Lecture - Week 5

Decision Trees
Decision Trees
• EXAMPLE
• 3

• Often, people must make a series of decisions at different points in

time.
• Then decision trees can be used to determine optimal decisions.
• A decision tree enables a decision maker to decompose a large
complex decision problem into several smaller problems.
Example
Colaco Marketing
• Colaco currently has assets of $150,000 and wants to decide whether
to market a new chocolate-flavored soda, Chocola. Colaco has three
alternatives:
• Alternative 1 Test market Chocola locally, then utilize the results of the
market study to determine whether or not to market Chocola nationally.
• Alternative 2 Immediately (without test marketing) market Chocola nationally.
• Alternative 3 Immediately (without test marketing) decide not to market
Chocola nationally.
Example
Colaco Marketing
• In the absence of a market study, Colaco believes that Chocola has a 55% chance
of being a national success and a 45% chance of being a national failure.
• If Chocola is a national success, Colaco’s asset position will increase by $300,000,
and if Chocola is a national failure, Colaco’s asset position will decrease by
$100,000.
• If Colaco performs a market study (at a cost of $30,000), there is a 60% chance
that the study will yield favorable results (referred to as a local success) and a
40% chance that the study will yield unfavorable results (referred to as a local
failure).
• If a local success is observed, there is an 85% chance that Chocola will be a
national success. If a local failure is observed, there is only a 10% chance that
Chocola will be a national success. If Colaco is risk-neutral (wants to maximize its
expected final asset position), what strategy should the company follow?
Solution
• To draw a decision tree that represents Colaco’s problem, we begin at
the present and proceed toward future events and decisions.
• A decision tree can be constructed with two kinds of forks: decision
forks (denoted by 🔲 ) and event forks (denoted by ⭕️ ).
• Let’s do it together.
Incorporating Risk Aversion into Decision Tree Analysis

• 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 begin by determining Colaco’s expected final asset position if the company

acts optimally and the test market study is costless.
• We call this expected final asset position Colaco’s expected value with sample
information (EVWSI).
• We see that if we test market and then act optimally, we will now have an
expected final asset position of 264,000 + 30,000 = $294,000.
• Since $294,000 is larger than the expected asset position of the “Don’t test
market” branch ($270,000), we find that EVWSI = $294,000.
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

• An art dealer’s client is willing to buy the painting Sunplant at $50,000.

• The dealer can buy the painting today for $40,000 or can wait a day and buy the
painting tomorrow (if it has not been sold) for $30,000. The dealer may also wait
another day and buy the painting (if it is still available) for $26,000.
• At the end of the third day, the painting will no longer be available for sale. Each
day, there is a .60 probability that the painting will be sold.
• What strategy maximizes the dealer’s expected profit?