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Lecture 5 - Decision Trees
Lecture 5 - Decision Trees
Decision Trees
Decision Trees
• EXAMPLE
• 3
• Note that Colaco’s optimal strategy yields a .45 chance that the company will end
up with a relatively small final asset position of $50,000.
• On the other hand, the strategy of test marketing and acting optimally on the
results of the test market study yields only a (.60)(.15) = .09 chance that Colaco’s
asset position will be below $100,000. (Why?)
• Thus, if Colaco is a risk-averse decision maker, the strategy of immediately
marketing nationally may not reflect the company’s preference.
Incorporating Risk
Profile into Decision
Tree Analysis
• Is Colaco risk averse or risk seeker if
it has the given utility function?
• To determine Colaco’s optimal
decisions (that is, the decisions that
maximize expected utility), simply
replace each final asset position x0
with its utility u(x0).
Expected Value of Sample Information
• Decision trees can be used to measure the value of sample or test market
information.
• To illustrate how this is done, we again assume that Colaco is risk-neutral.
• What is the value of the information that would be obtained by test marketing
Chocola?
Expected Value of Sample Information
• We next determine the largest expected final asset position that Colaco would
obtain if the test market study were not available.
• We call this the expected value with original information (EVWOI).
• From the ”Don’t test market” branch, we find EVWOI $270,000.
• Now the expected value of the test market information, referred to as expected
value of sample information (EVSI), is defined to be EVSI = EVWSI - EVWOI.
Expected Value of Perfect Information
• We can modify the analysis used to determine EVSI to find the value of perfect
information.
• By perfect information, we mean that all uncertain events that can affect Colaco’s final
asset position still occur with the given probabilities (so there is still a .55 chance of
Chocola being a national success and a .45 chance that Chocola will be a national failure),
but Colaco finds out whether Chocola is a national success, or a national failure before
making the decision to market Chocola nationally or not.
• This information can then be used to determine Colaco’s optimal marketing strategy.
Thus, expected value with perfect information (EVWPI) is found by drawing a decision
tree in which the decision maker has perfect information about which state has occurred
before making a decision.
• Then the expected value of perfect information (EVPI) is given by EVPI = EVWPI -
EVWOI.
Example: Art Dealer