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Decision Tree Analysis

The document discusses decision trees as a tool for making decisions under uncertainty. It provides: 1) Five steps to decision tree analysis: define the problem, structure the tree, assign probabilities, estimate payoffs, and compute expected monetary values. 2) An example of Thompson Lumber's decision of whether to construct a large plant, small plant, or do nothing, with payoffs shown in a table and decision tree. 3) The steps are demonstrated by structuring Thompson's decision as a tree, assigning probabilities to market states, estimating payoffs, and computing expected monetary values to identify the best option.

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AyniNuyda
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417 views

Decision Tree Analysis

The document discusses decision trees as a tool for making decisions under uncertainty. It provides: 1) Five steps to decision tree analysis: define the problem, structure the tree, assign probabilities, estimate payoffs, and compute expected monetary values. 2) An example of Thompson Lumber's decision of whether to construct a large plant, small plant, or do nothing, with payoffs shown in a table and decision tree. 3) The steps are demonstrated by structuring Thompson's decision as a tree, assigning probabilities to market states, estimating payoffs, and computing expected monetary values to identify the best option.

Uploaded by

AyniNuyda
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Decision Making with Uncertainty: Using the

Decision Trees
Decision trees are most beneficial
when a sequence of decisions must be
made.

All information included in a payoff
table is also included in a decision tree.
Five Steps to
Decision Tree Analysis
1. Define the problem.
2. Structure or draw the decision tree.
3. Assign probabilities to the states of
nature.
4. Estimate payoffs for each possible
combination of alternatives and states
of nature.
5. Solve the problem by computing
expected monetary values (EMVs) at
each state of nature node.
Structure of Decision Trees
A graphical representation where:

A decision node (indicated by a square
) from which one of several
alternatives may be chosen.

A state-of-nature node (indicated by a
circle ) out of which one state of
nature will occur.
Thompson Lumber:
Payoff Table
Alternative
State of Nature
Favorable
Market ($)
Unfavorable
Market ($)
Construct a
large plant
200,000 -180,000
Construct a
small plant
100,000 -20,000
Do nothing 0 0
Probabilities 0.50 0.50
Thompsons Decision Tree
1
2
A Decision
Node
A State of
Nature Node
Favorable Market
Unfavorable Market
Favorable Market
Unfavorable Market
Construct
Small Plant
Step 1: Define the problem
Lets re-look at John Thompsons decision regarding storage sheds.
This simple problem can be depicted using a decision tree.
Step 2: Draw the tree
Thompsons Decision Tree
1
2
A Decision
Node
A State of Nature
Node
Favorable (0.5)
Market
Unfavorable (0.5)
Market
Favorable (0.5)
Market
Unfavorable (0.5)
Market
Construct
Small Plant
$200,000
-$180,000
$100,000
-$20,000
0
Step 3: Assign probabilities to the states of nature.
Step 4: Estimate payoffs.
Thompsons Decision Tree
1
2
A Decision
Node
A State of
Nature Node
Favorable (0.5)
Market
Unfavorable (0.5)
Market
Favorable (0.5)
Market
Unfavorable (0.5)
Market
Construct
Small Plant
$200,000
-$180,000
$100,000
-$20,000
0
EMV
=$40,000
EMV
=$10,000
Step 5: Compute EMVs and make decision.

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