HO CHI MINH CITY OPEN UNIVERSITY

ADVANCED STUDY PROGRAM

Th.S: Nguyễn Thị Thanh Thủy

 LEARNING OBJECTIVES
After completing this chapter, students will be able to:
 Create a simple decision trees
 Explain when to use each of the three types of
decision-making environments
 Calculate an expected monetary value (EMV)
 Evaluate the node in a decision tree
 Create a decision tree with sequential decisions
 CHAPTER OUTLINE

I Introduction

II Decision process

III Decision trees

I. INTRODUCTION
 Widely used quantitative technique to make decision
 Any problem that can be presented in a decision table
can also be graphically represented in a decision tree
I. INTRODUCTION
 All decision trees contain decision points or nodes and
state-of-nature points or nodes
◦ A decision node from which one of several
alternatives may be chosen
◦ A state-of-nature node out of which one state of
nature will occur
 Decision trees are most beneficial when a sequence of
decisions must be made
State of nature State of nature
nodes branch
Decision
nodes

Alternatives
branch
I. INTRODUCTION
Structure of decision trees
 Trees start from left to right
 Represent decisions and outcomes in sequential order
 Squares represent decision nodes
 Circles represent states of nature nodes
 Lines or branches connect the decisions nodes and the
states of nature
I. INTRODUCTION
Decision trees
 Information in decision tables can be displayed as
decision trees
 A decision tree is a graphic display of the decision
process that indicates decision alternatives, states of
nature and their respective probabilities and payoffs for
each combination of decision alternative and state of
nature
 Appropriate for showing sequential decisions
II. DECISION PROCESS
Five steps to decision tree analysis

1 Define the problem

2 Structure or draw the decision tree

3 Assign probabilities to the states of nature

4 Estimate payoffs for each possible combination

of alternatives and states of nature

5 Solve the problem by computing expected

monetary values (EMVs) for each state of nature
node
II. DECISION PROCESS
Example: Thompson Lumber Company
Step 1: Thompson company consider all alternatives to
expand by manufacturing

STATE OF NATURE

FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 200,000 –180,000

Construct a small plant 100,000 –20,000

Do nothing 0 0

The probabilities for favorable market is 0.5 and

unfavorable market is .5
II. DECISION PROCESS
Step 2:Draw decision tree

Decision tree use two types of nodes:

A square or rectangle node called decision node form
which decision alternative branches will originate

A circle node called change node from which states of

nature or outcome branches will emanate
II. DECISION PROCESS
Step 2:Draw decision tree
II. DECISION PROCESS
Step 2: Draw
Thompson’s decision tree

A State-of-Nature Node
Favorable Market
A Decision Node
1
Unfavorable Market

Favorable Market
Construct
Small Plant 2
Unfavorable Market
II. DECISION PROCESS
Step 3: Assign probabilities to the state of nature
Step 4: Estimate payoffs for each possible
combination of alternatives and states of nature
Payoffs
Favorable Market (0.5)
$200,000

1
Unfavorable Market (0.5)
–$180,000

Favorable Market (0.5)

$100,000
Construct Small
Plant 2
Unfavorable Market (0.5)
–$20,000

$0
II. DECISION PROCESS

Step 5: Computing expected monetary values (EMVs) for

each state of nature node
Note: Drawing from left to right
Computing from the right to the left
II. DECISION PROCESS
Step 5: Computing expected monetary values (EMVs)
for each state of nature node

EMV for Node 1 = = (0.5)($200,000) + (0.5)(–$180,000)

$10,000
Payoffs
Favorable Market (0.5)
$200,000
Alternative with best EMV is
selected
40,000 1
Unfavorable Market (0.5)
–$180,000

Favorable Market (0.5)

$100,000
Construct Small
Plant 2
Unfavorable Market (0.5)
–$20,000

EMV for Node 2 =

= (0.5)($100,000)
$40,000 + (0.5)(–$20,000)

$0
II. DECISION PROCESS
Thompson’s complex decision tree
Larger Decision Tree with Payoffs and Probabilities for
Thompson Lumber:
First Decision Point Second Decision Point
Payoffs
Favorable Market (0.78)
$190,000
2 Unfavorable Market (0.22)
–$190,000
Favorable Market (0.78)
Small $90,000
Plant 3 Unfavorable Market (0.22)
–$30,000
No Plant –$10,000
1 Favorable Market (0.27)
$190,000
4 Unfavorable Market (0.73)
–$190,000
Favorable Market (0.27)
Small $90,000
Plant 5 Unfavorable Market (0.73)
–$30,000
No Plant
–$10,000

Favorable Market (0.50) $200,000

6 Unfavorable Market (0.50)
–$180,000
Favorable Market (0.50)
Small $100,000
Plant 7 Unfavorable Market (0.50)
–$20,000
No Plant
$0
III. DECISION TREES
Complex decision tree
Company has many situations to make the decision
Thompson considers expanding the manufacture, and it
has 3 alternatives
Before making decision to build the factory. Thompson
wants to know whether it conduct the survey

Thompson will base on the results of the survey so

Thompson can decide to build the factory
Company has two decisions:
III. DECISION TREES
Posterior Probability
Probability rules
Conditional probability – probability that an event
occurs given another event has already happened
III. DECISION TREES
Posterior Probability
 Probability rules
Conditional probability – probability that an event occurs
given another event has already happened

Probability of A given B : P (A/B) can computed by

The conditional probability is based on that B actually

occurs, therefore P (B)>0
VI. DECISION TREES
Let’s see how Mr. Thompson was able to derive these values
with Bayes’ theorem:

• From discussions with market research specialists, Mr.Thompson

knows that special surveys either be positive (predict a market)
or be negative (predict an unfavorable market).

• The experts have told Mr. Thompson that, statistically, of all new
products with a favorable market (FM), market surveys were
positive and predicted success correctly 70% of the time. Thirty
percent of the time the surveys falsely predicted negative
results or an unfavorable market (UM).

• When there was actually an unfavorable market for a new

product, 80% of the surveys correctly predicted negative
results. The surveys incorrectly predicted positive results the
remaining 20% of the time
III. DECISION TREES
Example: Conditional probability
Thompson’s complex decision tree:
 Probability of favorable market in the condition of
positive survey:0.7
𝑃 =𝐹𝑀
𝑃𝑆 =0.7
 Probability of favorable market in the condition of
negative survey:0.3
𝑃 =𝐹𝑀
𝑁𝑆 =0.3
 Probability of unfavorable market in the condition of
positive survey:0.2
𝑃 =𝑈𝐹𝑀
𝑃𝑆 =0.2
 Probability of unfavorable market in the condition of
negative survey:0.8
𝑃 =𝑈𝐹𝑀
𝑁𝑆 =0.8
VI. DECISION TREES
Calculating revised probabilities

In the Thompson Lumber case we used these four conditional

probabilities

P (favorable survey/favorable market)= 0.7

P (negative survey/favorable market)= 0.3
P (favorable survey/unfavorable market)= 0.2
P (negative survey/unfavorable market)= 0.8

The prior probabilities of these markets are

P (FM) = 0.50
P (UM) = 0.50
VI. DECISION TREES
• The experts have told Mr. Thompson that, statistically, of all new
products with a favorable market (FM), market surveys were
positive and predicted success correctly 70% of the time. Thirty
percent of the time the surveys falsely predicted negative
results or an unfavorable market (UM).

• When there was actually an unfavorable market for a new

product, 80% of the surveys correctly predicted negative
results. The surveys incorrectly predicted positive results the
remaining 20% of the time

ConditionalProbability
P (favorable survey/favorable market)= 0.7
P (negative survey/favorable market)= 0.3
P (favorable survey/unfavorable market)= 0.2
P (negative survey/unfavorable market)= 0.8
VI. DECISION TREES
Calculating revised probabilities

In the Thompson Lumber case we used these four conditional

probabilities

P (favorable survey/favorable market)= 0.7

P (negative survey/favorable market)= 0.3
P (favorable survey/unfavorable market)= 0.2
P (negative survey/unfavorable market)= 0.8

The prior probabilities of these markets are

P (FM) = 0.50
P (UM) = 0.50
III. DECISION TREES
Example
Conditional probability
P (favorable survey/favorable market)=0.7
P (negative survey/favorable market)=0.3
P (favorable survey/unfavorable market)=0.2
P (negative survey/unfavorable market)=0.8

Posterior Probabilities
Thompson’s complex decision tree:
P (favorable market/ positive survey result)=?
P (unfavorable market/positive survey result)=?
P (favorable market/negative survey result)=?
P (unfavorable market/negative survey result)=?

The joint probabilities of these markets are

P (favorable survey)=?
P (negative survey)=?
III. DECISION TREES
Bayes’ theorem is used to calculate posterior
probabilities
STATE OF NATURE
RESULT OF FAVORABLE MARKET UNFAVORABLE MARKET
SURVEY (FM) (UM)
Positive
(predicts P (survey positive | FM) P (survey positive | UM)
favorable market = 0.70 = 0.20
for product)
Negative
(predicts P (survey negative | FM) P (survey negative | UM)
unfavorable
market for = 0.30 = 0.80
product)
VI. DECISION TREES
Bayesian analysis
 Many ways of getting probability data
 It can be based on
Management’s experience and intuition
Historical data
Computed from other data using Bayes’ theorem
 Bayes’ theorem incorporates initial estimates and
information about the accuracy of the sources
 Allows the revision of initial estimates based on new
information
III. DECISION TREES
Calculating Posterior Probabilities
Recall Bayes’ theorem
P ( B | A)  P ( A)
P( A | B) =
P ( B | A)  P ( A) + P ( B | A )  P ( A )

Where
A, B = any two events
A’ = complement of A

For this example, A will represent a favorable market and B will

represent a positive survey
III. DECISION TREES
Calculating revised probabilities

P (FM | survey positive)

P ( survey positive | FM )  P ( FM )
=
P(survey positive |FM) P(FM) + P(survey positive |UM) P(UM)

(0.70)(0.50) 0.35
= = = 0.78
(0.70)(0.50) + (0.20)(0.50) 0.45

probability of
P (UM | survey positive) a positive survey

P ( survey positive | UM )  P (UM )

=
P(survey positive |UM) P(UM) + P(survey positive |FM) P(FM)

(0.20)(0.50) 0.10
= = = 0.22
(0.20)(0.50) + (0.70)(0.50) 0.45
III. DECISION TREES
Calculating Posterior Probabilities

POSTERIOR PROBABILITY
CONDITIONAL
PROBABILITY P(STATE OF
P(SURVEY NATURE |
STATE OF POSITIVE | STATE PRIOR JOINT SURVEY
NATURE OF NATURE) PROBABILITY PROBABILITY POSITIVE)
FM 0.70 X 0.50 = 0.35 0.35/0.45 = 0.78
UM 0.20 X 0.50 = 0.10 0.10/0.45 = 0.22
P(survey results positive) = 0.45 1.00
 III. DECISION TREES
Calculating Posterior Probabilities (Positive Survey)
State of Conditional Prior Joint Posterior
nature probability Probability Probability Probability
P(AB) after P (A/B)

Favorable
market

Unfavorable
market
 III. DECISION TREES
Calculating Posterior Probabilities (Positive Survey)
State of Conditional Prior Joint Posterior
nature probability Probability Probability Probability
P(AB) after P (A/B)

Favorable P (Fav sur/ fa P (Fa market) P (fa P (Fmarket/ fa

market market) 0.5 market.fasur) sur
0.7 0.7*0.5=0.35 0.35/0.45=0.78
P (AB)
Unfavorable P (Fav sur/ P (Unf market) P (unfa P (Unmarket/ fa
market Unfa market) 0.5 market.fasur) sur
0.2 0.2*05=0.10 0.1/0.45=0.22

P(favo survey)
035+0.10=
0.45 P(B)
III. DECISION TREES
Calculating Posterior Probabilities
P (FM | survey negative)

P ( survey negative | FM )  P ( FM )
=
P(survey negative |FM) P(FM) + P(survey negative |UM) P(UM)

(0.30)(0.50) 0.15
= = = 0.27
(0.30)(0.50) + (0.80)(0.50) 0.55
probability of
P (UM | survey negative) a negative survey

P ( survey negative | UM )  P (UM )

=
P(survey negative |UM) P(UM) + P(survey negative |FM) P(FM)

(0.80)(0.50) 0.40
= = = 0.73
(0.80)(0.50) + (0.30)(0.50) 0.55
III. DECISION TREES
Calculating Posterior Probabilities (Negative Survey)
State of Conditional Prior Joint Posterior
nature probability Probability Probability Probability
P(AB) after P (A/B)
Favorable P (Ne sur/ fa P (Fa market) P (fa market. P (Fmarket/ fa
market market) 0.5 Nesur) sur
0.3 0.3*0.5=0.15 0.15/0.55=0.27
Unfavorable P (negative sur/ P (Unf market) P (unfa P (Unmarket/ fa
market fa market) 0.5 market.fasur) sur
0.8 0.8*05=0.40 0.4/0.55=0.73

P(unfavo
survey)
015+0.40=
0.55 P(B)
III. DECISION TREES
Calculate P negative survey
State of Conditional Prior Joint Posterior
nature probability Probability Probability Probability
P(AB) after P (A/B)
Favorable
market

Unfavorabl
e
market
III. DECISION TREES

Calculating Posterior Probabilities

POSTERIOR PROBABILITY
CONDITIONAL
PROBABILITY
P(SURVEY
NEGATIVE | PRIOR JOINT P(STATE OF
STATE OF STATE OF PROBABILIT PROBABILIT NATURE | SURVEY
NATURE NATURE) Y Y NEGATIVE)
FM 0.30 X 0.50 = 0.15 0.15/0.55 = 0.27
UM 0.80 X 0.50 = 0.40 0.40/0.55 = 0.73
P(survey results positive) = 0.55 1.00
III. DECISION TREES
Example: Conditional probability
Thompson’s complex decision tree:
P (favorable survey/favorable market)=0.7
P (negative survey/favorable market)=0.3
P (favorable survey/unfavorable market)=0.2
P (negative survey/unfavorable market)=0.8

The prior probabilities of these markets are

P (favorable survey)=0.45
P (negative survey)=0.55

Posterior Results
P (favorable market/ positive survey result)=0.78
P (unfavorable market/positive survey result)=0.22
P (favorable market/negative survey result)=0.27
P (unfavorable market/negative survey result)=0.73
II. DECISION PROCESS
Thompson’s complex decision tree
Larger Decision Tree with Payoffs and Probabilities for Thompson
Lumber:
First Decision Point Second Decision Point
Payoffs
Favorable Market (0.78)
$190,000
2 Unfavorable Market (0.22)
–$190,000
Favorable Market (0.78)
Small $90,000
Plant 3 Unfavorable Market (0.22)
–$30,000
No Plant –$10,000
1 Favorable Market (0.27)
$190,000
4 Unfavorable Market (0.73)
–$190,000
Favorable Market (0.27)
Small $90,000
Plant 5 Unfavorable Market (0.73)
–$30,000
No Plant
–$10,000

Favorable Market (0.50) $200,000

6 Unfavorable Market (0.50)
–$180,000
Favorable Market (0.50)
Small $100,000
Plant 7 Unfavorable Market (0.50)
–$20,000
No Plant
$0
III. DECISION TREES
Thompson’s complex decision tree
1. Compute the expected value of the market survey,

EMV(node 2) = EMV(large plant/positive survey)

= (0.78)($190,00) + (0.22)(-$190,000)
= $106,400
EMV(node 3) = EMV((large plant/positive survey)
= (0.78)($90,000) + (0.22)(–$30,000)
= $63,600
EMV for no plant = - $10,000
If the survey results are favorable, a large plant should be
built
III. DECISION TREES
Thompson’s complex decision tree
Compute the expected value of the market survey-
The favorable market survey
EMV(node 2) = EMV(large plant/positive survey
= (0.78)($190,00) + (0.22)($190,000)
= $106,400
EMV(node 3) = EMV((large plant/positive survey)
= (0.78)($90,000) + (0.22)(–$30,000)
= $63,600
EMV for no plant = - $0
If the survey results are favorable, a large plant should be
built
III. DECISION TREES
Thompson’s complex decision tree
Compute the expected value of the market survey-
negative survey results
EMV(node 4) = EMV(large plant/positive survey
= (0.27)($190,00) + (0.73)(-$190,000)
= - $87,400
EMV(node 5) = EMV((large plant/positive survey)
= (0.27)($90,000) + (0.73)(–$30,000)
= $2,400
EMV for no plant = - $10,000
If the survey results are unfavorable, a small plant should be
built
III. DECISION TREES
Thompson’s complex decision tree
3.Compute the expected value of the market survey,
EMV(node 1)= EMV(conduct survey)
= (0.45)($106,400) + (0.55)($2,400)
= $47,880 + $1,320 = $49,200
4.If the market survey is not conducted,
EMV(node 6)= EMV(large plant)
= (0.50)($200,000) + (0.50)(–$180,000)
= $10,000
EMV(node 7)= EMV(small plant)
= (0.50)($100,000) + (0.50)(–$20,000)
= $40,000
EMV for no plant = $0
5. Best choice is to seek marketing information
III. DECISION TREES
Thompson’s complex decision tree
First Decision Point Second Decision Point Payoffs

$106,400 Favorable Market (0.78)

$190,000
Unfavorable Market (0.22)
–$190,000

$106,400
$63,600 Favorable Market (0.78)
Small $90,000
Plant Unfavorable Market (0.22)
–$30,000

No Plant
–$10,000

–$87,400 Favorable Market (0.27)

$190,000
Unfavorable Market (0.73)
–$190,000
$2,400 Favorable Market (0.27)
$2,400
Small $90,000
Plant Unfavorable Market (0.73)
–$30,000

No Plant
–$10,000
$49,200

$10,000 Favorable Market (0.50)

$200,000
Unfavorable Market (0.50)
–$180,000
$40,000
$40,000

Favorable Market (0.50)

Small $100,000
Plant Unfavorable Market (0.50)
–$20,000

No Plant
$0
Figure 3.4
III. DECISION TREES
Thompson’s complex decision tree

We move back to the first decision

node and choose the best
alternative:
→ The expected monetary value
of conducting the survey is $49,200,
versus an EMV of $40,000 for not
conducting the study, so the best
choice is to seek marketing
information.
• If the survey results are
favourable we should construct a
large plant!
• But if the research is negative,
he
should construct a small plant!
6
III. DECISION TREES
Thompson’s complex decision tree
Mr. Thompson now realizes that conducting the market
research is not free!
He would like to know what the actual value of doing a
survey is!
• One way of measuring the value of market information
is to compute the expected value of sample information
(EVSI) which is the increase in expected value resulting
from the sample information
III. DECISION TREES
Expected value of sample information
 Thompson wants to know the actual value of
doing the survey

Expected value Expected value

with sample of best decision
EVSI = –
information, assuming without sample
no cost to gather it information

= (EV with sample information + cost)

– (EV without sample information)

EVSI = ($49,200 + $10,000) – $40,000 = $19,200

III. DECISION TREES
Expected Value of Sample Information
Thompson wants to know the actual value of doing
the survey:

where:
EVSI = expected value of sample information
EV with SI = expected value with sample information
EV without SI = expected value without sample
information
EVSI = ($49,200 + $10,000) - $40,000 = $19,200

Mr Thompson could have paid up to $19,200 for a

market study and still come out ahead! Since it costs only
$10,000, the survey is indeed worthwhile!
III. DECISION TREES
Efficiency of Sample Information
• Possibly many types of sample information available
• Different sources can be evaluated

For Thompson:

Market survey is only 32% as efficient as perfect

information!
III. DECISION TREES
Sensitivity analysis
How sensitive are the decisions to changes in the
probabilities?
How sensitive is our decision to the probability of a
favorable survey result?
That is, if the probability of a favorable result (p = .45)
where to change, would we make the same decision?
How much could it change before we would make a
different decision?
III. DECISION TREES
Sensitivity analysis
p = probability of a favorable survey result
(1 – p) = probability of a negative survey result

EMV(node 1) = ($106,400)p +($2,400)(1 – p)

= $104,000p + $2,400
We are indifferent when the EMV of node 1 is the
same as the EMV of not conducting the survey,
$40,000
$104,000p + $2,400 = $40,000
$104,000p = $37,600
p = $37,600/$104,000 = 0.36