Decision Tree Diagram

A Payoff Table, also known as a Decision Table, is a valuable decision-making tool that presents
the range of possible outcomes (payoffs) associated with different decision alternatives under
various possible future scenarios, often referred to as "states of nature." This table provides a
structured way to analyze and evaluate potential outcomes, enabling decision-makers to make
more informed choices when facing uncertainty and risk.
In a payoff table, each row typically represents a potential decision or action, while each column
represents a possible state of nature or external condition that could occur. The cell at the
intersection of a given decision and state of nature shows the payoff (outcome) associated with
that combination. These payoffs could be in the form of profits, costs, or other relevant
performance metrics, depending on the context. This method allows decision-makers to visually
compare options and consider the effects of uncertainty on outcomes, facilitating a clearer
pathway toward selecting the best course of action.

Payoff table exercise

King Faker bakes and sells cookies. Each cookie is sold for Php20. Before the day ends, all
unsold cookies by 6pm are sold at half the regular price to Churches to be given away to street
children. The variable cost per cookie is Php12. Past experience has shown that the daily
demand and their probabilities are as follows
Cookie sales per day Probability
1,200 25%
1,400 60%
1,600 15%
Required: Determine the best course of action to take or the option that would yield the highest
expected value of contribution margin.
Answer: Make and sell 1,400 cookies for a contribution margin of Php10,700.

Perfect Information and Decision-Making Under Certainty

Perfect Information refers to a scenario where a decision-maker has complete knowledge of
which future state of nature will actually occur. In other words, it means having certainty regarding
future events. Under perfect information, the probability distribution representing future outcomes
accurately reflects their relative frequencies, and the decision-maker knows precisely when each
state of nature will take place. This level of insight allows the decision-maker to select the best
possible action with complete confidence, as they are assured of which future state will unfold.
Perfect information eliminates the element of uncertainty, as it permits certainty that a specific
state of nature will occur. For example, if a business knew with certainty what the demand for its
product would be in the next quarter, it could adjust its production levels accordingly, ensuring
optimal inventory and minimizing the risk of overproduction or stockouts. However, perfect
information is rarely available in real-life scenarios, and decision-makers often rely on probabilities
to estimate likely outcomes instead.
Expected Value of Perfect Information (EVPI)
The Expected Value of Perfect Information (EVPI) is a critical concept in decision analysis. It
quantifies the maximum amount a decision-maker would be willing to pay to obtain perfect
information about future states of nature. The EVPI is calculated as the difference between the

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expected value of the best action that could be taken with perfect information and the expected
value of the best decision made without perfect information.
In practical terms, the EVPI represents the "value" of having perfect knowledge about future
events. It helps decision-makers gauge the financial worth of obtaining additional information
before making a decision. The formula for EVPI can be expressed as follows:

EVPI = Expected Value with Perfect Information − Expected Value of best scenario
without Perfect Information
In scenarios where perfect information is available, the decision-maker knows in advance which
state of nature will occur and can take the optimal action for that particular state, maximizing the
expected payoff. Without perfect information, decisions are based on the expected values across
different possible outcomes, which introduces the risk of choosing a less-than-optimal action due
to uncertainty.

Expected value of perfect information and cost of perfect information

In the previous exercise, let us assume that King Faker knew the daily sales demand for
cookies, she then would prepare exactly the number of cookies demanded.
Required: Determine the expected value of perfect information. Php340

Practical Applications and Benefits of Payoff Tables and EVPI

The use of payoff tables and the concept of EVPI are instrumental across various fields, including
finance, manufacturing, marketing, and strategic planning. They provide a structured framework
for comparing decisions in the face of uncertainty and allow decision-makers to weigh the costs
and benefits of acquiring additional information. Key advantages include:
1. Enhanced Decision Clarity: Payoff tables lay out all possible outcomes in a single view,
enabling decision-makers to analyze each option systematically.
2. Risk Management: By considering the likelihood of different states of nature, decision-
makers can better manage risk and make more resilient choices.
3. Optimal Resource Allocation: Calculating the EVPI can guide investments in
information-gathering tools, helping businesses decide whether it is worth investing in
forecasting or market research.
Improved Strategic Planning: In long-term planning, these tools aid in creating strategies that
are robust against various future conditions, promoting stability and profitability.
In sum, payoff tables and the expected value of perfect information help organizations make
rational, informed decisions by systematically analyzing uncertainties and assessing the potential
benefits of additional information. Through this approach, businesses and individuals can not only
make better choices but also allocate resources wisely, ultimately enhancing their ability to
achieve favorable outcomes in uncertain environments.

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Decision Tree
A decision tree is a graphical representation used in decision-making processes to outline
possible choices, outcomes, and the likelihood of different events occurring. It organizes decisions
in a branching structure that visually maps out all possible courses of action and their associated
payoffs, costs, or other relevant metrics. Each "branch" in the tree represents a possible decision
or outcome, helping decision-makers clearly see and evaluate different scenarios, especially
when future events and conditions are uncertain.
Decision trees are particularly useful in complex decision-making situations because they allow
for a systematic exploration of all potential options, making them a valuable tool for strategic
planning, risk assessment, and evaluating the expected value of various decisions under different
circumstances. This tool is commonly applied in business, finance, project management, and
operations management to aid in navigating complex decisions where various possible outcomes
or states of nature must be considered.
Structure of a Decision Tree
A decision tree typically consists of nodes and branches that represent the sequence of
decisions and outcomes. Here’s a breakdown of its components:
1. Decision Nodes: Represented by squares, these nodes indicate points where a decision
must be made. Each branch stemming from a decision node corresponds to a possible
choice or action the decision-maker can take.
2. Chance Nodes: Represented by circles, chance nodes denote points where the outcome
is uncertain. Each branch from a chance node represents a possible state of nature or
event, along with an associated probability that it will occur.
3. End Nodes: Represented by triangles, end nodes signify the final outcome of a sequence
of decisions and events, showing the payoff or outcome of each possible path through the
decision tree.
4. Branches: Lines connecting the nodes, branches represent the decisions and potential
outcomes that lead from one node to the next. Each branch from a decision node indicates
a different choice, while branches from a chance node represent the probabilities and
possible outcomes of uncertain events.
How a Decision Tree Works
The decision tree process begins at the root node, the starting point of the decision-making
process. At each decision node, the decision-maker chooses among several alternatives. From
each choice, a branch leads either to another decision node (if additional decisions are needed),
a chance node (if uncertainty is involved), or an end node, where the payoff of that particular path
is determined. By working through each branch, the decision-maker can identify all possible
outcomes of their choices and calculate expected values to determine the optimal decision.
The key to using a decision tree effectively is calculating the expected value at each decision
node, which allows the decision-maker to quantify the anticipated outcome for each choice based
on the probabilities of different events occurring. This is often done by rolling back the decision
tree, a process in which the tree is analyzed from the end nodes back to the root, calculating the
expected values and identifying the best option at each stage.

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