DECISION TREE

PART 2
 End of this topic students able to:
1. Develop accurate and useful decision tree

2. Determine decision from decision tree

3. Calculate the Expected Value of Sample Information (EVSI)

 Decision Trees

Any problem that can be presented in a decision table

can also be graphically represented in a decision tree.
Decision trees are most beneficial when a sequence
of decisions must be made.
All decision trees contain decision points or nodes,
from which one of several alternatives may be chosen.

All decision trees contain state-of-nature points or

nodes, out of which one state of nature will occur.

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 Five Steps of
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) for each state of nature
node.
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Structure of Decision Trees
Trees start from left to right.
Trees represent decisions and outcomes in
sequential order.
◦ Squares represent decision nodes.
◦ Circles represent states of nature nodes.
◦ Lines or branches connect the decisions nodes and the
states of nature.

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EXAMPLE:
 A State-of-Nature Node

Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
r
n st P l a
e
Co arg
L Favorable Market
Construct
2
Small Plant Unfavorable Market
Do
No
th
in
g
Figure 3.2

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 EMV for Node = (0.5)($200,000) + (0.5)(–$180,000)
1 = $10,000
Payoffs
Favorable Market (0.5)
$200,000
Alternative with best
EMV is selected 1
Unfavorable Market (0.5)
ct nt –$180,000
r u
n st P l a
e
Co arg
L Favorable Market (0.5)
$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000
Do
No
th EMV for Node = (0.5)($100,000)
in
g 2 = $40,000 + (0.5)(–$20,000)
Figure 3.3
$0
Copyright © 2012 Pearson Education 3-8
 First Decision Second Decision Payoffs
Point Point
Favorable Market (0.78)
$190,000
nt 2 Unfavorable Market (0.22)
ePla –$190,000
g
Lar Favorable Market (0.78)
$90,000
Small
5) 3 Unfavorable Market (0.22)
0 .4 Plant –$30,000
(
e y ts le
rv ul ab No Plant
Su Res vor –$10,000
a
1 S ur v F Favorable Market (0.27)
e $190,000

y
Re y (
ve
nt 4 Unfavorable Market (0.73)
ur Ne s u 0 . 5 ePla –$190,000
5) g
Lar
tS
ga lts Favorable Market (0.27)
ti v Small $90,000
ke

e 5 Unfavorable Market (0.73)

ar

Plant –$30,000
Mt
uc

No Plant
–$10,000
nd
Co

Do Favorable Market (0.50)

Not $200,000
Con nt 6 Unfavorable Market (0.50)
duc Pla –$180,000
t ge
Sur
ve y Lar Favorable Market (0.50)
$100,000
Small
Plant
7 Unfavorable Market (0.50)
Figure 3.4 –$20,000
No Plant
$0

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. Given favorable survey results,
EMV(node 2) = EMV(large plant | positive survey)
= (0.78)($190,000) + (0.22)(–$190,000) = $106,400
EMV(node 3) = EMV(small plant | positive survey)
= (0.78)($90,000) + (0.22)(–$30,000) = $63,600
EMV for no plant = –$10,000
. Given negative survey results,
EMV(node 4) = EMV(large plant | negative survey)
= (0.27)($190,000) + (0.73)(–$190,000) = –$87,400
EMV(node 5) = EMV(small plant | negative survey)
= (0.27)($90,000) + (0.73)(–$30,000) = $2,400
EMV for no plant = –$10,000

Copyright © 2012 Pearson Education 3-10

Compute the expected value of the market survey,
EMV(node 1) = EMV(conduct survey)
= (0.45)($106,400) + (0.55)($2,400)
= $47,880 + $1,320 = $49,200
If the market survey is not conducted,
EMV(node 6) = EMV(large plant)
= (0.50)($200,000) + (0.50)(–$180,000) = $10,000
EMV(node 7) = EMV(small plant)
= (0.50)($100,000) + (0.50)(–$20,000) = $40,000
EMV for no plant = $0
The best choice is to seek marketing information.

Copyright © 2012 Pearson Education 3-11

 First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
la nt Unfavorable Market (0.22)

$106,400
P –$190,000
ge
Lar $63,600 Favorable Market (0.78)
$90,000
Small
5) Unfavorable Market (0.22)
0 .4 Plant –$30,000
(
e y ts le
rv ul ab No Plant
Su Res vor –$10,000
Su Fa –$87,400 Favorable Market (0.27)
rv $190,000
e

y
Re y (
ve
a n t Unfavorable Market (0.73)
ur Ne s u 0 . 5 Pl –$190,000
5) rge
tS
ga lts $2,400

$2,400
La Favorable Market (0.27)
ti v Small $90,000
ke

e Unfavorable Market (0.73)

ar

Plant –$30,000
M
ct

No Plant
du

–$10,000
on
$49,200
C

Do $10,000 Favorable Market (0.50)

Not $200,000
Con t Unfavorable Market (0.50)
duc P lan –$180,000
ge
$40,000
t Sur Lar $40,000 Favorable Market (0.50)
ve y Small $100,000
Unfavorable Market (0.50)
Plant –$20,000
Figure 3.5
No Plant
$0

Copyright © 2012 Pearson Education 3-12

EXAMPLE 1
Expected Value of Sample Information
Suppose Thompson wants to know the actual value of doing the survey.

Expected value Expected value

with sample of best decision
EVSI = information, assuming – without sample
no cost to gather it information

= (EV with sample information + cost)

– (EV without sample information)

EVSI = ($49,200 + $10,000) – $40,000 = $19,200

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 Bayesian Analysis

 There are many ways of getting

probability data. It can be based on:
 Management’s experience and intuition.
 Historical data.
 Computed from other data using Bayes’
theorem.
 Bayes’ theorem incorporates initial
estimates and information about the
accuracy of the sources.
 It also allows the revision of initial
estimates based on new information.

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 Calculating Revised Probabilities

 In the Thompson Lumber case we used these four

conditional probabilities:
P (favorable market(FM) | survey results positive) = 0.78
P (unfavorable market(UM) | survey results positive) = 0.22
P (favorable market(FM) | survey results negative) = 0.27
P (unfavorable market(UM) | survey results negative) = 0.73

 But how were these calculated?

 The prior probabilities of these markets are:

P (FM) = 0.50
P (UM) = 0.50

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 Calculating Revised Probabilities
 Through discussions with experts Thompson has
learned the information in the table below.
 He can use this information and Bayes’ theorem
to calculate posterior probabilities.
STATE OF NATURE
RESULT OF FAVORABLE MARKET UNFAVORABLE MARKET
SURVEY (FM) (UM)

Positive (predicts P (survey positive | P (survey positive |

favorable market FM) UM)
for product) = 0.70 = 0.20

Negative (predicts P (survey negative P (survey negative

unfavorable | FM) | UM)
market for
product) = 0.30 = 0.80

Table 3.12
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 Calculating Revised Probabilities
 Recall Bayes’ theorem:

P ( B | A)  P ( A)
P( A | B) 
P ( B | A)  P ( A)  P ( B | A )  P ( A )

where
A, B  any two events
A  complement of A

For this example, A will represent a favorable

market and B will represent a positive survey.

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 Calculating Revised Probabilities
 P (FM | survey positive)
P ( survey positive | FM )  P ( FM )

P(survey positive |FM)  P(FM)  P(survey positive |UM)  P(UM)

(0.70)(0.50) 0.35
   0.78
(0.70)(0.50)  (0.20)(0.50) 0.45

 P (UM | survey positive)

P ( survey positive | UM )  P (UM )

P(survey positive |UM)  P(UM)  P(survey positive |FM)  P(FM)

(0.20)(0.50) 0.10
   0.22
(0.20)(0.50)  (0.70)(0.50) 0.45

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 Calculating Revised Probabilities

Probability Revisions Given a Positive Survey

POSTERIOR PROBABILITY
CONDITIONAL
PROBABILITY P(STATE OF
P(SURVEY NATURE |
STATE OF POSITIVE | STATE PRIOR JOINT SURVEY
NATURE OF NATURE) PROBABILITY PROBABILITY POSITIVE)
FM 0.70 X 0.50 = 0.35 0.35/0.45 = 0.78
UM 0.20 X 0.50 = 0.10 0.10/0.45 = 0.22
P(survey results positive) = 0.45 1.00

Table 3.13

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 Calculating Revised Probabilities
 P (FM | survey negative)
P ( survey negative | FM )  P ( FM )

P(survey negative |FM)  P(FM)  P(survey negative |UM)  P(UM)

(0.30)(0.50) 0.15
   0.27
(0.30)(0.50)  (0.80)(0.50) 0.55

 P (UM | survey negative)

P ( survey negative | UM )  P (UM )

P(survey negative |UM)  P(UM)  P(survey negative |FM)  P(FM)

(0.80)(0.50) 0.40
   0.73
(0.80)(0.50)  (0.30)(0.50) 0.55

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 Calculating Revised Probabilities

Probability Revisions Given a Negative Survey

POSTERIOR PROBABILITY

CONDITIONAL
PROBABILITY P(STATE OF
P(SURVEY NATURE |
STATE OF NEGATIVE | STATE PRIOR JOINT SURVEY
NATURE OF NATURE) PROBABILITY PROBABILITY NEGATIVE)
FM 0.30 X 0.50 = 0.15 0.15/0.55 = 0.27

UM 0.80 X 0.50 = 0.40 0.40/0.55 = 0.73

P(survey results positive) = 0.55 1.00

Table 3.14

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EXAMPLE 2
EXAMPLE 3