SS / 08-10 Date : 14/11/2008

Operations Research

Decision Theory
Decision situations that involve multiple stages- called sequential decision problems, they are
characterized by a sequence of decisions in which following each decision , a chance event
occurs which in turn influences the next decision.

In analyzing multiple stage decision situations we have to evaluate the decision proceeding
in a backward manner by evaluating the best course of action at the later stages to decide
the best action at the earlier stages. For this purpose the decision tree or the decision flow
diagram as it is sometimes called , is a very effective device.

A decision tree is a graphic representation of the sequence 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 distinct 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. It may be mentioned that the criterion on the basis of
which the decisions are made in the decision tree approach is generally the expectation principle.
So we may choose the alternative that maximizes the expected profit , or the alternative that
minimizes the expected cost .. and so on.

Example :

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 tests showing a success.

Whether the tests show the possibility of ultimate success or not or even if no tests are
undertaken at all, the company could still pursue its drilling programme or alternatively consider
selling its rights to drill in the area. Thereafter , however if it carries out the drilling programme,
the likelihood of final success or failure is considered dependent 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 , the expectation of success in drilling is given as 20:80
 if no tests have been carried out at all the possible outcomes and the net present value of
each is as follows:
 Outcome Net Present Value ( Rs Million)
Success :
With prior tests 100
Without prior tests 120
Failure :
With prior tests -50
Without prior tests -40
Sale of exploitation rights:
Prior tests show ‘success’ 65
Prior tests show ‘failure’ 15
Without prior tests 45

a) draw up a decision ( probability ) tree diagram to represent the above information ; and
b) evaluate the tree in order to advise the management of the company on its best course of
action.

The decision tree is given as under

22
Decision node

-40
Chance node

-50
Failure 0.45 6
5
sell
12 Failure 0.2
0

Succe
drill 10
ss
2 Success 0.8 0
0.55

+ve 0.7

1
-ve 0.3
sell
Success 0.2
10
1 drill 0

4
5
Failure 0.8

sell
-50
1
5

A square represents a decision node or decision fork at which the decision maker has to take a
decision, while a circle represents a chance node or chance fork at which events (i.e the states of
nature) are branched out.

At decision node 3 , there are branches , representing three alternatives of drilling, testing for oil
and selling of rights of which the decision maker has to select one. Now if company decides to
drill, there are two possible events – it may get oil or not, which are shown as branches
emanating from circle, whose probabilities are 0.55 and 0.45 respectively . A profit of Rs 120
million would result in case oil is obtained and a loss of Rs 40 million if it is not .

The second alternative at the decision node 3 is to go for a test, which may give positive or
negative results, with probabilities 0.7 and 0.3 respectively . In case a positive result is indicated
a choice has to be made as to whether to sell the rights for Rs 65 million or to drill , which is
likely to succeed and fail with chances 80 :20 . Therefore a decision node number 2 is shown by
a square .
Similarly for a negative indication there are two options- to sell for Rs 65 million or to drill,
which has a 20 % chance of success . Thus decision node 1 is indicated here.

The third alternative is to sell the rights for Rs 45 million.

The method of solution : as mentioned earlier , the decisions have to be evaluated in a backward
manner by evaluating the best course of action at the later stages so as to decide on the best
course of action on the earlier stages. Thus a solution to the problem is obtained by working
backwards from right to left through the tree.

This is called as rollback technique . In this technique we assume that we have reached various
decision nodes on the tree and then decide on the optimal act conditional on having reached the
node being analysed.

Thus on reaching any decision node, we evaluate each of the alternative courses of action
available there and select the most appropriate one. We begin with the right most decision node
and after having analysed it , we move backward and analyze the preceeding decision node in a
similar manner. The process is continued till the first , the leftmost decision node is analysed.
The decision at the first node represents the best initial decision.

We begin with the evaluation of decision node 1 in the first instance. Note that this point is
reached after a ‘ negative’ is indicated by the test. The expected values of each of the two
alternatives , to drill and to sell , are obtained below .

Alternative Outcome Pro Conditional Expected Value

b Value
1 drill Success 0.2 100 20
Failure 0.8 (40)
Total (20)
2 sell 1.0 15 15
The expected value of the drilling option is a loss of Rs 20 million while if the site is sold, we
can get Rs 15 million. On the basis of the criterion of maximization of the expected profit , our
decision would be to sell the site, which is conditional upon the negation indicated by the test.
Now evaluating the decision node 2. for this node the alternatives together with their expected
values are shown below.

Alternative Outcome Pro Conditional Expected Value

b Value
1 Sell 1.0 65 65
2 drill success 0.8 100 80
failure 0.2 (50) (10)
Total 70
The two alternative courses of action , namely selling and drilling have expected values equal to
Rs 65 million and Rs 70 million , respectively . Obviously therefore provided that a positive
result is indicated by the test, the best course would be to go in for oil drilling.

Now at this stage we have two conditional decisions – sell the site if a negative is obtained on the
test and drill in case the test indicates a positive . At each node , the branches on which we have
not to move, representing the options ruled out , have been shown cancelled. Next we move to
the decision node where a decision has to be taken whether to drill at the outset, to undertake a
test or to sell the rights outright.

The alternatives along with their expected values are shown . Also the expected values
associated with the different chance nodes and the decision nodes are indicated in which the
decision tree is given is reproduced.

Alternative Outcome Pro Conditional Expected Value

b Value
1 drill success 0.55 120 66
drill failure 0.45 (40) (18)
Total 48
Total 70
2 test positive 0.7 70 49.0
negative 0.3 15 4.5
Total 53.5
3 sell 1.0 45 45

The expected value of the alternative of carrying out a test is Rs 53.5 million , which is the
highest of the three. Therefore it is better to test before drilling . This is the initial decision . The
overall decision can now be stated as : The test be carried out . If it proves negative , the rights
should be sold to give a return of Rs 15 million . To proceed with drilling , if that happens ,
would expectedly lead to a loss. However if the test proves positive , the drilling should be
undertaken.