Lecture No.

41 Chapter 12 Contemporary Engineering Economics Copyright 2010

Contemporary Engineering Economics, 5th edition, 2010

Decision Tree Analysis

A graphical tool for

describing (1) the actions available to the decision-maker, (2) the events that can occur, and (3) the relationship between the actions and events.

Contemporary Engineering Economics, 5th edition, 2010

Constructing a Decision Tree

A Company is considering marketing a new product. Once the product is introduced, there is a 70% chance of encountering a competitive product. Two options are available each situation. Option 1 (with competitive product): Raise your price and see how your competitor responds. If the competitor raises price, your profit will be $60. If they lower the price, you will lose $20. Option 2 (without competitive product): You still two options: raise your price or lower your price. The conditional profits associated with each event along with the likelihood of each event is shown in the decision tree.
Contemporary Engineering Economics, 5th edition, 2010
Competitors price

Conditional Profit

Decision Points
Events

Our Price
High

High (0.5) (0.5) Low

$60 -$20

) Probability Market Competitive Product (0.7)

High Low (0.2) Low High

(0.8)

$40

No Competitive Product (0.3) Do not market

$10 $100

Low

$0
First Decision Point

$30
Second Decision Point

Rollback Procedure
To analyze a decision tree, we begin at the end of the

tree and work backward. For each chance node, we calculate the expected monetary value (EMV), and place it in the node to indicate that it is the expected value calculated over all branches emanating from that node. For each decision node, we select the one with the highest EMV (or minimum cost). Then those decision alternatives not selected are eliminated from further consideration.

Contemporary Engineering Economics, 5th edition, 2010

Making Sequential Investment Decisions

High (0.5)

$60
(0.5)

$20
Set High Price

Low

-$20

$44
Market $44

Competitive $20 Product (0.7)

High
Low (0.2)

$40
(0.8)

No Competitive Product (0.3) Do not market

$100 $0
Contemporary Engineering Economics, 5th edition, 2010

$16
Low
Set High Price

$10

$100
Low

$30

Decision Rules
Market the new product.
Whether or not you encounter a competitive

product, raise your price.

The expected monetary value associated

with marketing the new product is $44.

Contemporary Engineering Economics, 5th edition, 2010

Practice Problem
A company is considering the purchase of a new labor-

saving machine. The machines cost will turn out to be $55 per day. Each hour of labor that is saved reduces costs by $5. However, there is some uncertainty over the number of hours that actually will be saved. It is judged that the hours of labor saved per day will be 10, 11, or 12, with probabilities of 0.10, 0.60, 0.30, respectively. Let us define profit as the excess of labor-cost savings over the machine cost.
Contemporary Engineering Economics, 5th edition, 2010

Construct a Decision Tree

-$5 0.10 $1.0 Invest $1 10

11
12 Do not invest

0.60

0.30 $5

EMV = $1.0 Decision: Purchase the equipment

Contemporary Engineering Economics, 5th edition, 2010

Expected Value of Perfect Information (EVPI)

What is EVPI? This is equivalent to asking yourself how much you can

improve your decision if you had perfect information. Mathematical Relationship: EVPI = EPPI EMV = EOL where EPPI (Expected profit with perfect information) is the expected profit you could obtain if you had perfect information, and EMV (Expected monetary value) is the expected profit you could obtain based on your own judgment. This is equivalent to expected opportunity loss (EOL).

Contemporary Engineering Economics, 5th edition, 2010

Expected Value of Perfect Information (EVPI)

State of Nature Best Strategy Maximum Payoff Probability the State of Nature Occurs
0.10 0.60 0.30

Expected Payoff or each State

0 0 1.5

10 11 12

Dont Buy Indifferent Buy

0 0 5

Expected Profit with Perfect Information (EPPI): (0.10)(0) + (0.60)(0) + (0.30)(5) = $1.5 Expected Value of Perfect Information (EVPI) = EPPI EMV $1.5 - $1 = $0.5
Contemporary Engineering Economics, 5th edition, 2010

Bills Decision Problem $50,000 to Invest

Decision Problem:
Buying a highly

speculative stock (d1) with three potential levels of return High (50%), Medium (9%), and Low (30%). Buying a very safe U.S. Treasury bond (d2) with a guaranteed 7.5% return.

Seek advice from an expert?

Seek professional advice

before making the decision Do not seek professional advice do on his own.

Contemporary Engineering Economics, 5th edition, 2010

Decision Tree for Bills Investment Problem

Contemporary Engineering Economics, 5th edition, 2010

Evaluating Options in Bills Investment Problem

Option 1: 1) Period 0: (-$50,000 - $100) = -$50,100 Period 1: (+$75,000 - $100) - 0.20($24,800) =$69,940 PW(5%)=-$50,100 + $69,940 (P/F, 5%, 1) = $16,510 2) Period 0: (-$50,000 - $100)= -$50,100 Period 1: (+$54,500 - $100)- (0.20)($4,300) = $53,540 PW(5%) = -$50,100 + $53,540 (P/F, 5%, 1) = $890 3) Period 0: (-$50,000 - $100) = -$50,100 Period 1: (+$35,000 - $100) (0.20)(-$14,800) = $37,940 PW(5%)= - $50,100 + $37,940 (P/F, 5%, 1) = -$13,967 Option 2: Period 0: (- $50,000 - $150) = -$50,150 EMV = $898 Period 1: (+$53,750 - $150) = $53,600 Or, prior optimal PW (5%)= -$50,150 + $53,600 (P/F, 5%, 1) = $898 decision is Option 2

(c) 2001 Contemporary Engineering Economics

13

Expected Value of Perfect Information

Decision Option

Potential Return Level

Probability

Option1: Invest in Stock $16,510 890 -13,967 -$405

(Prior Optimal) Option 2: Invest in Bonds $898 898 898 $898

Optimal Choice with Perfect Information

Opportunity Loss Associated with Investing in Bonds

High (A) Medium (B) Low(C)

0.25 0.40 0.35 EMV

Stock Bond Bond

$15,612 0 0 $3,903

EPPI = (0.25)($16,510) + (0.40)($898) + (0.35)($898) = $4,801

EVPI = EPPI EV = $4,801 - $898 = $3,903

EOL = (0.25)($15,612) + (0.40)(0) + (0.35)(0) = $3,903

Contemporary Engineering Economics, 5th edition, 2010

Bills Investment Problem with an Option of Getting Professional Advice

Updating Conditional Profit (or Loss) after Paying a Fee to the Expert (Fee = $200)

Revised Decision Tree

Contemporary Engineering Economics, 5th edition, 2010

Conditional Probabilities of the Experts Prediction, Given a Potential Return on the Stock

Given Level of Stock Performance What the Report Will Say Favorable (F) Unfavorable (UF) High (A) 0.80 0.20 Medium (B) 0.65 0.35 Low (C) 0.20 0.80

Contemporary Engineering Economics, 5th edition, 2010

Natures Tree: Conditional Probabilities and Joint Probabilities

Natures Tree Joint & Marginal Probabilities
P(A,F) = P(F|A)P(A) = (0.80)(0.25) = 0.20 P(A,UF|A)P(A) = (0.20)(0.25) = 0.05 P(B,F) = P(F|B)P(B) = (0.65)(0.40) = 0.26 P(B,UF) = P(UF|B)P(B) = (0.35)(0.40) = 0.14

P(F) = 0.20 + 0.26 + 0.07 = 0.53 P(UF) = 1 P(F) = 1 0.53 =

0.47
Contemporary Engineering Economics, 5th edition, 2010

Joint and Marginal Probabilities

What the Report Will Say Joint Probabilities When Potential Level of Return is Given High (A) Medium (B) Low (C) Marginal Probabilities Favorable (F) 0.20 0.26 0.07 0.53 Unfavorable (UF) 0.05 0.14 0.28 0.47 Marginal Probabilities of Return Level 0.25 0.40 0.35 1.00

Contemporary Engineering Economics, 5th edition, 2010

Determining Revised Probabilities

P(A|F) = P(A,F)/P(F) = 0.20/0.53 = 0.38 P(B|F) = P(B,F)/P(F) = 0.26/0.53 = 0.49 P(C|F) = P(C,F)/P(F) = 0.07/0.53 = 0.13

P(A|UF) = P(A,UF)/P(UF) = 0.05/0.47 = 0.11

P(B|UF) + P(B,UF)/P(UF) = 0.14/0.47 = 0.30

P(C|UF) = P(C,UF)/P(UF) = 0.28/0.47 = 0.59
Contemporary Engineering Economics, 5th edition, 2010

Decision Making after Having Imperfect Information

- $6,319

Contemporary Engineering Economics, 5th edition, 2010