Decision Trees

Presents decision alternatives and outcomes in a sequential manner

Decision node: Arcs (lines) originating from a decision node denote all decision alternatives available to
the decision maker at that node
Outcome node: Arcs (lines) originating from an outcome node denote all outcomes that could occur at
that node

Thompson Lumber

A decision tree usually

begins with a decision node
 Folding back a Decision Tree

• The process by which a decision tree is analyzed to identify the optimal decision is referred to as
folding back the decision tree
• Start with the payoffs (i.e., the right extreme of the tree) and work your way back to the first
decision node

• At each outcome node: Compute the expected payoff using the probabilities of all possible
outcomes at that node and the payoffs associated with those outcomes
• At each decision node: Select the alternative that yields the better expected payoff
• If the expected payoffs represent profits, select the alternative with the largest value
• If the expected payoffs represent costs, select the alternative with the smallest value
Folding back a Decision Tree

The EMV is calculated at each outcome node.

The best alternative is selected at a decision node
 Multi-stage Decision Making Problems
Multistage decision problems are analyzed using decision trees

• Before deciding about building a new plant, John Thompson has been approached by Smart
Services, another market research firm.
• Smart will charge John $4,000 to conduct a market survey. The results of the survey will
indicate either positive or negative market conditions for storage sheds.
• What should John do?
Expanded Decision
Tree for Thompson
Lumber
Expanded Decision
Tree for Thompson
Lumber
(with EMVs)

So, what is the optimal strategy

for Thompson?
 Sample Information
• John recognizes that Smart’s market survey will not provide him with perfect information, but
it may help him get a better feel for the outcomes nevertheless.
• The type of information obtained here is referred to either as sample information or imperfect
information.
• Recall that if the results of the market survey are going to be 100% accurate, John should be
willing to pay up to $24,000 for the survey.
• Because Smart’s survey will cost significantly less (only $4,000), it is at least worth
considering further.
• However, given that it yields only imperfect information, how much is it actually worth?
 Sample Information
Expected Value of Sample Information (EVSI)
EVSI = (EMV of best decision with sample
information, assuming no cost to get it) EVSI measures the value of
– (EMV of best decision without any sample information
information)
EVSI = $91,961 – $86,000 = $5,961

Efficiency of Sample Information Comparing EVSI to EVPI

provides a good measure of
Efficiency of sample information = EVSI / EVPI the relative value of the
current survey.
= $5,961 / $24,000 = 0.2484 or 24.84%
Estimating Probabilities using Bayesian Analysis
• Allows probability values to be revised based on new information (from a
survey or test market)

• Prior probabilities are the probability values before new information

• Revised probabilities are obtained by combining the prior probabilities with

the new information
Estimating Probabilities using Bayesian Analysis
P(HD) = 0.30
P(MD) = 0.50
P(LD) = 0.20

• How do we find the revised probabilities where the survey

result is given?
• For example: P(HD|PS) = ?
 Bayes’ Theorem
𝑃 𝐴𝑖 𝑃(𝐵|𝐴𝑖 )
𝑃 𝐴𝑖 𝐵 =
𝑃 𝐴1 𝑃 𝐵 𝐴1 + 𝑃 𝐴2 𝑃 𝐵 𝐴2 + ⋯ + 𝑃 𝐴𝑛 𝑃(𝐵|𝐴𝑛 )

Where:
𝐴𝑖 = 𝑖 𝑡ℎ event of 𝑘 mutually exclusive and collectively exhaustive events
𝐵 = new event that might impact 𝑃(𝐴𝑖 )

Bayes’ theorem is applicable when the events for which we want to compute posterior probabilities
are mutually exclusive and collectively exhaustive.
The marketing research firm provided the following probabilities based on its track
record of survey accuracy:
• Smart has data on 75 past surveys that it has conducted
• 29 of 30 past cases where a product’s demand subsequently turned out to be high, Smart’s
surveys had predicted positive market conditions
• 7 of 15 past cases where a product’s demand subsequently turned out to be moderate, Smart’s
surveys had predicted negative market conditions
• 2 of 30 past cases where a product’s demand subsequently turned out to be low, Smart’s surveys
had predicted positive market conditions

• The probability of positive survey results, given high demand P(PS|HD) = 0.967
• And, P(NS|HD) = 0.033
• The probability of negative survey results, given moderate demand, P(NS|MD) = 0.467
• And, P(PS|MD) = 0.533
• Similarly, P(PS|LD) = 0.067 P(NS|LD) = 0.933

• But, here the demand is “given,” but we need to reverse the events such that the survey result is
“given”
• Finding probability of the demand outcome given the survey result:
P(HD|PS) = P(HD and PS)/ P(PS)
= P(PS|HD) x P(HD)/P(PS)

• Known probability values are in blue, so need to find P(PS)

P(PS|HD) x P(HD) 0.967 x 0.30

+ P(PS|MD) x P(MD) + 0.533 x 0.50
+ P(PS|LD) x P(LD) + 0.067 x 0.20
P(PS) = = 0.57
• Now we can calculate P(HD|PS):

P(HD|PS) = P(PS|HD) x P(HD) / P(PS)

= 0.967 x 0.30 / 0.57
= 0.509

• The other five conditional probabilities are found in the same

manner
• Notice that the probability of HD increased from 0.30 to 0.509
given the positive survey result
 Problem
Prob 1) The percentage of adult users of the Internet who use Facebook has increased over time.

Of adult Internet users age 18–49, 81% use Facebook.

Of adult Internet users age 50 and older, 54% use Facebook.

Assume that 52% of adult Internet users are age 18–49.

Given that an adult Internet user uses Facebook, what is the probability that he/she is age 18–49?

0.6190
 Problem
Prob 2) Suppose that you want to invest $10,000 in the stock market by buying shares in one of two
companies: A and B. Shares in Company A are risky but could yield a 50% return on investment
during the next year in a rising market (i.e. “bull” market). If the stock market conditions are not
favorable (i.e., “bear” market), the stock may lose 20% of its value. Company B provides safe
investments with 15% return in a “bull” market and only 5% in a “bear” market. All the publications
you have consulted are predicting a 60% chance for a “bull” market and 40% for a “bear” market.
Where should you invest your money according to the EMV Criterion?
Further, instead of solely relying on the publications, suppose you have the option to consult your
friend who has a great experience of stock market. The friend offers the general opinion of “for” or
“against” investment. This opinion is further quantified in the following manner: If it is a “bull”
market, there is a 90% chance that vote will be “for”. If it is a “bear” market, the chance of a “for”
vote is 50%. Construct the complete decision tree and tell how do you make use of this
additional information?
 Problem
Prob 3) A market research company has approached you about the possibility of using its services to
help you decide whether to launch a new product. According to its customer portfolio, it has correctly
predicted a favorable market for its clients’ products 14 out of the last 16 times. It has also correctly
predicted an unfavorable market for its clients’ products 9 out of 11 times. Without this research
company’s help, you have estimated the probability of a favorable market at 0.55. Calculate the
posterior probabilities, using the track record of the research firm.

P(FM) = 0.563; P(F/FM) = 0.855