Summary:

Chapter 5s Decision Theory
Decision theory can be used by management in a company for a variety of different decisions, including capacity planning, location planning, production and service design, and equipment selection. There are three different elements that should be considered in decision making: list of alternatives, known payoff for each alternative, and a set of possible future conditions for each alternative. There are three basic environments in which decisions need to be made: certainty, uncertainty, and risk. In order to make decisions under uncertainty, the following four decision criteria are used:

Certainty: Values of parameters and known to users (such as cost, demand..etc)
Risk: Probabilistic outcomes
Uncertainty: The parameters are unknown, and it is not possible to assess probabilities of certain outcomes.
  1. Maximin (choose the alternative with the best of the worst possible payoffs)
  2. Maximax (choose the alternative with the best possible payoffs)
  3. Laplace (choose the alternative with the best average payoff of any of the alternative)
  4. Minimax Regret (choose the alternative that has the least of the worst regrets)

Tools like Decision Tree, which presents a visual and schematic representation of the available alternatives and their possible consequences, can be used for decision making under risk. Other useful methods for manager to make decisions include Expected Value of Perfect Information (EVPI), Sensitivity Analysis, and Expected monetary value criterion (EMV). EVPI considers the possibility of state of nature that will occur in the future, while Sensitivity Analysis determines the payoffs and the range of possibility for which a best decision can be made. EMV finds the expected payoff of all alternatives to reveal the one with the best payoff. In addition to the different decision making methods, the decision-making process is also discussed which includes the following steps:
  1. Identifying the problem
  2. Specify objectives
  3. Develop alternatives
  4. Analyze and compare alternatives
  5. Select the best alternative
  6. Implement the solution
  7. Monitor to see if the desired result is achieved

Test Questions

1.) A manager needs to decide the capacity of their facility which will be used to store company's inventory and the manager has three options on capacity size: Large, Medium, or Small. Which method should the manager use in order to determine the best possible payoff?
a) Expected monetary value (EMV) criterion
b) Decision tree
c) Laplace
d) Sensitivity analysis
e) Minimax

Answer: b, page 219

2.) Which type of decision method is defined as a schematic representation of the available alternatives and their possible outcomes?
a) Bounded rationality
b) Maximin
c) Payoff table
d) Decision tree
e) None of the above

Answer: d, page 219

3.) A manager had a choice between two alternatives and wanted to determine the range of probabilities for which the chosen alternative has the best expected payoff. Which type of decision method is the MOST useful?
a) Sensitivity Analysis
b) Decision Tree
c) Risk
d) Minimax Regret
e) None of the above

Answer: a, page 222

4.) I: Is the following statement true or false: a decision tree is read from left to right with circular nodes representing decision points and square nodes representing chance events.
II: Decision trees are not useful for analyzing sequential decisions.

a) I is False and II is True
b) I is False and II is False
c) I is True and II is False
d) I is True and II is True
e) Cannot be determined

Answer: B, Page 220
(This question should be considered for determining whether one statement is true/false rather than determining two)

5.) Which decision process involves a graph providing a visual indication of the range of probability over which the various alternatives are optimal?
a) Decision Tree
b) Payoff Table
c) Sensitivity Analysis
d) There is no decision process that involves a graph
e) Decision making under risk

Answer: c, page 222-223

6) Using Minimax regret, you would choose the alternative that has:
a) the best of the best possible payoffs
b) the least of the worst regrets
c) the worst of the best possible payoffs
d) the best possible payoff
e) none of the above

Answer: b, page 217

7) If the expected payoff under certainty is $15, the expected monetary value is $12, the expected payoff under risk is $13, and the expected payoff under uncertainty is $16, then the expected value of perfect information is:
a) $28
b) $4
c) $2
d) $25
e) $20

Answer: c, page 221

9) What is the type of environment in which relevant parameters such as costs, capacity, and demand have known values?
a) Suboptimization
b) Certainty
c) Risk
d) Design capacity
e) All of the above

Answer: b, page 216

10. Which of the following is a reason for poor decision making?
a. unforeseeable circumstances
b. bounded rationality
c. mistakes in the decision process
d. suboptimization
e. all of the above

Answer: e, page 215 and 216

11. Determining the average payoff for each alternative and choosing the alternative with the highest average is the approach called:
a. Weighted factor analysis
b. Laplace
c. Minimin
d. Maximin
e. Maximax

Answer: e, page 217

12. Bounded rationality is a phrase that refers to the limits imposed on decision-making because of the following factors:
a. costs
b. human abilities
c. technology
d. time
e. all of the above

Answer: e, page 216

13. Which of the following treats the states of nature as equally likely:
a. Maximax
b. Maximin
c. Laplace
d. Minimax regret
e. None of the above

Answer:c, page 217

14. Which of the following approaches is widely used in decision making under risk?
a. Sensitivity Analysis
b. EMV
c. Laplace
d. EVPI
e. None of the above

Answer: b, page 218

15. Sensitivity analysis provides a range of probability over which the choice of alternatives would remain:
A. above 1
B. equal
C. the same
D. below 1
E. none of the above

Answer: c, page 222

16. Decision theory represents an approach to decision making.
A. perfect
B. consistent
C. inconsistent
D. general
E. none of the above

Answer: d, page 214

17. The type of illustration that shows the expected payoffs for each alternative in every possible state of nature is known as a:
A. expectance table
B. profit table
C. decision table
D. certainty table
E. none of the above

Answer: e (payoff table), page 215

18. Which of the follwing is not a cause of poor decision making?
A. develop alternatives
B. implement the solution
C. specify objectives
D. all of the above
E. none of the above

Answer: d, page 215

19. Which of the following method chooses the best alternative with the best of the worst possible payoffs?
a) Maximin
b) Laplace
c) Maximax
d) Minimax
e) None of the above

Answer: a, page 217

20. True or False? The difference between the expected payoff with perfect information and expected payoff under risk is expected monetary value criterion.
A. True
B. False

Answer: b (expected value of perfect information), page 221

21. When various departments each try to reach the best solution for that department, it is called:
a) Bounded Rationality
b) decision making under certainty
c) Maximax
d) Suboptimization
e) EVPI

Answer: D (pg. 216)

22. Which of the following shows the best expected value out of the alternatives?
a) Decision trees
b) EMV
c) EVPI
d) Suboptimization
e) None of the above

Answer: B (pg. 218)

23. What is the equation for EVPI?
a) Expected payoff under risk - Expected payoff under certainty
b) Expected payoff under risk - Expected payoff under uncertainty
c) Expected payoff under certainty - Expected payoff under risk
d) Expected payoff under uncertainty - Expected payoff under risk
e) None of the above

Answer: c (pg. 221)

24. All of the following are categories of decision environments, except:
a) risk
b) bounded rationality
c) uncertainty
d) certainty
e) none of the above

Answer: B (pg. 216)

25. Which of the following approaches represent maximax:
a. Determine the best possible payoff
b. Determine the worst possible payoff
c. Determine average payoff
d. Determine the worst regret for each possible alternative
e. None of the above

Answer: A p.217

26. The expected monetary value approach is most appropriate when a decision maker is:
a. risk neutral
b. risk averse
c. risk seeking
d. risk taking
e.none of the above

Answer: A p.219

27. Which or who plays the critical role in total quality management (TQM):
a. employees
b. CEO
c. management
d. customers
e. technology

Answer: C p. 427

28. Who developed the concept of zero defects?
a. Joseph Juran
b. Philip B. Crosby
c. Genichi Taguchi
d. Armand Feigenbaum
e. None of the above

Answer: B p. 411

29. The limitations on decision making caused by cost, human abilities, time, technology and availability of information is called:
a. suboptimization
b. certainty
c. risk
d. bounded rationality
e. sensitivity analysis

Answer: D p. 216

30. The difference between a given payoff and the best payoff for a state of nature is called?
a. risk
b. sensitivity analysis
c. maxmin
d. regret
e. maximax

Answer: d, page 209

31. Which the following is not a step of the decision process?
a. develop suitable alternatives
b. identify the problem
c. receive feedback
d. specify objectives
e. implement the solution

Answer: c, page 206

32. means the relevant parameters such as costs, capacity, and demand have known values.
a. certainty
b. expected value of perfect information
c. decision criterion
d. bounded rationality
e, uncertainty

Answer: a, page 207


Low
Moderate
High
Small Facility
$12
$12
$14
Medium Facility
$5
$6
$12
Large Facility
$-2
$6
$19

33. Based on the table above, find the Laplace criterion for the medium facility
a. 12.6
b. 14.6
c. 7.7
d. 9.6
e. 4.6

Answer: c,page 208

34. If the expected payoff under risk is $27.5 and the expected payoff under certainty is $31.2, what is the expected value of perfect information?
a. 5.7
b. 1.1
c. 8.4
d. 3.7
e. 9.8

Answer: d, page 212