7.3 Decision Methods (Pay off & Tree)
Learning Objectives
After completing this chapter, you should be able to:
• Describe the decision environments of certainty and
uncertainty
• Construct a payoff table and an opportunity-loss table
• Apply the expected value criterion for decision- making
• Compute the value of perfect information
• Develop decision trees for decision-making
Introduction
Decision theory is an analytic and systematic
approach to the study of decision making.
A good decision is based on logic, considers all
available data and possible alternatives, and the
quantitative approach.
7.1 General Model for decision making -
ayes’ Decision Rule
The Six Steps in Decision-Making
1. Clearly define the problem at hand
2. List the possible alternatives
3. Identify the possible outcomes or states of nature
4. List the payoff or profit of each combination of
alternatives and outcomes
5. Select one of the mathematical decision theory models
6. Apply the model and make your decision
…..7.1 General Model for decision making
Decision Making
Decision Environment Decision Criteria
Certainty Nonprobabilistic
Uncertainty Probabilistic
…..7.1 General Model for decision making
Non-probabilistic Decision Decision Criteria
Criteria:
Decision rules that can be applied if the
* Nonprobabilistic
probabilities of uncertain events are not
known.
Probabilistic
maximax criterion
maximin criterion
minimax regret criterion
…..7.1 General Model for decision making
Probabilistic Decision Criteria:
Decision Criteria
Consider the probabilities of uncertain events
and select an alternative to maximize the
expected payoff of minimize the expected loss Nonprobabilistic
maximize expected value
minimize expected opportunity loss * Probabilistic
7.2 Decision Making under Certainty &
Uncertainty
Decision Environment Certainty: The results of
decision alternatives are known
Certainty * Example:
Must print 10,000 color brochures
Uncertainty Offset press A: $2,000 fixed cost
+ $.24 per page
Offset press B: $3,000 fixed cost
+ $.12 per page
…..7.2 Decision Making under Certainty & Uncertainty
Uncertainty: The outcome that will occur
Decision Environment after a choice is unknown
Certainty Example:
You must decide to buy an item now or wait.
Uncertainty * If you buy now the price is $2,000. If you
wait the price may drop to $1,500 or rise to
$2,200. There also may be a new model
available later with better features.
7.3 Decision Method
Features of Decision-Making
• List Alternative Courses of Action (Possible Events or Outcomes)
• Determine ‘Payoffs’ (Associate a Payoff with Each Event or Outcome)
• Adopt Decision Criteria (Evaluate Criteria for Selecting the Best
Course of Action)
7.3 Decision Methods
Two Methods of Listing
Payoff Table Decision Tree
7.3.1 A Payoff Table
A payoff table shows alternatives, states of nature, and payoffs
Profit in $1,000’s
Investment Choice (States of Nature)
(Alternatives)
Strong Stable Weak
Economy Economy Economy
Large factory 200 50 -120
Average factory 90 120 -30
Small factory 40 30 20
Maximax Solution
The maximax criterion (an optimistic approach):
1. For each option, find the maximum payoff
Profit in $1,000’s
1.
Investment (States of Nature)
Choice Strong Stable Weak Maximum
(Alternatives) Economy Economy Economy Profit
Large factory 200 50 -120 200
Average factory 90 120 -30 120
Small factory 40 30 20 40
Maximax Solution
The maximax criterion (an optimistic approach):
[Link] each option, find the maximum payoff
[Link] the option with the greatest maximum payoff
Profit in $1,000’s 2.
1.
Investment (States of Nature)
Choice Maximum Greatest
Strong Stable Weak
(Alternatives) Profit maximum
Economy Economy Economy
is to
Large factory 200 50 -120 200 choose
Average factory 90 120 -30 120 Large
Small factory 40 30 20 40 factory
Maximin Solution
The maximin criterion (a pessimistic approach):
1. For each option, find the minimum payoff
Profit in $1,000’s
1.
Investment (States of Nature)
Choice Strong Stable Weak Minimum
(Alternatives) Economy Economy Economy Profit
Large factory 200 50 -120 -120
Average factory 90 120 -30 -30
Small factory 40 30 20 20
Maximin Solution
The maximin criterion (a pessimistic approach):
[Link] each option, find the minimum payoff
[Link] the option with the greatest minimum payoff
Profit in $1,000’s 2.
1.
Investment (States of Nature)
Choice Strong Stable Weak Minimum
(Alternatives) Economy Economy Economy Profit Greatest minimum
Large factory 200 50 -120 is to choose Small
-120
Average factory 90 120 -30 factory
-30
Small factory 40 30 20 20
Opportunity Loss
Opportunity loss is the difference between an actual payoff for a decision and the
optimal payoff for that state of nature
Payoff Table Profit in $1,000’s
Investment Choice (States of Nature)
(Alternatives) Strong Stable Weak
Economy Economy Economy
Large factory 200 50 -120
Average factory 90 120 -30
Small factory 40 30 20
The choice “Average factory” has payoff 90 for “Strong Economy”.
Giv
en “Strong Economy”,
the choice of “Large factory” would have given a payoff of 200, or
110 higher.
Opportunity loss = 110 for this cell.
Opportunity Loss
Profit in $1,000’s Payoff
Investment Choice (States of Nature)
Table
(Alternatives) Strong Stable Weak
Economy Economy Economy
Large factory 200 50 -120
Average factory 90 120 -30
Opportunity
Small factory 40 30 20
Loss Table
Opportunity Loss in $1,000’s
Investment Choice (States of Nature)
(Alternatives) Strong Stable Weak
Economy Economy Economy
Large factory 0 70 140
Average factory 110 0 50
Small factory 160 90 0
Minimax Regret Solution
The minimax regret criterion:
1. For each alternative, find the maximum
opportunity loss (or “regret”)
Opportunity Loss Table
Opportunity Loss in $1,000’s 1.
Investment Choice (States of Nature)
Maximum
(Alternatives) Strong Stable Weak
Economy Economy Economy
Op. Loss
Large factory 0 70 140 140
Average factory 110 0 50 110
Small factory 160 90 0 160
Minimax Regret Solution
The minimax regret criterion:
[Link] each alternative, find the maximum opportunity
loss (or “regret”)
[Link] the option with the smallest maximum loss
Opportunity Loss Table
Opportunity Loss in $1,000’s 1. 2.
Investment Choice (States of Nature)
Maximum Smallest
(Alternatives) Strong Stable Weak
Economy Economy Economy
Op. Loss maximum
loss is to
Large factory 0 70 140 140 choose
Average factory 110 0 50 110 Average
Small factory 160 90 0 160 factory
Expected Value Solution
The expected value is the weighted average
payoff, given specified probabilities for each state of nature
Profit in $1,000’s
(States of Nature)
Investment Choice Strong Stable Weak
(Alternatives) Economy Economy Economy
(.3) (.5) (.2) Suppose these
Large factory 200 50 -120 probabilities
have been
Average factory 90 120 -30
Small factory 40 30 20
assessed for
these states of
nature
Expected Value Solution
Example: EV (Average factory) = 90(.3) + 120(.5) + (-
30)(.2)
= 81 Profit in $1,000’s
(States of Nature)
Investment Choice Strong Stable Weak
(Alternatives) Economy Economy Economy Expected Maximize
(.3) (.5) (.2)
Values expected
value by
Large factory 200 50 -120 61 choosing
Average factory 90 120 -30 81 Average
Small factory 40 30 20 31 factory
Expected Opportunity Loss Solution
Example: EOL (Large factory) = 0(.3) + 70(.5) +
(140)(.2)
= 63
Opportunity Loss Table Opportunity Loss in $1,000’s
(States of Nature)
Expected
Investment Strong Stable Weak Op. Loss Minimize
Choice Economy Economy Economy expected
(Alternatives) (.3) (.5) (.2) (EOL)
op. loss by
Large factory 0 70 140 63 choosing
Average factory 110 0 50 43 Average
Small factory 160 90 0 93 factory
Value of Information
Expected Value of Perfect Information, EVPI
(also called Cost of Uncertainty)
Expected Value of Perfect Information
= Expected Value Under Certainty (EVUC)
– Expected Value without information (EV)
so: EVPI = EVUC – EV
Expected Value Under Certainty
Expected Under Profit in $1,000’s
Value Certainty (States of Nature)
(EVUC): Investment Choice Strong Stable Weak
(Alternatives) Economy Economy Economy
EVUC = expected value of
(.3) (.5) (.2)
the best decision,
Large factory 200 50 -120
given perfect information
Average factory 90 120 -30
Small factory 40 30 20
200 120 20
Example: Best decision
given “Strong Economy” is
“Large factory”
Expected Value Under Certainty
No weight these Profit in $1,000’s
w
outcomes thei (States of Nature)
r
probabilities to find EVUC: Investment Choice Strong Stable Weak
(Alternatives)
with Economy Economy Economy
(.3) (.5) (.2)
Large factory 200 50 -120
Average factory 90 120 -30
Small factory 40 30 20
200 120 20
EVUC = 200(.3)+120(.5)+20(.2)
= 124
Value of Information Solution
Expected Value of Perfect Information
(EVPI)
= Expected Value Under Certainty (EVUC)
– Expected Value without information (EV)
Recall: EVUC = 124
EV is maximized by choosing “Average factory”,
where EV = 81
so: EVPI = EVUC – EV
= 124 – 81
= 43
7.3.2 Decision Tree Method
General Steps to construct Tree diagram
• Identify a high priority problem that need to be solved earliest
• Identify priority means
• Identify secondary means for primary means
• Tertiary means
• Continue the process till the group feels that the end of the line
has been reached
• Use of post- it pad
• Consensus of means
• Title it
Constructing a Tree Diagram - Group Method Approach
1. Write Relations Diagram topic (Objective card)
2. Identify constraints on how objective can be achieved
3. Discuss means of achieving objective (primary means, first
level strategy)
4. Take each primary mean, write objective for achieving it
(secondary means)
5. Continue to expand to the fourth level
6. Review each system of means in both directions (from
objective to means and means to objective)
7. Add more cards if needed
8. Connect all levels
Next, complete the diagram
Decision Tree Diagram 4th means
Secondary means 3rd means 4th means
3rd means 4th means
Primary means 4th means
3rd means
4th means
Secondary means 3rd means
4th means
To Accomplish
4th means
3rd means 4th means
Secondary means 3rd means 4th means
4th means
Primary means
3rd means 4th means
Constraints
Secondary means 3rd means 4th means
End of Chapter One