3 Decision Tree

DECISION MAKING WITH
RISKS: DECISION TREE
STQM6034 Decision and Game Analysis

 Provides a graphical representation of the
decision making process
 Reveals more about the decision diagram

details
 Decision maker is able to express the big

and complex decision problem into a few
smaller manageable sections/aspects
Decision Tree 1st Element
 Square : Decision to be made
 Branches coming out from are decision
alternatives available to decision maker
 Example with 2 decision alternatives:

Decision alternative 1
Decision alternative 2
Decision to be made
Decision Tree 2nd Element
 Circle : Chance event
 Branches coming out from are all
possible outcomes of a chance event (states
of nature)
 Example with 2 states of nature:
State of nature 1
State of nature 2
Chance event
Decision Tree 3rd Element
 Payoffs of states of nature from chance event
 Example for 1 decision alternative & 2 states of

nature
Payoff from state of nature 1
Payoff from state of nature 2
At the ends of branches

Decision Tree
 Example: 2 decision alternatives (A1 & A2) and with
2 possible outcomes (K1 & K2) from the chance
event
Flow : Left  Right
K1 Payoff A1/K1
A1
K2 Payoff A1/K2
K1
Payoff A2/K1
A2
K2
Payoff A2/K2
WHAT NEED TO KNOW AND
UNDERSTAND WHEN
CONSTRUCTING THE
DECISION TREE

 Combination strategies can also be
represented by a decision tree.
 Example: To decide whether to go visit

brother, or sister, or both, or neither
Visit brother
Visit sister
Visit both
Do not visit both

2. Nature of outcomes
 Each chance node must have branches that
correspond to a set of MUTUALLY EXCLUSIVE
& COLLECTIVELY EXHAUSTIVE outcomes
Only one of the

Payoff from state outcomes can occur
of nature 1
+
Payoff from No other
state of nature 2 possibilities exist
=
ONE & ONLY ONE of the
outcomes can occur
 A decision tree represents ALL possible
paths that a decision maker might follow
through time.
◦ Number of paths depends on the complexity of
the decision problem.
K1 Payoff A1/K1
A1
K2 Payoff A1/K2
4 paths
K1
Payoff A2/K1
A2
K2
Payoff A2/K2
 Sometimes useful to think that the nodes
as occurring in a time sequence.
◦ Some possibilities:
A decision must be
made in anticipation of
the chance events
A decision is made conditional

on the specific chance
outcome having occurred
A sequence of chance events between decisions
SOME BASIC TYPES OF
DECISION TREES

 Basic risky decision
 Imperfect Information
 Multiple Objectives and Trade-offs
 Sequential Decisions
 Refer to given extra materials.

 Suppose NATE Cosmetics Corp. is producing a new
anti-aging cream. Historical records showed that similar
anti-aging creams in the past have been successful 60%
of the time. If NATE markets the cream and it is
successful, NATE will earn a profit of RM50,000; but will
lose RM35,000 otherwise. NATE needs to test the
effectiveness of the new cream first and it will cost
NATE RM5,000. If the test result is favorable, the new
cream will be successful with a probability of 0.80;
otherwise, the new cream will be successful with a
probability of only 0.30. NATE thinks it is reasonable to
say that there is a 60% chance that the test result is
favorable.
favorable.
of the time.
Product Successful
p=0.6
Product Unsuccessful
p=0.4
favorable.
lose RM35,000 otherwise.
RM50,000
Market
Product successful
p = 0.6
-RM35,000
Do not
Market Product unsuccessful
RM0 p = 0.4
favorable.
Product testing cost = RM5,000

favorable.
 If the test result is favorable, the new cream will be
successful with a probability of 0.80; otherwise, the new
cream will be successful with a probability of only 0.30.
Product successful
p = 0.8 RM45,000
Market
7 Product
Favorable result unsuccessful
4 p = 0.2 -RM40,000
Do not
Market
Do test -RM5,000
2 Product successful
Unfavorable Market p = 0.3 RM45,000
result, Product
8
unsuccessful
5 p = 0.7
Do not -RM40,000
Market
-RM5,000
favorable.
 NATE thinks it is reasonable to say that there is a 60%
chance that the test result is favorable.
Product successful
p = 0.8 RM45,000
Market
7 Product
Favorable result, unsuccessful
4 p = 0.2 -RM40,000
Do not
Market
Do test -RM5,000
result Product
8
unsuccessful
5 p = 0.7
Do not -RM40,000
Market
-RM5,000
Product successful
p = 0.8 RM45,000
Market
7 Product
4 p = 0.2 -RM40,000
Do not
Market
Do test -RM5,000
result Product
8
unsuccessful
5 p = 0.7
Do not -RM40,000
Market
-RM5,000
Product successful
p = 0.8 RM45,000
Market
7 Product
p = 0.6 4 p = 0.2 -RM40,000
Do not
Market
Do test -RM5,000
result, p = 0.4 Product
8
unsuccessful
5 p = 0.7
Do not -RM40,000
Market
-RM5,000
Product successful
p = 0.8 RM45,000
Market
7 Product
p = 0.6 4 p = 0.2 -RM40,000
Do not
Market
-RM5,000
Do test
8
unsuccessful
5 p = 0.7
Do not -RM40,000
1 Market
-RM5,000
RM50,000
Market
Product successful
Don’t 6 p = 0.6
do test
3 Do not
-RM35,000
RM0 p = 0.4
 Suppose you are planning a party. An
outdoor BBQ would be best, but only if the
sun shines; otherwise rain would spoil the
BBQ. On the other hand, an indoor party is
good too. Although an indoor party would
not be as nice as an outdoor party in the
bright sunshine, but definitely better than a
BBQ drenching in the rain. Surely, foregoing
the party altogether is also a possible
choice.
DECISION STRATEGY

 A decision strategy is a sequence of
decisions and chance outcomes where the
decisions chosen depends on the yet to be
determined outcomes of chance events.
 Apply a backward pass through the decision

tree to obtain the optimal decision strategy
 Steps:
1. At chance event nodes, compute the

expected value by multiplying the payoff
at the end of each branch by the
corresponding branch possibilities.
2. At decision nodes, select the decision
branch that leads to the best expected
value. This expected value becomes the
expected value at the decision node.
 On the branches of the decision nodes that
give the best expected value, put a “//”
symbol, and write the value at the
corresponding decision nodes.
DECISION STRATEGY
FOR A
RISK-NEUTRAL
DECISION MAKER

 Find the optimal decision strategy for NATE
Cosmetics Corp if NATE is risk-neutral.
 Step 1:
 Calculate the expected value for all
branches coming out of chance event nodes
Product successful
p = 0.8 RM45,000
Market
7 Product
p = 0.6 4 p = 0.2 -RM40,000
Do not
Market
-RM5,000
Do test
8
unsuccessful
5 p = 0.7
Do not -RM40,000
1 Market
-RM5,000
RM50,000
Market
Product successful
Don’t 6 p = 0.6
do test
3 Do not -RM35,000
RM0 p = 0.4
 Node 7:
◦ EV(Node 7) = 0.8(RM45,000) + 0.2(-RM40,000)
= RM28,000
 Node 8:
◦ EV(Node 8) = 0.3(RM45,000) + 0.7(-RM40,000)
= -RM14,500
 Node 6:
◦ EV(Node 6) = 0.6(RM50,000) + 0.4(-RM35,000)
= RM16,000
 Node 2:
◦ EV(Node 2) = 0.6EV(Node 4) + 0.4EV(Node 5)
 Need to find EV(Node 4) and EV(Node 5), but Node

4 and Node 5 are decision nodes.
 Step 2:
 Select the decision branch that leads to the best
expected value
Product successful
p = 0.8 RM45,000
Market
7 Product
p = 0.6 4 p = 0.2 -RM40,000
Do not
Market
-RM5,000
Do test
8
unsuccessful
5 p = 0.7
Do not -RM40,000
1 Market
-RM5,000
RM50,000
Market EV(7) =
Product successful
6 RM28,000
Don’t p = 0.6
do test
3 Do not -RM35,000 EV(8) =
Market Product unsuccessful -RM14,500
RM0 p = 0.4
EV(6) =
RM16,000
 Node 4:
◦ EV(Node 4) = max( RM28,000 , -RM5,000)
= RM28,000
 Node 5:
◦ EV(Node 5) = max( -RM14,500 , -RM5,000)
= -RM5,000
 Node 3:
◦ EV(Node 3) = max( RM16,000 , RM0)
= RM16,000
 Node 1:
◦ EV(Node 1) = max( EV(Node2) , EV(Node 3))
 Need to find EV(Node 2) but EV(Node 2) has not

been decided yet.
 Node 2:
◦ EV(Node 2) = 0.6EV(Node 4) + 0.4EV(Node 5)
= 0.6(RM28,000) + 0.4(-RM5,000)
= RM14,800
 So, EV(Node 1) = max( RM14,800 , RM16,000)

= RM16,000
RM28,000 Product successful
p = 0.8 RM45,000
RM28,000 Market
7 Product
p = 0.6 4 p = 0.2 -RM40,000
Do not
Market
RM14,800 -RM5,000
Do test
8
unsuccessful
5 p = 0.7
Do not -RM40,000
1 RM16,000 -RM5,000 Market
-RM5,000
-RM14,500
RM50,000
Market
Product successful
Don’t 6 p = 0.6
do test
3 Do not -RM35,000
NOTE:
RM16,000 p = 0.4
RM0 Don’t forget
RM16,000 the “//”
symbol
p = 0.8 RM45,000
RM28,000 Market
7 Product
p = 0.6 4 p = 0.2 -RM40,000
Do not
Market
RM14,800 -RM5,000
Do test
8
unsuccessful
5 p = 0.7
Do not -RM40,000
1 RM16,000 -RM5,000 Market
-RM5,000
-RM14,500
RM50,000
Market
Product successful
Don’t 6 p = 0.6
do test
3 Do not -RM35,000
NOTE:
RM16,000 p = 0.4
RM0 Don’t forget
RM16,000 the “//”
symbol
 Find the optimal decision strategy for NATE
Cosmetics Corp if NATE is risk-neutral.
 ANSWER ??
 Since the expected value at Node 1 is
RM16,000, which is the MAXIMUM profit
that NATE can achieve, that means NATE
Cosmetics Corp should just market the new
anti-aging cream without doing the test.
DECISION STRATEGY
FOR A
RISK-AVERSE
DECISION MAKER

Product successful
p = 0.8 RM45,000
Market
7 Product
p = 0.6 4 p = 0.2 -RM40,000
Do not
Market
-RM5,000
Do test
8
unsuccessful
5 p = 0.7
Do not -RM40,000
1 Market
-RM5,000
RM50,000
Market
Product successful
Don’t 6 p = 0.6
do test
3 Do not
-RM35,000
RM0 p = 0.4
Product successful
p = 0.8 RM45,000
Market
7 Product
p = 0.6 4 p = 0.2 -RM40,000
Do not
Market
-RM5,000
Do test
8
unsuccessful
5 p = 0.7
Do not -RM40,000
1 Market
-RM5,000
RM50,000
Market
Product successful
Don’t 6 p = 0.6
do test
3 Do not
-RM35,000
RM0 p = 0.4
 Recall from the decision tree that if NATE do not do
the test, and market the new anti-aging cream, and
it turns out that the cream is unsuccessful, NATE
will lose RM35,000 with a probability of this
happening to be 0.40.
 Check other options where cream is unsuccessful:

a) Do test  favorable result  cream unsuccessful
Probability = (0.6)(0.2) = 0.12
b) Do test  unfavorable result  cream unsuccessful
Probability = (0.4)(0.7) = 0.28
Although both (a) & (b) give more losses

(-RM40,000), their probabilities are
SMALLER
 Assume now NATE is being risk-averse.
 Use Expected Utility Criteria Approach (from lecture

2) to see if NATE should take a different decision
strategy. Let’s say that NATE’s utility function is
u(x) = +√x
EXPECTED VALUE OF
SAMPLE INFORMATION

 Most of the times, decision makers have
preliminary or prior probability assessments
for the states of nature that are the best
probability values available at that
particular time.
 To make the best POSSIBLE decision,

additional information about the states of
nature MAY help.
 Most often the way to seek for additional
information is through experiments /studies
designed to provide sample information about the
states of nature.
 Example:
◦ product testing, raw materials sampling, market research
studies
 A decision maker may want to revise or update the

prior probabilities of the states of nature, giving
him/her posterior probabilities of the states of
nature.
EVSI = EVwSI – EVwoSI
where
EVSI = expected value of sample information
EVwSI = expected value with sample
information about states of nature
EVwoSI = expected value without sample
 Steps to determine EVwSI:
1. From market survey/test, obtain the last expected
payoff through the optimal decision strategy, say
EVMSO (MSO: Market Survey Optimal)
2. Add the cost value of conducting the market
survey/test.
EVwSI =EVMSO + MS Cost
3. If the EVwSI is larger than the overall optimal

decision strategy, then accept the EVwSI value.
 EVwoSI is the expected value of payoffs with
REAL information, i.e. the last expected value
of payoffs through optimal decision strategy
when no market survey / test is conducted.
 EVSI value suggests the amount of money
that the market survey/test will add to the
decision maker’s expected payoff.
 OR
 The maximum amount that the decision

maker should be willing to pay to conduct
the market survey / test.
 Previous notes and examples are for
maximization problems.
 YOUR TASK:
 Calculate the EVSI for NATE Cosmetics Corp.
and comment on the EVSI value.
p = 0.8 RM45,000
RM28,000 Market
7 Product
p = 0.6 4 p = 0.2 -RM40,000
Do not
Market
RM14,800 -RM5,000
Do test
8
unsuccessful
5 p = 0.7
Do not -RM40,000
1 RM16,000 -RM5,000 Market
-RM5,000
-RM14,500
RM50,000
Market
Product successful
Don’t 6 p = 0.6
do test
3 Do not -RM35,000
RM16,000 p = 0.4 With product test
RM0
RM16,000 No product test
 From decision tree,
EVwSI =EVMSO + MS Cost
= RM14,800 + RM5,000 = RM19,800
 RM19,800 > RM16,000, therefore accept

EVwSI = RM19,800
 EVSI = EVwSI – EVwoSI

= RM19,800 – RM16,000 = RM3,800
 EVSI = RM3,800 means the maximum amount
that NATE Cosmetics Corp. needs to spend on
testing the new anti-aging cream is RM3,800.
 The cost of testing the new anti-aging cream is

RM5,000 which is larger than EVSI (RM3,800).
 Therefore, NATE Cosmetics Corp. should NOT

conduct the testing of the new anti-aging
cream.
EXPECTED VALUE OF
PERFECT INFORMATION

 Purpose to provide information and help decision
maker to improve the probabilities for the states of
nature.
 To check the potential value of the information,

suppose that the study could provide PERFECT
INFORMATION regarding the states of nature.
 In other words, the decision maker could determine

with certainty, prior to making a decision, which
state of nature is going to occur.
EVPI = EVwPI – EVwoPI
where
EVPI = expected value of perfect information
EVwPI = expected value with perfect
EVwoPI = expected value without perfect
 Steps to determine EVwPI:
1. Develop a decision strategy once
information on which state of nature will
occur is known.
2. Find the expected value of the decision
strategy
EVwPI =EV(decision strategy)

 EVwoPI is the expected value of payoffs with
REAL information, i.e. the last expected value
of payoffs through optimal decision strategy
without the benefit of perfect information on
states of nature.
 EVPI value suggests the additional expected
value that can be obtained if perfect
information is available about the states of
nature.
 OR
 The BEST (maximum/worth) cost of

conducting a market survey /test (that gives
the TRUE payoff)
 Generally speaking, a market survey / test
will not provide the “perfect” information.
 However, if the market survey / test is a

good one, the information gathered might be
worth as much as EVPI.
 Calculate the EVPI for NATE Cosmetics Corp.
and comment on the EVPI value.
 NATE Cosmetics Corp. knows whether the
new anti-aging cream will be successful
before NATE decides on whether to market
the new cream.
 From question: “Historical records showed

that similar anti-aging creams in the past
have been successful 60% of the time.”
Product successful
p = 0.8 RM45,000
Market
7 Product
p = 0.6 4 p = 0.2 -RM40,000
Do not
Market
-RM5,000
Do test
8
unsuccessful
5 p = 0.7
Do not -RM40,000
1 Market
-RM5,000
RM50,000
Market
Product successful
Don’t 6 p = 0.6
do test
3 Do not
-RM35,000
RM0 p = 0.4
 Develop the decision strategy. Consider the
perfect test.
Market
Product successful RM50,000
p = 0.6
Do not
Market
RM0
Market -RM35,000
Product unsuccessful
p = 0.4
RM0
Do not
Market
Market
Product successful RM50,000
p = 0.6
RM50,000 RM0
Do not
Market
RM30,000 EVwPI =
RM30,000
Market -RM35,000
Product unsuccessful
p = 0.4 RM0
RM0
Do not
Market
p = 0.8 RM45,000
RM28,000 Market
7 Product
p = 0.6 4 p = 0.2 -RM40,000
Do not
Market
RM14,800 -RM5,000
Do test
8
unsuccessful
5 p = 0.7
Do not -RM40,000
1 RM16,000 -RM5,000 Market
-RM5,000
-RM14,500
RM50,000
Market
Product successful
Don’t 6 p = 0.6
do test
3 Do not -RM35,000
Market Product unsuccessful No product
RM16,000 p = 0.4 test/No perfect
RM0
RM16,000 information
EVwoPI
 EVPI = EVwPI – EVwoPI
= RM30,000 – RM16,000 = RM14,000
 The BEST (maximum/worth) cost of

conducting a market survey /test (that gives
the TRUE payoff) for NATE Cosmetics Corp.
is RM14,000.
 It would be worth RM14,000 for NATE

Cosmetics Corp. to conduct the test before
selecting the best decision.
 Previous notes and example are for
maximization problems.
 YOUR TASK:
SAMPLE EFFICIENCY

 “Perfect information” is not really anticipated,
but the value of the market survey / test
information can be expressed in terms of
EFFICIENCY.
 Efficiency rating E for sample information is
EVSI
E= × 100
EVPI
 LOW E  decision maker might want to look
for other types of information
 HIGH E  sample information is as good as

perfect information and that additional
sources of information would not yield
significantly better results
 What is the efficiency measure for sample
information for NATE Cosmetics Corp.?
Comment on the efficiency rating.
EVSI
E= × 100
EVPI
RM3,800
E= × 100 = 27.14%
RM14,000
 Efficiency rating E is 27.14% which is quite low.

 Therefore, NATE Cosmetics Corp. might want to
seek for other types of information to help decide
on the best decision.

3 Decision Tree

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3 Decision Tree

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DECISION MAKING WITH

RISKS: DECISION TREE

STQM6034 Decision and Game Analysis

 Reveals more about the decision diagram

 Decision maker is able to express the big

 Example with 2 decision alternatives:

 Example with 2 states of nature:

 Example for 1 decision alternative & 2 states of

Payoff from state of nature 1

Payoff from state of nature 2

At the ends of branches

STQM6034 Decision and Game Analysis

 Example: To decide whether to go visit

Do not visit both

Only one of the

A decision is made conditional

STQM6034 Decision and Game Analysis

 Refer to given extra materials.

Product testing cost = RM5,000

STQM6034 Decision and Game Analysis

 Apply a backward pass through the decision

1. At chance event nodes, compute the

STQM6034 Decision and Game Analysis

 Need to find EV(Node 4) and EV(Node 5), but Node

 Need to find EV(Node 2) but EV(Node 2) has not

 So, EV(Node 1) = max( RM14,800 , RM16,000)

STQM6034 Decision and Game Analysis

 Check other options where cream is unsuccessful:

Although both (a) & (b) give more losses

 Use Expected Utility Criteria Approach (from lecture

STQM6034 Decision and Game Analysis

 To make the best POSSIBLE decision,

 A decision maker may want to revise or update the

EVwSI =EVMSO + MS Cost

3. If the EVwSI is larger than the overall optimal

 The maximum amount that the decision

 RM19,800 > RM16,000, therefore accept

 EVSI = EVwSI – EVwoSI

 The cost of testing the new anti-aging cream is

 Therefore, NATE Cosmetics Corp. should NOT

STQM6034 Decision and Game Analysis

 To check the potential value of the information,

 In other words, the decision maker could determine

EVwPI =EV(decision strategy)

 The BEST (maximum/worth) cost of

 However, if the market survey / test is a

 From question: “Historical records showed

 The BEST (maximum/worth) cost of

 It would be worth RM14,000 for NATE

STQM6034 Decision and Game Analysis

 Efficiency rating E for sample information is

 HIGH E  sample information is as good as

 Efficiency rating E is 27.14% which is quite low.

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