Introduction Decision trees Decision trees enable one to look at decisions: alternativesstates of nature with many alternatives and states of nature which.

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Presentation transcript:

Introduction Decision trees Decision trees enable one to look at decisions: alternativesstates of nature with many alternatives and states of nature which must be made in sequence 1

Decision Trees A graphical representation where: a decision node from which one of several alternatives may be chosen a state-of-nature node out of which one state of nature will occur 2

Five Steps to Decision Tree Analysis 1.Define the problem 2.Structure or draw the decision tree 3.Assign probabilities to the states of nature 4.Estimate payoffs for each possible combination of alternatives and states of nature 5.Solve the problem by computing expected monetary values (EMVs) for each state of nature node. 3

Career Decision Tree 4 Decision Table Career Choice

Decision Tree Example = (.5)($200,000) + (.5)(-$180,000) EMV for node 1 = $10,000 EMV for node 2 = $40,000 = (.5)($100,000) + (.5)(-$20,000) Payoffs$200,000 -$180,000 $100,000 -$20,000 $0 Construct large plant Construct small plant Do nothing Favorable market (.5) Unfavorable market (.5) 1 Favorable market (.5) Unfavorable market (.5) 2 5

Complex Decision Tree Example 6

Complex Example 1.Given favorable survey results EMV(2) = (.78)($190,000) + (.22)(-$190,000) = $106,400 EMV(3) = (.78)($90,000) + (.22)(-$30,000) = $63,600 The EMV for no plant = -$10,000 so, if the survey results are favorable, build the large plant 7

2.Given negative survey results EMV(4) = (.27)($190,000) + (.73)(-$190,000) = -$87,400 EMV(5) = (.27)($90,000) + (.73)(-$30,000) = $2,400 The EMV for no plant = -$10,000 so, if the survey results are negative, build the small plant Complex Example 8

3.Compute the expected value of the market survey EMV(1) = (.45)($106,400) + (.55)($2,400) = $49,200 The EMV for no plant = $0 so, given no survey, build the small plant 4.If the market survey is not conducted EMV(6) = (.5)($200,000) + (.5)(-$180,000) = $10,000 EMV(7) = (.5)($100,000) + (.5)(-$20,000) = $40,000 Complex Example 9

Decision Trees in Ethical Decision Making  Maximize shareholder value and behave ethically  Technique can be applied to any action a company contemplates 10

YesNo Yes No Decision Trees in Ethical Decision Making Yes Is it ethical? (Weigh the affect on employees, customers, suppliers, community verses shareholder benefit) No Is it ethical not to take action? (Weigh the harm to shareholders verses benefits to other stakeholders) No Yes Does action maximize company returns? Is action legal? Do it Don’t do it Do it, but notify appropriate parties Don’t do it Action outcome 11

Summary 12 Decision trees are used when we have to make sequential decisions Decision trees are used when we have to make sequential decisions Look at the risk profile of the decision maker Look at the risk profile of the decision maker