Chapter 4

Decision Tree & Utility Theory

 Decision Trees
A decision node

A state of nature node

Five Steps of Decision Tree Analysis
• Define the problem
• Structure or draw the decision tree
• Assign probabilities to the states of nature
• Estimate payoffs for each possible combination
of alternatives and states of nature
• Compute expected monetary values (EMVs) for
each state of nature node. At decision nodes,
the alternative with the best EMV is selected.
EMV (node1)=$10,000 = (0.50)($200,000)+(0.5)(-180,000)=$10,000
Payoffs
Favor-Market (0.5)
$200,000

1 Unfavor-market (0.5)
$-180,000
Large plant
Favor-Market (0.5)
$100,000
Small plant
2 Unfavor-Market (0.5)
$-20,000
EMV (node2)=$40,000

Do nothing

$0

Build the small plant

 Modeling in the real world
• Defining the problem
• Developing a model
• Acquiring input data
• Developing a solution
• Testing the solution
• Analyzing the results
• Implementing the results
 A more complex decision for Thompson
Lumber
• Now, Thompson has two decisions to make,
with the second decision dependent on the
outcome of the first. In this case, he has the
option to conduct a survey at a cost of
$10,000. The information from his survey
could help to decide whether to construct a
large plant, a small plant, or do nothing.
 (cont)
• EMV (conduct study) = $49,200 > EMV (not
conduct)= $40,000  best choice is to
conduct study.
– If the results are favorable  build a large plant
– If the results are unfavorable  build a small plant
 Expected Value of Sample Information

• EVSI = (expected value of best decision with

sample info, assuming no cost to gather it) –
(expected value of best decision without
sample info) = (EV with sample info + cost) –
(EV without sample info)
= ($49,200 + $10,000) – $40,000 = $19,200
i.e. the cost of survey should not exceed $19,200
(in this case it is $10,000 OK)
 How probability values are estimated by
Bayesian analysis
• In the Thomson Lumber case, we made the
assumption that the following four conditional
probabilities were known:
P(favor-market FM/survey positive SP) = 0.78
P(UM/SP) = 0.22 (=1-.78)
P(FM/SN) = 0.27
P(UM/SN) =0.73 (=1-.27)
How to derive these values with Bayes’ theorem?
 (cont)
• In discussion with a market researcher, Thompson
knows that the survey can be positive (SP) or
negative (SN).
• The researcher told that, statistically, of all new
products with a FM, market survey were correct in
70% of the time, 30% of the time the surveys were
false.
• On the other hand, when there was an unfavorable
market for a new product, 80% of the surveys were
correctly predicted, 20% were false.
 (cont)
•  P(A|B) =
 Utility theory
• Whether should you keep the lottery ticket
with a chance of 50/50 winning $5 mil, or take
$2 mil for sure?
• Most people take $2 mil. What about you?
Utility theory (cont)
 Measuring utility & constructing a utility
curve
• U(best outcome) =1
• U(worst outcome) = 0
(cont)
 (cont)
• E.g. Jane would like to construct her utility curve to reveal
her preference for money between $0 and $10,000.
• A utility curve is a graph that plots utility value versus
monetary value.
• If the money is invested in the bank, in 3 years Jane would
receive $5,000. If she invested in the real estate, after 3 years
she could receive either nothing or $10,000. Jane thinks that
unless she has the chance of 80% getting $10,000 from the
real estate deal, she would prefer to deposit her money into
the bank. Thus, her utility of $5,000 is
U($5,000) = 0.8
 P = 0.80 $10,000
U($10,000) = 1.0

$0
1-P = 0.20
Real estate U($0.00) = 0.0

Bank $5,000
U($5,000) = p = 0.8

U($5,000) = pU($10,000) + (1-p) U($0) = 0.8*1 + 0*0.0 = 0.8

Other utility values can be conducted in the same manner
 Preferences for Risk

Risk seeker Risk avoider Risk indifference

 Utility as a Decision Making Criterion

• E.g. Mark loves to gamble. He plays the game

tossing thumbtacks. If the point on the
thumbtack is facing up after landing, Mark
wins $10,000, if down then Mark loses
$10,000. Mark believes that 45% chance of
winning $10,000 and 55% of losing $10,000.
Alternative 2 is not to gamble. What should
Mark do? Suppose his utility curve as in the
next fig.
U(-$10,000) = 0.05
U($0) = 0.15
U($10,000) = 0.30
E(play) = 0.45*0.30 + 0.55*0.05 = 0.162
E(not play) = 0.15
End