Decision Tree

Choice of the Best Alternative

Manahan Siallagan
 Review

We discussed how to set what is problem:

How to set objectives;
How to set criteria and alternatives;
How to choose alternative without uncertainties
How to construct utility function
 Problems of Choice

C1 O1
D
C2 O2

D : a decision maker
C : possible courses of action
(alternatives)
O1 : desirable outcome;
3 O2 : undesirable outcome
 Complex Rational Choice

The information and insight

needed to predict the I cant see
consequences of each option

Incomplete information
The other side may influences the
consequences (Strategic/Interactive
Decision).

It is assumed that we can calculate

probability of the consequences

4
Decision Analysis Problems
Decision analysis is designed to address
decision making in the face of great
uncertainty
Introducing new product into
marketplace:
What will the reaction of potential
customers ? Competitors?
Investing in securities :
How is the economy?
How about interest rates?
Selecting the mix of crops and livestock
for the upcoming season :
What will be the weather conditions?
Drilling for oil in particular location :
How likely is there to be oil in that
location?
How much?
Tools: Decision tree
 Why Decision Tree?
It can help a decision maker to develop a clear view of the
structure of a problem anda make it easier to determine the
possible scenarios that can result if a particular course of
action is chosen.
Decision trees can also help a decision maker to judge the
nature of the information that needs to be gathered in order
to tacke a problem.
It can be an excellent medium for communicating one
persons perception of a problem to other individuals.

6
 Model of Decision Tree
p1,1
E1,1 O1
C1 p1,2
E1,2 O2
D p2,1 O1
E2,1
C2
E2,2 p2,2 O2

D : a decision maker
C : possible courses of action (alternatives)
O1 and O2 : possible outcomes/consequences/payoffs
Ei,j : Events (State of Natures/SON)
pi,j : probabilities
7
 Structure of Decision Tree
Decision Node
Alternatives available for decision maker to choose;
Situation controllable by decision maker.

Alternatives of actions
8
 Structure of Decision Tree
Event Node
Events may happen after every action made by decision maker;
Uncontrollable by decision maker;
Decision maker only has information about probability of each
event no complete information.

p1
E1

E2 p2
An action
E3
p3

9 Events
 Building Decision Tree

1. Identify what decisions should be made by DM;

What are the first decision, and next decisions to be made?
2. Identify what SON happen after each decision;
3. Draw decision node and event node (SON);
4. Complete information about probabilities;
5. Complete information about payoff.

10
Goferbroke Company Case
 Goferbroke Company(1)
Max Flyer is the founder of and sole owner of the Goferbroke Company, which
develops oil wells in unproven territory. Maxs friends refer to him affectionately as
a wildcatter. However he prefers to think himself as an entrepreneur. He has poured
his life savings into the company in the hope of making it big with a large strike of oil.
Now his chance possibly has come. His company has purchased various tracts of land
that larger oil companies have spurned as unpromising even though they are near
some large oil fields. Now Max has received an exciting report about one of these tracts. A
consulting geologist has just informed Max that he believes there is one chance in four of oil
there.
Max has learned from bitter experience to be skeptical about the chances of oil
reported by consulting geologist. Drilling for oil on this tract would require an
investment of about $100,000. If the lands turns out to be dry (no oil), the entire
investment would be lost. Since his company doesnt have much capital left,
this lost would be quite serious.
Goferbroke Company(2)
On the other hand, if the tract does contain oil, the consulting geologist estimates
that there would be enough there to generate a net revenue of approximately
$800,000, leaving an approximate profit of:
Profit if find oil = Revenue if find oil Drilling cost
= $800,000 - $100,000
= $700,000

There is another option that another oil company has gotten wind of consulting
geologists report and so has offered to purchase the tract of land from Max for
$90,000. This is very tempting. This too would provide a welcome infusion of
capital into the company, but without incurring the large risk of a very
substansial loss of $100,000.
 The Goferbroke Company
Problem

Decision that must be taken:

Should Max sell his land or doing drilling?
Alternative:
1. Sell land
2. Drilling
Possibility event that could happen (state of nature):
- Found Oil
- No Oil (dry)
Payoff Table (Information from the case)
Payoffs
State of Nature (thousands)
Alternative Oil Dry
Drill for oil $700 -$100
Sell the land $90 $90
Prior Probability 0.25 0.75

If you are Max, which alternatives that you would

choose?
The Maximax Decision Criterion
Focus only on the best that can happen the
maximax criterion always chooses the decision
alternative that can give the largest possible
payoff Total Optimist
Identify the maximum payoff from any SoN for
each decision alternative
Find the maximum of these maximum payoffs
and choose the corresponding decision alternative
Weakness : abandoning prior probability and
abandoning other payoff beside only the biggest.

State of Nature Max in Row

Alternative Oil Dry
Drill for oil $700 -$100 700 Maximax
Sell the land $90 $90 90
The Maximin Decision Criterion
Focus only on the worst that can happen to us
(total pessimist)
Identify the minimum payoff from any SoN for each
decision alternatives
Find the maximum of these minimum payoffs and
choose the corresponding decision alternative
Weakness : abandoning prior probability and
abandoning other payoff beside only the maximin.

State of Nature Min in Row

Alternative Oil Dry
Drill for oil $700 -$100 -$100
Sell the land $90 $90 90 Maximin
The Maximum Likelyhood Criterion
Focus on the most likely state of nature.
Identify the state of nature with the largest
prior probability;
Choose the decision alternative that has
the largest payoff for this state of nature.
Weakness: abandoning payoff, that
actually payoff maybe very big.

State of Nature (thousands)

Alternative Oil Dry
Drill for oil $700 -$100
Sell the land $90 $90 Step 2 : Maximum
Prior Probability 0.25 0.75
Step 1 : Maximum
Bayes Decision Rule
Bayes Decision Rule choose best alternative by considering
entire information that being owned by doing steps mentioned:
Calculate Expected Value for every decision alternative
EV = (prior prob x payoff)
Choose the decision alternative that has the largest Expected
Value
Advantage :
Considering entire information (alternatives, payoffs, and prior
probabilities);
In long term, if the decision occur sequential, then this criteria
will resulting payoff that mostly probably happen.

State of Nature (thousands)

Alternative Oil Dry EV
Drill for oil $700 -$100 100 Maximum
Sell the land $90 $90 90
Prior Probability 0,25 0,75
Decision Trees of Goferbroke

Decision tree is decision making help

tools that could describe entire
alternatives with whole events that may
happen (SoN).
Showing : Alternatives, SoN, Prior
Probability, and Payoff.
Using Bayes Decision Rule to choose the
best action.
DT of Goferbrokes Case
Decision:
Drill or Sell the Land
SON
Oil or Dry

Decision nodes Drill

-100

Sell

90
DT of Goferbrokes Case
Event nodes

Oil 0.25
800
Drill

-100 Dry 0,75

0
Sell

90
DT of Goferbrokes Case
Payoff

Oil 0.25
700
800
Drill

-100 Dry 0,75

-100
0
Sell
90
90
DT of Goferbrokes Case
Payoff

Oil 0.25
700
800
Drill

-100 100 Dry 0,75

-100
0
Sell
100 Expected payoff
90 = MAX [100,90]
90 90
= 100
Expected Value (EV) per event node;

Action: Drill

100=(0.25*700) + (0.75*(-100))
 Decision Analysis:
New Information or Posterior
Probability

24
 Process in Revising Decision tree
Prior probability

New information

Posterior probability

25
Assessing Probability
There are three approaches to assessing the probability of an
uncertain event:
1. a priori classical probability
X number of ways the event can occur
probability of occurrence
T total number of elementary outcomes

2. empirical classical probability

number of favorable outcomes observed
probability of occurrence
total number of outcomes observed

3. subjective probability
an individual judgment or opinion about the probability of occurrence
 Computing Joint and
Marginal Probabilities

The probability of a joint event, A and B:

number of outcomes satisfying A and B

P( A and B)
total number of elementary outcomes

Computing a marginal (or simple) probability:

P(A) P(A and B1) P(A and B2 ) P(A and Bk )

Where B1, B2, , Bk are k mutually exclusive and collectively exhaustive
events
Joint Probability Example

P(Red and Ace)

number of cards that are red and ace 2

total number of cards 52

Color
Type Red Black Total
Ace 2 2 4
Non-Ace 24 24 48
Total 26 26 52
Marginal Probability Example

P(Ace)

2 2 4
P( Ace and Re d) P( Ace and Black )
52 52 52

Color
Type Red Black Total
Ace 2 2 4
Non-Ace 24 24 48
Total 26 26 52
 Computing Conditional Probabilities
A conditional probability is the probability of one event, given
that another event has occurred:

P(A and B) The conditional probability

P(A | B) of A given that B has
P(B) occurred

P(A and B) The conditional probability

P(B | A) of B given that A has
P(A) occurred

Where P(A and B) = joint probability of A and B

P(A) = marginal probability of A
P(B) = marginal probability of B
 Conditional Probability Example

Of the cars on a used car lot, 70% have air conditioning

(AC) and 40% have a CD player (CD). 20% of the cars
have both.

What is the probability that a car has a CD player, given that it

has AC ?

i.e., we want to find P(CD | AC)

 Conditional Probability Example
(continued)
Of the cars on a used car lot, 70% have air conditioning (AC) and 40% have a CD player
(CD).
20% of the cars have both.

CD No CD Total

AC 0.2 0.5 0.7

No AC 0.2 0.1 0.3
Total 0.4 0.6 1.0

P(CD and AC) 0.2

P(CD | AC) 0.2857
P(AC) 0.7
 Conditional Probability Example
(continued)
Given AC, we only consider the top row (70% of the cars). Of these, 20% have a CD
player. 20% of 70% is about 28.57%.

CD No CD Total

AC 0.2 0.5 0.7

No AC 0.2 0.1 0.3
Total 0.4 0.6 1.0

P(CD and AC) 0.2

P(CD | AC) 0.2857
P(AC) 0.7
 Using Decision Trees
.2
Given AC or no AC: .7 P(AC and CD) = 0.2

P(AC and CD) = 0.5

.5
.7
All
Cars
.2
.3 P(AC and CD) = 0.2

.1 P(AC and CD) = 0.1

.3
 Using Decision Trees
(continued)
.2
Given CD or no CD: .4 P(CD and AC) = 0.2

P(CD and AC) = 0.2

.2
.4
All
Cars
.5
.6 P(CD and AC) = 0.5

.1 P(CD and AC) = 0.1

.6
 Bayes Theorem
Bayes theorem is used to revise previously calculated probabilities after new information is
obtained

P(A | B i )P(B i )
P(B i | A)
P(A | B 1 )P(B 1 ) P(A | B 2 )P(B 2 ) P(A | B k )P(B k )
where:
Bi = ith event of k mutually exclusive and collectively
exhaustive events
A = new event that might impact P(Bi)
Goferbrokes Case Continued
Survey by geologist will provide more accurate
information about P(oil);
How if Max has to decide two alternatives:
1. Do survey before drill/sell
2. Drill/sell without Survey
Events:
Do Survey
FSS : Favorable Seismic Sounding : Oil is fairly likely
USS : Unfavorable seismic sounding: Oil is quite unlikely.
Drill or Sell
Oil
Dry
Max`s Experience
P(state) prior; which is P(Oil)=0.25 & P(Dry)=0.75;
P (finding|state) being known based on Maxs
experiences; which is
P(FSS|Oil)=0.6,
P(USS|Oil)=0.4,
P(FSS|Dry)=0.2, and
P(USS|Dry)=0.8

Which:
State : Oil and Dry;
Finding : FSS and USS;
FSS : favorable seismic sounding; oil is fairly likely;
USS : unfavorable seismic sounding; oil is quite unlikely.
 P=?
Oil

Drill

P=?
P=? Dry
Unfavorable

Sell

Do Survey
P=?
30000 Oil

Drill

P=?
P=? Dry
Favorable
1

Sell

P=?
Oil

Drill

P=?
Dry
No Survey

Sell
Max`s Experience
P(state) prior; which is P(Oil)=0.25 & P(Dry)=0.75;
P (finding|state) being known based on Maxs
experiences; which is
P(FSS|Oil)=0.6,
P(USS|Oil)=0.4,
P(FSS|Dry)=0.2, and
P(USS|Dry)=0.8

Which:
State : Oil and Dry;
Finding : FSS and USS;
FSS : favorable seismic sounding; oil is fairly likely;
USS : unfavorable seismic sounding; oil is quite unlikely.
 P(OilUSS)
Oil
P(FSSOil) = 0,6 Drill

P(USSOil) = 0,4 P(DryUSS)

P(USS) Dry
Unfavorable
P(FSSDry) = 0,2
1
P(USSDry) = 0,8
Sell

Do Survey
P(OilFSS)
Oil

Drill

P(DryFSS)
P(FSS) Dry
Favorable

Sell

P(Oil)
Oil

Drill

P(Dry)
Dry
No Survey

Sell
Posterior Probability Formula

P(FSS|Oil) = P(FSS&Oil) / P(Oil)

P(FSS|Dry) = P(FSS&Dry) / P(Dry)
P(Oil|FSS) = P(Oil&FSS) / P(FSS)
P(Dry|FSS) = P(Dry&FSS) / P(FSS)
P(Oil|USS) = P(Oil&USS) / P(USS)
P(Dry|USS) = P(Dry&USS) / P(USS)
P(FSS&Oil) = P(Oil&FSS) Law of Probability
Contingency table

FSS USS P(FSS|Oil) = P(FSS& Oil) / P(Oil)

Since :
P (Oil) = 0.25; P(FSS|Oil) = 0.6
Oil 0.15 0.1 0.25 Then
P(FSS & Oil) = P(FSS|Oil) x P(Oil)
Dry 0.15 0.6 0.75 = 0.6 X 0.25
= 0.15
0.3 0.7 Do same step for find P (FSS&Dry) = 0.15
So :
P(FSS) = P(FSS&Oil)+P(FSS&Dry)
= 0.3
Posterior Probability Formula (contd)
P(Oil|FSS) = P(Oil&FSS) / P(FSS)
Since : P(FSS) = 0.3; from contigency table
P(Oil&FSS) = P(FSS&Oil) = 0.15
Then : P(Oil|FSS) = 0.15 / 0.3 = 0.5
Do same step for P(Oil|FSS); P(Dry|FSS); P(Oil|USS);
P(Dry|USS)
 FSS USS P(Oil|FSS)= P(Oil&FSS) = 0.15 = 0.5
P(FSS) 0.3
Oil 0.15 0.1 0.25

Dry 0.15 0.6 0.75 P(Dry|FSS)= P(Dry&FSS) = 0.15 = 0.5

P(FSS) 0.3
0.3 0.7

Do same step for P(Oil|USS); P(Dry|USS)

45
 Leveled Decision Analysis
Decision T ree for Goferbroke Co. Problem (With Survey)
0,143
Oil
P(Oil|USS)
P(USS) Drill 800 670
670

0,7
-100 -15,714 0,857
Dry P(Dry|USS)
Unfavorable -130
2 0 -130

Expected payoff
0 60

= MAX [123,100]
Sell
60

= 123
90 60
Do Survey
0,5 P(Oil|FSS)
-30 123 Oil

P(FSS) Drill 800 670

670

-100 270 0,5 P(Dry|FSS)

0,3 Dry
Favorable -130
1 0 -130
0 270

1 Sell
123 60
90 60

0,25
Oil P(Oil)
700
Drill 800 700

-100 100 0,75

Dry P(Dry)
No Survey -100
1 0 -100
0 100

Sell
90
90 90
Posterior Probability
Given:
P(state)=prior probability: P(oil) and P(dry)
P(finding|state) = Maxs experience on probabilities of finding (FSS or
USS) could occur if some SoN (oil or dry) has been already happened.

P(FSS|oil) 0.25*0.6=0.15 0.15/0.3=0.5 P(oil|FSS)

Oil and FSS Oil, diket FSS
0.6 et Oil
, di
k P(Oil and FSS) P(state|finding)
F SS Prob. posterior
US 0
P(oil) S, .4 P(Oil and USS)
dik
et O
25 il 0.25*0.4=0.1 0.1/0.7=0.14
P(oil|USS)
0. il P(USS|oil) Oil and USS Oil, diket USS
O

P(finding and state)

0.
Dr 75 P(FSS|dry) 0.75*0.2=0.15 0.15/0.3=0.5
P(dry|FSS)
y Dry and FSS Dry, diket FSS
0.2 et Dry P(Dry and FSS)
k
P(dry) , di
F SS
US 0.
S , di 8 P(Dry and USS)
ket
Dry 0.75*0.8=0.6 0.6/0.7=0.86
P(USS|dry) Dry and USS Dry, diket USS
P(dry|USS)
 0,143
Oil
670
Drill 800 670

-100 -15,6 0,857

0,7 Dry
Unfavorable -130
2 0 -130
0 60

Sell
60
90 60
Do Survey
0,5
-30 123 Oil
670
Drill 800 670

-100 270 0,5

0,3 Dry
Favorable -130
1 0 -130
0 270

1 Sell
123 60
90 60

0,25
Oil
700
Drill 800 700

-100 100 0,75

Dry
No Survey -100
1 0 -100
0 100

Sell
90
90 90
 Case Exercise
An engineer who works at compay of equipment
for the food processing industry has been asked to
consider the development of a new type of
processor.

There are two alternative power sources could be

used for the processor, namely gas and electricity,
There are technical reasons each power source would
require a fundamentally different design.
Resource constraints mean that the company will only
be able to pursue one of the designs, and because the
processor would be more advanced than others which
have been developed it is by no means certain that
either design would be a success.
49
 Estimation
The engineer estimates that
there is a 75% chance that
the electricity-powered
design would be
successful.
1. If success will get
profit $10 M and
2. If fail then it loses $3M
only a 60% chance that the
gas-powered design
would be a success.
1. If success will get
profit $15 M and
2. If fail then it loses $7M

50
 Thank You

51