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Decision Making Tree Probability

This document discusses using a decision tree and expected value approach to determine the best decision alternative when there are probabilities associated with different states of nature. It provides an example where a company considers three options for a condominium complex project with different payoffs depending on whether demand is strong or weak. By calculating the expected value of each option as the probability-weighted sum of payoffs, option 3 has the highest expected value of $14.2 million, so it is the recommended decision.

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AudreyMae
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53 views

Decision Making Tree Probability

This document discusses using a decision tree and expected value approach to determine the best decision alternative when there are probabilities associated with different states of nature. It provides an example where a company considers three options for a condominium complex project with different payoffs depending on whether demand is strong or weak. By calculating the expected value of each option as the probability-weighted sum of payoffs, option 3 has the highest expected value of $14.2 million, so it is the recommended decision.

Uploaded by

AudreyMae
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Decision Making Tree Probability

Where there are probability assessment for state of nature, we can usethe expected
value approach to
identify the best decision alternative.
Let:
N _ the number of states of nature
P(sj) _ the probability of state of nature sj

Provided that, these probabilities given satisfies the conditions of probabilities.


The expected value (EV) of decision alternative di is defined as follows:

Which means that the expected value of a decision alternative is the sum of weighted
payoffs for the
decision alternative
Sample Problem:
PDC is optimistic about the potential for the luxury high-rise condominium complex.
Suppose that this optimism leads to an initial subjective probability assessment of 0.8 that
demand
will be strong (s1) and a corresponding probability of 0.2 that demand will be weak (s2).
Using the payoff values below, and the EV Equation,

Thus, P(s1) _ 0.8 and P(s2) _ 0.2. Using the payoff values in Table 4.1 and equation (4.4),
we compute the expected value for each of the three decision alternatives as follows:
EV(d1) = 0.8(8) + 0.2(7) = 7.8
EV(d2) = 0.8(14) + 0.2(5) = 12.2
EV(d3) = 0.8(20) + 0.2(-9) = 14.2

The calculations required to identify the decision alternative with the best expected
value can be conveniently carried out on a decision tree.
PDC DECISION TREE WITH STATE-OF-NATURE BRANCH PROBABILITIES

Applying The Expected Value Approach Using A Decision Tree

First compute the expected value at each chance node. That is, at each
chance node, we weight each possible payoff by its probability of occurrence. By doing so,

we obtain the expected values for nodes 2, 3, and 4, as shown in Figure


Thus, using the expected value approach, we find that the large condominium complex, with
an expected value of $14.2 million, is the recommended decision.

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