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Decision Tree Analysis

Decision tree analysis is a method that can help businesses make better decisions in a changing environment. It involves laying out the potential decisions, outcomes, probabilities, and payoffs in a visual tree structure. There are different approaches depending on whether probabilities of outcomes are known (decision under risk) or unknown (decision under uncertainty). The maximum expected value approach under risk selects the decision with the highest expected or average payoff calculated by weighting each outcome by its probability. Decision trees can also be used sequentially over multiple decision points to analyze complex, multi-stage decisions.

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Andri Ginting
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162 views

Decision Tree Analysis

Decision tree analysis is a method that can help businesses make better decisions in a changing environment. It involves laying out the potential decisions, outcomes, probabilities, and payoffs in a visual tree structure. There are different approaches depending on whether probabilities of outcomes are known (decision under risk) or unknown (decision under uncertainty). The maximum expected value approach under risk selects the decision with the highest expected or average payoff calculated by weighting each outcome by its probability. Decision trees can also be used sequentially over multiple decision points to analyze complex, multi-stage decisions.

Uploaded by

Andri Ginting
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Decision Tree Analysis

Maydison Ginting
maydison.ginting@prasetiyamulya.ac.id
Why (business) Decision Analysis

• Help us make a better business decision that


makes companies stay competitive in a
dynamically-changing environment
Innovate or Die (?)
success
Reward = +++

innovate

failure
Reward = - - -

Don’t
Reward = 0
innovate
Uncertainty vs Risk

• Decisions Under Uncertainty (Decision Making


without Probabilities)
– A decision model for which there is more than one state of
nature, but without knowledge of the probabilities for
occurrence of the various state of nature.

• Decisions Under Risk (Decision Making with


Probabilities)
– A decision model for which there is more than one state of
nature, and a probability for occurrence of each state of
nature is known.
Uncertainty vs Risk
Payoff Table
States of Nature
Decision
a (x%)* b ((100-x)%)*
1 Payoff 1a Payoff 1b
2 Payoff 2a Payoff 2b

* if known, decisions under risk


if not known, decisions under uncertainty

States of nature: the events that may occur in the future


- high or low demand
- good or bad economic conditions
Decision Making without Probabilities

Decision situation:

States of Nature
Decision
(Purchase) Good Economic Poor Economic
Conditions Conditions
Apartment building $ 50,000 $ 30,000
Office building 100,000 - 40,000
Warehouse 30,000 10,000
Decision Making without Probabilities
The Maximax Criterion
• In the Maximax criterion the decision maker selects the decision
that will result in the maximum value of the maximum return of
each decision
• An optimistic criterion

States of Nature
Decision
(Purchase) Good Economic Poor Economic Maximum
Conditions Conditions payoff
Apartment building $ 50,000 $ 30,000 50,000
Office building 100,000 - 40,000 100,000
Warehouse 30,000 10,000 30,000

What if the payoff table consists of costs?


The selection would be the minimum of the minimum costs  Minimin
Decision Making without Probabilities
The Maximin Criterion
• In the Maximin criterion the decision maker selects the decision
that will result in the maximum value of the minimum return of
each decision
• A pessimistic criterion

States of Nature
Decision
(Purchase) Good Economic Poor Economic Minimum
Conditions Conditions payoff
Apartment building $ 50,000 $ 30,000 30,000
Office building 100,000 - 40,000 - 40,000
Warehouse 30,000 10,000 10,000

What if the payoff table consists of costs?


The selection would be the minimum of the maximum costs  Minimax
Decision Making with Probability
GOOP algorithm:

• Tentukan apa yang menjadi tujuan dan/atau value yang


ingin dicapai. (Goals)
• Tentukan sekumpulan alternatif keputusan. (Options)
• Tentukan peristiwa/event/state of the world yang akan
terjadi beserta besar payoff/reward untuk masing-masing
alternatif keputusan di setiap event. (Outcomes)
• Tentukan nilai probabilitas dari masing-masing event.
(Probability)
• Tentukan expected value untuk setiap alternatif keputusan.
• Pilih alternatif yang memiliki expected value terbesar.
Decision Making with Probabilities
The Expected Value
• There is more one state of nature
• The decision maker can arrive at a probability estimate for the occurrence of the
states of nature
• Expected value is computed by multiplying each decision outcome under each
state of nature by the probability of its occurrence
• Management should make the decision that maximizes the Expected Value

States of Nature
Decision
(Purchase) Good Economic Poor Economic
Conditions Conditions
Apartment building $ 50,000 $ 30,000
Office building 100,000 - 40,000
Warehouse 30,000 10,000
Probability 0,60 0,40
Decision Making with Probabilities
States of Nature
Decision
(Purchase) Good Economic Poor Economic
Conditions Conditions
Apartment building $ 50,000 $ 30,000
Office building 100,000 - 40,000
Warehouse 30,000 10,000
Probability 0,60 0,40

The Expected Value

• EV(Apartment) = $50,000(0.6) + 30,000(0.4) = 42,000


• EV(Office) = $100,000(0.6) + (-40,000)(0.4) = 44,000 (Max value)
• EV(Warehouse) = $30,000(0.6) + 10,000(0.4) = 22,000
Decision Trees
A dicision tree is a diagram consisting of
• decision nodes (represented as squares)
• probability nodes (circles)
• decision alternatives (branches)

Chance Branch

Choice
Decision Making with Probabilities
A Decision Tree
Sequential Decision Trees
• A sequential decision tree is used to illustrate a
situation requiring a series of decisions.
• Used where a payoff table, limited to a single
decision, cannot be used.
Real estate investment example modified to encompass a ten-year period in
which several decisions must be made:
Buying a Used Car

• Costs $1000
• Can sell it for $1100, $100 profit
• Every car is a lemon or a peach
• 20% are lemons 80% peach
• Costs $40 to repair a peach, $200 to
repair a lemon
• Should we buy a car?
THANK YOU

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