DECISION TREE

Bayesian Approach

DECISION TREES

A decision tree is a chronological representation of the decision problem. Each decision tree has two types of nodes; round nodes correspond to the states of nature while square nodes correspond to the decision alternatives. The branches leaving each round node represent the different states of nature while the branches leaving each square node represent the different decision alternatives. At the end of each limb of a tree are the payoffs attained from the series of branches making up that limb.
2

FIVE STEPS TO DECISION TREE ANALYSIS

1. 2. 3. 4.

Define the problem. Structure or draw the decision tree. Assign probabilities to the states of nature. 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.

EXAMPLE

A developer must decide how large a luxury condominium complex to build small, medium, or large. The profitability of this complex depends upon the future level of demand for the complexs condominiums.

ELEMENTS OF DECISION THEORY

States of nature: The states of nature could be defined as low demand and high demand. Alternatives: Developer could decide to build a small, medium, or large condominium complex. Payoffs: The profit for each alternative under each potential state of nature is going to be determined.
We develop different models for this problem on the following slides.

PAYOFF TABLE

THIS IS A PROFIT PAYOFF TABLE

Alternatives Small Medium Large

States of Nature Low High 8 8 5 15 -11 22

(payoffs in millions)

DECISION TREE 8

8 5 Medium Complex 15

-11

22

EXAMPLE: BURGER PRINCE

Burger Prince Restaurant is contemplating opening a new restaurant on Main Street. It has three different models, each with a different seating capacity. Burger Prince estimates that the average number of customers per hour will be 80, 100, or 120. The payoff table (profits) for the three models is on the next slide.

EXAMPLE: BURGER PRINCE

Payoff Table Average Number of Customers Per Hour s1 = 80 s2 = 100 s3 = 120 Model A Model B Model C $10,000 $ 8,000 $ 6,000 $15,000 $18,000 $16,000 $14,000 $12,000 $21,000

EXAMPLE: BURGER PRINCE

Expected Value Approach Calculate the expected value for each decision. The decision tree on the next slide can assist in this calculation. Here d1, d2, d3 represent the decision alternatives of models A, B, C, and s1, s2, s3 represent the states of nature of 80, 100, and 120.

10

EXAMPLE: BURGER PRINCE

Payoffs
s1 s2 s3 s1 .4 .2 .4 .4 .2 .4 .4

10,000 15,000

d1 1 d2 d3

s2 s3 s1 s2 s3

14,000 8,000
18,000

12,000
6,000

.2
.4

16,000
21,000
11

EXAMPLE: BURGER PRINCE

Expected Value For Each Decision

EMV = .4(10,000) + .2(15,000) + .4(14,000) = $12,600

Model A

d1

Model B d2

EMV = .4(8,000) + .2(18,000) + .4(12,000) = $11,600

Model C

d3

EMV = .4(6,000) + .2(16,000) + .4(21,000) = $14,000

Choose the model with largest EV, Model C.

12

EXAMPLE PROBLEM: THOMPSON LUMBER COMPANY

Thompson Lumber Company is trying to decide whether to expand its product line by manufacturing and marketing a new product which is backyard storage sheds. The courses of action that may be chosen include: (1) large plant to manufacture storage sheds, (2) small plant to manufacture storage sheds, or (3) build no plant at all.

THOMPSON LUMBER COMPANY

Probability

0.5

0.5

EXPECTED MONETARY VALUE

Thompson Lumber Company

Probability of favorable market is same as probability of unfavorable market. Each state of nature has a 0.50 probability.

CALCULATING THE EVPI

Best outcome for state of nature "favorable market" is "build a large plant" with a payoff of $200,000. Best outcome for state of nature "unfavorable market" is "do nothing," with payoff of $0. Therefore, Expected profit with perfect information EPPI = ($200,000)(0.50) + ($0)(0.50) = $ 100,000 If one had perfect information, an average payoff of $100,000 could be achieved in the long run. However, the maximum EMV (EVBEST) or expected value without perfect information, is $40,000. Therefore, EVPI = $100,000 - $40,000 = $60,000.

TO TEST OR NOT TO TEST

Often, companies have the option to perform market tests/surveys, usually at a price, to get additional information prior to making decisions. However, some interesting questions need to be answered before this decision is made:
How will the test results be combined with prior information? How much should you be willing to pay to test?

The good news is that Bayes Theorem can be used to combine the information, and we can use our decision tree to find EVSI, the Expected Value of Sample Information. In order to perform these calculations, we first need to know how reliable the potential test may be.

MARKET SURVEY RELIABILITY IN PREDICTING ACTUAL STATES OF NATURE

Assuming that the above information is available, we can combine these conditional probabilities with our prior probabilities using Bayes Theorem.

MARKET SURVEY RELIABILITY IN PREDICTING ACTUAL STATES OF NATURE

PROBABILITY REVISIONS GIVEN POSITIVE SURVEY

Alternatively, the following table will produce the same results:

PROBABILITY REVISIONS GIVEN NEGATIVE SURVEY

The bottom of the tree is the no test part of the analysis; therefore, the prior probabilities are assigned to these events.
P(favorable market) = P(FM) = 0.5
P(unfavorable market) = P(UM) = 0.5

PLACING POSTERIOR PROBABILITIES ON THE DECISION TREE

The calculations here will be identical to the EMV calculations performed without a decision tree. The top of the tree is the test part of the analysis; therefore, the posterior probabilities are assigned to these events.

DECISION TREES FOR TEST/NO TEST MULTI-STAGE DECISION PROBLEMS

DECISION TREE SOLUTION

Thompson Lumber Company

IN-CLASS PROBLEM 3
Leo can purchase a historic home for $200,000 or land in a growing area for $50,000. There is a 60% chance the economy will grow and a 40% change it will not. If it grows, the historic home will appreciate in value by 15% yielding a $30,00 profit. If it does not grow, the profit is only $10,000. If Leo purchases the land he will hold it for 1 year to assess the economic growth. If the economy grew during the first year, there is an 80% chance it will continue to grow. If it did not grow during the first year, there is a 30% chance it will grow in the next 4 years. After a year, if the economy grew, Leo will decide either to build and sell a house or simply sell the land. It will cost Leo $75,000 to build a house that will sell for a profit of $55,000 if the economy grows, or $15,000 if it does not grow. Leo can sell the land for a profit of $15,000. If, after a year, the economy does not grow, Leo will either develop the land, which will cost $75,000, or sell the land for a profit of $5,000. If he develops the land and the economy begins to grow, he will make $45,000. If he develops the land and the economy does not grow, he will make $5,000.

2
Purchase historic home

No growth (.4)

IN-CLASS PROBLEM 3: SOLUTION

Economy grows (.6)
Economy grows (.8) Build house

6
No growth (.2)

1
Purchase land Economy grows (.6)

Sell land

3
No growth (.4) Develop land

Economy grows (.3)

7
No growth (.7)

Sell land

IN-CLASS PROBLEM 3: SOLUTION

$22,000

Economy grows (.6)

No growth (.4) $10,000 Economy grows (.8)

$30,000

2
Purchase historic home

$47,000 Build house

$55,000

6
No growth (.2) $15,000 $15,000

$35,000

4
Economy grows (.6) $47,000

Purchase land

Sell land

3
$35,000 No growth (.4) Develop land

$17,000

Economy grows (.3) No growth (.7)

$45,000 $5,000

7
$5,000

5
$17,000

Sell land

SIMPLE EXAMPLE: UTILITY THEORY

Lets say you were offered $2,000,000 right now on a chance to win $5,000,000. The $5,000,000 is won only if you flip a coin and get tails. If you get heads you lose and get $0. What should you do?
$2,000,000

$0 Heads (0.5) Tails (0.5) $5,000,000

Decision Trees

Planning Tool

DECISION TREES

Enable a business to quantify decision making Useful when the outcomes are uncertain Places a numerical value on likely or potential outcomes Allows comparison of different possible decisions to be made

DECISION TREES

Limitations:
How accurate is the data used in the construction of the tree? How reliable are the estimates of the probabilities?

Data may be historical does this data relate to real time?

Necessity of factoring in the qualitative factors human resources, motivation, reaction, relations with suppliers and other stakeholders

Process

THE PROCESS
Economic growth rises 0.7 Expected outcome 300,000

Expand by opening new outlet Economic growth declines 0.3 Maintain current status 0 Expected outcome -500,000

The circle denotes the point where different outcomes could occur. The estimates of the probability and the knowledge of the expected outcome A square denotes the point where a decision is made, In this example, a business contemplating allow the firm to make a calculation of the likely return. In is this example it is: There is also the outlet. option The to do nothing and current status wouldcontinues have an outcome opening a new uncertainty is maintain the state the of the economy quo! if theThis economy to grow of Economic growth 0.7 x 300,000 expected, the potentialrises: loss is estimated at 500,000. = 210,000
0. healthily the option is estimated to yield profits of 300,000. However, if the economy fails to grow as

Economic growth declines: 0.3 x 500,000 = -150,000

The calculation would suggest it is wise to go ahead with the decision ( a net benefit figure of +60,000)

The Process
Economic growth rises 0.5 Expected outcome 300,000 Expand by opening new outlet Economic growth declines 0.5 Maintain current status 0 Expected outcome -500,000

Look what happens however if the probabilities change. If the firm is unsure of the potential for growth, it might estimate it at 50:50. In this case the outcomes will be: Economic growth rises: 0.5 x 300,000 = 150,000 Economic growth declines: 0.5 x -500,000 = -250,000 In this instance, the net benefit is -100,000 the decision looks less favourable!

Advantages

Disadvantages