Decision Making Under Uncertainty:

Decision Tree Analysis

 Decision Tree Analysis
The decision making process can be represented graphically by a
combination of lines and nodes called a decision tree. The purpose of
the tree is to pictorially depict the sequence of possible actions and
outcomes.

There are two types of nodes used in a decision tree. A Square

represents a decision point, which is the action (alternative) taken by
the decision maker and a Circle represents an event or chance,
which is the state of nature. The branches (lines) in the tree represent
the decision path related to alternatives and states of nature.

Decision trees are generally most helpful when a sequence of

decisions must be made, but they can also be used to illustrate a
single decision
 Decision Tree Analysis
 Example: Burger Prince Restaurant
Burger Prince Restaurant is considering opening a new restaurant on
Main Street. The company has three different building designs (A, B,
and C), each with a different seating capacity. Burger Prince estimates
that the average number of customers arriving per hour will be 40, 60,
or 80.
 Decision Alternatives d1 = use building design A
d2 = use building design B
d3 = use building design C
 States of Nature
s1 = an average of 40 customers arriving per hour
s2 = an average of 60 customers arriving per hour
s3 = an average of 80 customers arriving per hour
 Decision Tree Analysis
Payoff Table (Payoffs are Profit (Rs. ) Per Week)

Average Number of
Customers Per Hour
s1 = 40 s2 = 60 s3 = 80

Design A 10,000 15,000 14,000

Design B 8,000 18,000 12,000
Design C 6,000 16,000 21,000

 In next slide, the decision tree has two types of nodes i.e. circle nodes
correspond to chance events and square nodes correspond to decisions.
 Branches leaving a circle node represent the different states of nature;
Branches leaving a square node represent the different decision alternatives.
 At the end of a limb of the tree is the payoff attained from the series of
branches making up the limb.
 Decision Tree
40 customers per hour (s1)
10,000
Design A (d1) 60 customers per hour (s2)
2 15,000
80 customers per hour (s3)
14,000
40 customers per hour (s1)
8,000
Design B (d2) 60 customers per hour (s2)
1 3 18,000
80 customers per hour (s3)
12,000
40 customers per hour (s1)
6,000
Design C (d3) 60 customers per hour (s2)
4 16,000
80 customers per hour (s3)
21,000
Decision Tree Analysis of a decision making
problem under uncertainty with known
probabilities

Jenny Lind is a writer of romance novels. A movie

production company and a TV channel both want
exclusive rights to one of her more popular works. If
she signs with the TV channel, she will receive a single
lump sum, but if she signs with the movie production
company, the amount she will receive depends on the
market response to her movie. What should she do?
(Payoff and Probabilities are given in next slide)
 Payoffs and Probabilities

 Movie production company Payoff

 Small box office – Rs. 2,000,000
 Medium box office – Rs. 10,000,000
 Large box office – Rs. 30,000,000
 TV channel Payoff
 Flat rate – Rs. 9,000,000
 Probabilities
 P(Small Box Office) = 0.3
 P(Medium Box Office) = 0.6
 P(Large Box Office) = 0.1
 Payoff Table

States of Nature
Decisions
Small Box Medium Box Large Box
Office Office Office
Sign with Movie
Production 2,000,000 10,000,000 30,000,000
Company
Sign with TV
9,000,000 9,000,000 9,000,000
channel

Probabilities 0.3 0.6 0.1

 Using Decision Trees
 Can be used as visual aids to structure and solve
sequential decision problems
 Especially beneficial when the complexity of the problem
grows
 Three types of “nodes”
 Decision nodes - represented by Squares ( )
 Chance nodes - represented by Circles (Ο)
 Terminal nodes - represented by Triangles ( )
 Solving the tree involves pruning all but the best
decisions at decision nodes, and finding expected
values of all possible states of nature at chance nodes
 Create the tree from left to right
 Solve the tree from right to left
Example Decision Tree

Chance
Event 1
node
Decision Event 2
node Event 3
 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.

 Solve the problem by computing expected monetary values

(EMVs) for each state of nature node. This is done by working
backward, that is, starting at the right of the tree and working back
to decision nodes on the left. Also, at each decision node, the
alternative with the best EMV is selected.
 Decision Tree

Small Box Office

2,000,000
0.3
Sign with Movie Co. Medium Box Office
10,000,000
0.6
Large Box Office
30,000,000
0.1
Small Box Office
9,000,000
0.3
Sign with TV channel Medium Box Office
9,000,000
0.6
Large Box Office
9,000,000
0.1
 Decision Tree
Small Box Office
ER 2,000,000
?
Sign with Movie Co. 0.3 Medium Box Office
10,000,000
ER 0.6
? Large Box Office
30,000,000
0.1
Small Box Office
ER 9,000,000
?
Sign with TV channel 0.3 Medium Box Office
9,000,000
0.6
Large Box Office
9,000,000
0.1
Decision Tree - Solved

Small Box Office

2,000,000
9,600,000
0.3
Sign with Movie Co. Medium Box Office
10,000,000
0.6
ER
? Large Box Office
30,000,000
0.1
Small Box Office
9,000,000
9,000,000
0.3
Sign with TV Network Medium Box Office
9,000,000
0.6
Large Box Office
9,000,000
0.1
Decision Tree - Solved

Small Box Office

2,000,000
9,600,000 0.3
Sign with Movie Co. Medium Box Office
10,000,000
0.6

9,600,000 Large Box Office

30,000,000
0.1
Small Box Office
9,000,000
9,000,000
0.3
Sign with TV Network Medium Box Office
9,000,000
0.6
Large Box Office
9,000,000
0.1
 Decision Tree Analysis for Multi stage
Decision Making

An art dealer’s client is willing to buy a painting named

‘SUNPLANT’ at Rs. 50,000. The dealer can buy the
painting from an Art Gallery today for Rs. 40,000 or can
wait a day and buy the painting tomorrow (if it has not
been sold) for Rs. 30,000. The dealer may also wait
another day and buy the painting (if it is still available) for
Rs. 26,000. At the end of the third day, the painting will
no longer be available for sale. Each day, there is a 0.60
probability that the painting will be sold. What strategy
maximizes the dealer’s expected profit?
 Decision Tree

Buy the painting

10,000 [50,000 – 40,000]
ER
?

Available
ER 0.4
?
Don’t Buy the painting

0.6
Sold
0

FIRST DAY
 Decision Tree

[50,000 – 40,000]
Buy the painting
10,000 [50,000 – 30,000]
Buy the painting
20,000
ER
?
ER
?
Available
ER
Don’t Buy ? 0.4 Available
the painting ER
Don’t Buy
? 0.4
the painting
0.6
Sold
0 0.6
0
Sold

FIRST DAY SECOND DAY

 Decision Tree

Buy the [50,000 – 40,000]

painting
10,000 Buy the [50,000 – 30,000] [50,000 – 26,000]
painting
20,000 Buy the
ER painting
? 24,000
ER
?
Available ER
ER ?
Available
?
0.4 ER
?
0.4
Don’t Buy 0.6
the painting Don’t Buy
0 the painting 0.6 0
Sold Don’t Buy
0 the painting
Sold

FIRST DAY SECOND DAY THIRD DAY

 Decision Tree

Buy the [50,000 – 40,000]

painting
10,000 Buy the [50,000 – 30,000] [50,000 – 26,000]
painting
20,000 Buy the
ER painting
? 24,000
ER
?
Available 24,000
ER
Available
?
0.4 ER
?
0.4
Don’t Buy 0.6
the painting Don’t Buy
0 the painting 0.6 0
Sold Don’t Buy
0 the painting
Sold

FIRST DAY SECOND DAY THIRD DAY

 Decision Tree

Buy the [50,000 – 40,000]

painting
10,000 Buy the [50,000 – 30,000] [50,000 – 26,000]
painting
20,000 Buy the
ER painting
? 24,000
ER
?
Available 24,000
ER Available
? 0.4
9,600
0.4
Don’t Buy 0.6
the painting Don’t Buy
0 the painting 0.6 0
Sold Don’t Buy
0 the painting
Sold

FIRST DAY SECOND DAY THIRD DAY

 Decision Tree

Buy the [50,000 – 40,000]

painting
10,000 Buy the [50,000 – 30,000] [50,000 – 26,000]
painting
20,000 Buy the
ER
painting
? 24,000
20,000
Available 24,000
ER
Available
?
0.4
9,600
0.4
Don’t Buy 0.6
the painting Don’t Buy
0 the painting 0.6 0
Sold Don’t Buy
0 the painting
Sold

FIRST DAY SECOND DAY THIRD DAY

 Decision Tree

Buy the [50,000 – 40,000]

painting
10,000 Buy the [50,000 – 30,000] [50,000 – 26,000]
painting
20,000 Buy the
ER painting
? 24,000
20,000
Available 24,000
Available
8,000
0.4
9,600
0.4
Don’t Buy 0.6
the painting Don’t Buy
0 the painting 0.6 0
Sold Don’t Buy
0 the painting
Sold

FIRST DAY SECOND DAY THIRD DAY

 Decision Tree

Buy the [50,000 – 40,000]

painting
10,000 Buy the [50,000 – 30,000] [50,000 – 26,000]
painting
20,000 Buy the
10,000 painting
24,000
20,000
Available 24,000
Available
8,000
0.4
9,600
0.4
Don’t Buy 0.6
the painting Don’t Buy
0 the painting 0.6 0
Sold Don’t Buy
0 the painting
Sold

FIRST DAY SECOND DAY THIRD DAY

 Case: Colaco Marketing
Colaco currently has assets of $150,000 and wants to decide whether
to market a new chocolate flavored soda brand named 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.

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.
 Case: Colaco Marketing

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 wants to maximize its expected final asset position, what

strategy should the company follow?