Decision Trees

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

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

Thomson Case Thomson lumber a profitable company located in Portland, Oregon. Step 1: John Thomson to identify whether to expand his product line. He then try to find alternatives to define a course of action or strategy that a decision maker can use.

Thomson Case (Cont.) Step 2: Thomson decides that there are 3 alternatives. 1. to build a large new plant 2. a small plant 3. no plant at all. Step 3: He determines that there are only 2 possible outcomes : The market for new product could be favorable (high demand for the new product) or unfavorable (low demand). Step 4: Thomson wants to maximize his profit to evaluate each consequence. He evaluated the potential profits with the various outcomes. For favorable market, the new large plant will yield a net profit of $200,000 while if the market unfavorable will turn to a net loss of $180,000. A small plant will yield a net profit of $100,000 under favorable market and a net loss of $20,000 for unfavorable market. Finally if he does nothing would result in $0 profit in either market.

Thomson Case (Cont.) Step 5 &6 : The last two steps are to select a decision theory model and apply it to the data to help making decision. Selecting the model depends on the environment in which you are operating and the amount of risk and uncertainty involve.

Thomson Case (Cont.) State of Nature AlternativeFavorable market Unfavorable market Construct a large plant 200, ,000 Construct a small plant 100,000-20,000 Do nothing00

Thompson’s Decision Tree Fig A Decision Node A State of Nature Node Favorable Market Unfavorable Market Favorable Market Unfavorable Market Construct Large Plant Construct Small Plant Do Nothing

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.

Thompson’s Decision Tree Fig. 4.2 A Decision Node A State of Nature Node Favorable Market (0.5) Unfavorable Market (0.5) Favorable Market (0.5) Unfavorable Market (0.5) Construct Large Plant Construct Small Plant Do Nothing $200,000 -$180,000 $100,000 -$20,000 0 EMV =$40,000 EMV =$10,