2023 3 Decision Tree Analysis
2023 3 Decision Tree Analysis
2023 3 Decision Tree Analysis
Decision Analysis
• Managers often must make decisions in environments that are fraught with
uncertainty.
• Some Examples
– A manufacturer introducing a new product into the marketplace
• What will be the reaction of potential customers?
• How much should be produced?
• Should the product be test-marketed?
• How much advertising is needed?
– A financial firm investing in securities
• Which are the market sectors and individual securities with the best prospects?
• Where is the economy headed?
• How about interest rates?
• How should these factors affect the investment decisions?
9-2
The Goferbroke Company Problem
• Drilling for oil on this tract would require an investment of about $100,000.
• If the tract contains oil, it is estimated that the net revenue generated would be
approximately $800,000.
• Another oil company has offered to purchase the tract of land for $90,000.
9-3
Prospective Profits
Profit
Status of Land Oil Dry
Alternative
Drill for oil $700,000 –$100,000
Chance of status 1 in 4 3 in 4
9-4
Decision Analysis Terminology
• The decision maker is the individual or group responsible for making the
decision.
• The outcome is affected by random factors outside the control of the decision
maker. These random factors determine the situation that will be found when
the decision is executed. Each of these possible situations is referred to as a
possible state of nature.
• The decision maker generally will have some information about the relative
likelihood of the possible states of nature. These are referred to as the prior
probabilities.
9-5
Prior Probabilities
9-6
Payoff Table (Profit in $Thousands)
State of Nature
Alternative Oil Dry
9-7
The Maximax Criterion
• The maximax criterion is the decision criterion for the eternal optimist.
• Procedure:
– Identify the maximum payoff from any state of nature for each alternative.
– Find the maximum of these maximum payoffs and choose this alternative.
State of Nature
Alternative Oil Dry Maximum in Row
Drill for oil 700 –100 700 Maximax
Sell the land 90 90 90
9-8
The Maximin Criterion
• The maximin criterion is the decision criterion for the total pessimist.
• Procedure:
– Identify the minimum payoff from any state of nature for each alternative.
– Find the maximum of these minimum payoffs and choose this alternative.
State of Nature
Alternative Oil Dry Minimum in Row
Drill for oil 700 –100 –100
Sell the land 90 90 90 Maximin
9-9
Bayes’ Decision Rule
• Procedure:
– For each decision alternative, calculate the weighted average of its payoff by
multiplying each payoff by the prior probability and summing these products. This
is the expected payoff (EP).
– Choose the decision alternative that has the largest expected payoff.
A B C D E F
1 Bayes' Decision Rule for the Goferbroke Co.
2
3 Payoff Table State of Nature Expected
4 Alternative Oil Dry Payoff
5 Drill 700 -100 100
6 Sell 90 90 90
7
8 Prior Probability 0.25 0.75
9-10
Bayes’ Decision Rule
9-11
Decision Trees
• A decision tree can apply Bayes’ decision rule while displaying and analyzing
the problem graphically.
9-12
Decision Tree for Goferbroke
Payoff
700
Oil (0.25)
Drill
Dry (0.75)
-100
A
Sell
90
9-13
Using TreePlan
9-14
Using TreePlan
4. To replace a node (such as the terminal node of the drill branch in F3) by a
different type of node (e.g., an event node), click on the cell containing the node,
choose Decision Tree again from the Add-Ins tab (Excel 2007 or 2010) or Tools
menu (other versions of Excel), and select “Change to event node”.
9-15
Using TreePlan
9-16
TreePlan Results
• The numbers inside each decision node indicate which branch should be
chosen (assuming the branches are numbered consecutively from top to
bottom).
• The numbers to the right of each terminal node is the payoff if that node is
reached.
• The number 100 in cells A10 and E6 is the expected payoff at those stages in
the process.
9-17
Consolidate the Data and Results
A B C D E F G H I J K
1 0.25
2 Oil
3 700
4 Drill 800 700
5
6 -100 100 0.75
7 Dry
8 -100
9 1 0 -100
10 100
11
12 Sell
13 90
14 90 90
15
16
17 Data
18 Cost of Drilling 100
19 Revenue if Oil 800
20 Revenue if Sell 90
21 Revenue if Dry 0
22 Probability Of Oil 0.25
23
24 Action Drill
25
26 Expected Payoff 100
9-18
Sensitivity Analysis: Prior Probability of Oil = 0.15
A B C D E F G H I J K
1 0.15
2 Oil
3 700
4 Drill 800 700
5
6 -100 20 0.85
7 Dry
8 -100
9 2 0 -100
10 90
11
12 Sell
13 90
14 90 90
15
16
17 Data
18 Cost of Drilling 100
19 Revenue if Oil 800
20 Revenue if Sell 90
21 Revenue if Dry 0
22 Probability Of Oil 0.15
23
24 Action Sell
25
26 Expected Payoff 90
9-19
Sensitivity Analysis: Prior Probability of Oil = 0.35
A B C D E F G H I J K
1 0.35
2 Oil
3 700
4 Drill 800 700
5
6 -100 180 0.65
7 Dry
8 -100
9 1 0 -100
10 180
11
12 Sell
13 90
14 90 90
15
16
17 Data
18 Cost of Drilling 100
19 Revenue if Oil 800
20 Revenue if Sell 90
21 Revenue if Dry 0
22 Probability Of Oil 0.35
23
24 Action Drill
25
26 Expected Payoff 180
9-20
Data Table Results
The Effect of Changing the Prior Probability of Oil
I J K
16 Probability Expected
17 of Oil Action Payoff
18 Drill 100
19 0.15 Sell 90
20 0.17 Sell 90
21 0.19 Sell 90
22 0.21 Sell 90
23 0.23 Sell 90
24 0.25 Drill 100
25 0.27 Drill 116
26 0.29 Drill 132
27 0.31 Drill 148
28 0.33 Drill 164
29 0.35 Drill 180
9-21
Checking Whether to Obtain More Information
• A quick way to check is to pretend that it is possible to actually determine the true
state of nature (“perfect information”).
9-22
Expected Payoff with Perfect Information
B C D
3 Payoff Table State of Nature
4 Alternative Oil Dry
5 Drill 700 -100
6 Sell 90 90
7 Maximum Payoff 700 90
8
9 Prior Probability 0.25 0.75
10
11 EP (with perfect info) 242.5
9-23
Expected Payoff with Perfect Information
A B C D E F G H I J K
1
2 Drill
3 0.25 700
4 Oil 700 700
5 1
6 0 700
7 Sell
8 90
9 90 90
10
11 242.5
12 Drill
13 0.75 -100
14 Dry -100 -100
15 2
16 0 90
17 Sell
18 90
19 90 90
9-24