16-Jan-18
Objective
Module-I: Decision Theory
Lecture: 4 – Multi Stage Decision Making
Problems: Decision Tree
Multi-Stage Decision-Making Problems
Decision Tree
► The decision tree is a graphic representation of the sequences of action-
event combinations available to the decision maker.
► It depicts in a systematic manner all possible sequences of decisions and
consequences.
► Each such sequence is shown by a path through the tree.
► A decision tree enables the decision maker to see the various elements of
his problem in proper perspective and in a systematic manner.
Multi-Stage Decision-Making Problems
Decision Tree
► These are characterized by the presence of chance nodes. A single-stage
stochastic decision tree is one that contains at least one chance node and
involves the making of only one decision.
► A multistage stochastic decision tree is one that contains at least one
chance node and involves the making of a sequence of decisions.
The objective of this lecture is as follows
► The purpose of this Lecture is to facilitate you to understand the concept
of decision making in different decision environment.
The topics will be covered in this lecture are mentioned below.
► Multi stage Decision Making
► Decision Tree
Multi-Stage Decision-Making Problems
Decision Tree
► A deterministic decision tree represents a problem in which each possible
alternative and its outcome are known with certainty. That is, a
deterministic tree does not contain any chance node.
► A single stage deterministic decision tree is one that contains no chance
nodes and involves the making of only one decision.
Decision Tree
Problem-01
► An oil company has recently acquired rights in a certain area to conduct
surveys and test drillings to lead to lifting oil if it is found in commercially
exploitable quantities.
► The area is considered to have good potential for finding oil in commercial
quantities. At the outset, the company has the choice to conduct further
geological tests or to carry out a drilling programme immediately. On the
known conditions, the company estimates that there is a 70:30 chance of
further test showing ‘success’.
► Whether the tests show the possibility of ultimate success or not even if
no test are undertaken at all, the company can still pursue its drilling
programme, the likelihood of final success or failure is considered
depending on the foregoing stages. Thus:
► If successful tests have been carried out, the expectation of success in
drilling is given as 80:20
► If the tests indicate failure, then the expectation of success in drilling is
given as 20:80
► If no test carried out the expectation of success is given by 55:45
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Decision Tree Solution

Problem-01 (Cont.) -40

65
-50

Failure
► Costs and revenues have been estimated for all possible outcomes and Failure Sell
0.2
0.45
the net present value of each is as follows.
Success Drill Success
Outcome Net Present Value (Rs. Million) 120
2 0.8
100
Success 0.55
Drill
With Prior Tests 100 Positive
Without Prior Tests 120 0.7
Failure Test
With Prior Tests -50 3
Without Prior Tests -40
Sell 0.3
Sale of Exploitation rights:
Negative
Prior tests show success 65 Drill
Prior tests show Failure 15 45 1 100
Without Prior Tests 45 Success

► A. Draw a decision (probability) tree diagram to represent the above Decision Node Sell
Failure

information abd -50

15
► B. Evaluate the tree in order to advice the management of the company
Chance Node
on its best course of action. Decision Tree

Solution Solution

Evaluation of Decision Node -01 Evaluation of Decision Node -02

Evaluation of Decision Node 1

Sl No Alternatives Outcome Probability Conditional Value Evaluation of Decision Node2
1 Drill Success 0.20 100 20 Sl No Alternatives Outcome Probability Conditional Value
Failure 0.80 -50 (40) 1 Sell Success 1.00 65 65
TOTAL (20) 2 Drill Success 0.80 100 80
2 Sell Success 1.00 15.00 15 Failure 0.20 -50 -10
TOTAL 70

On the criterion of maximization of the expected profit, our decision would be Obviously that a positive result is indicated by the test, the best course would
sell the site be go in for oil drilling

Solution Decision Tree

Evaluation of Decision Node -03 -40

65 -50
Failure Failure
Sell
Evaluation of Decision Node3 0.45
0.2

Sl No Alternatives Outcome Probability Conditional Value Success Drill Success

1 Drill Success 0.55 120 66 48
0.55
120
70 70
0.8
100

Failure 0.45 -40 -18 Drill

Positive

TOTAL 48 0.7

2 Test Positive 0.70 70 49 Test

53
53.5 .5
Negative 0.30 15 4.5
Sell 0.3
TOTAL 53.5
Negative
3 Sell Success 1.00 45 45 Drill
45 15 -20
Success
100

As we may observe, that the expected value of alternative of carrying our a

Failure
test is Rs. 53.5 Million, which is the highest of the three. Therefore it is better Decision Node Sell
-50
to test before drilling 15

Chance Node
Decision Tree

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THANK YOU…
Questions…