Chapter 6

Decision Models

Introduction to Decision Analysis

The field of decision analysis provides a framework for
making important decisions.
Decision analysis allows us to select a decision from a set of
possible decision alternatives when uncertainties regarding
the future exist.
The goal is to optimize the resulting payoff in terms of a
decision criterion.
Example
2

Criteria
Maximizing expected profit is a common criterion when
probabilities can be assessed.

Maximizing the decision makers utility function is the mechanism

used when risk is factored into the decision making process.

Payoff Table Analysis

Payoff Tables
Application: Tom Brown Investment Decision
Tom Brown has inherited $1000 from a distant relative. Since he still has another
year of studies before graduation from Iowa State University, Tom has
decided to invest the $1000 for a year. Literally tens of thousands of different
investment possibilities are available to him, including growth stocks, income
stocks, corporate bonds, municipal bonds, government bonds, futures, limited
partnerships, annuities, and bank accounts.
Given the limited amount of money he has to invest, Tom has decided that it is
not worthwhile to spend the countless hours required to fully understand those
various investments. Therefore he has turned to a broker for investment
guidance.

The broker has selected five potential investments she believes would be
appropriate for Tom: gold, a junk bond, a growth stock, a certificate of deposit
and a stock option hedge. Tom would like to set up a payoff table to help him
choose the appropriate investment.

The states of nature are mutually

exclusive and collectively exhaustive.

The Payoff Table

DJA is up more
than1000 points

DJA is up
[+300,+1000]

DJA moves
within
[-300,+300]

DJA is down
[-300, -800]

DJA is down more

than 800 points

Define
the states
of nature.
Decision
States
of Nature
Alternatives Large Rise Small Rise No Change Small Fall Large Fall
Gold
-100
100
200
300
0
Bond
250
200
150
-100
-150
Stock
500
250
100
-200
-600
C/D account
60
60
60
60
60
Stock option
200
150
150
-200
-150
6

Alternatives Large Rise Small Rise No Change Small Fall Large Fall
Gold
-100
100
200
300
0
Bond
250
200
150
-100
-150
Stock
500
250
100
-200
-600
C/D account
60
60
60
60
60
Stock option
200
150
150
-200
-150

The Payoff Table

Determine the
set of possible
decision
alternatives.

The Payoff Table

Decision
States of Nature
Alternatives Large Rise Small Rise No Change Small Fall Large Fall
Gold
-100
100
200
300
0
Bond
250
200
150
-150
-100
Stock
500
250
100
-200
-600
C/D account
60
60
60
60
60
Stock option
200
150
150
-200
-150

The stock option alternative is dominated by the

bond alternative
8

Classifying Decision Making Criteria

Decision making under certainty.
The future state-of-nature is assumed known.
Example

Decision making under risk.

There is some knowledge of the probability of the states of nature
occurring.
-Decision making under uncertainty.
There is no knowledge about the probability of the states of
nature occurring.
9

Decision Making Under Uncertainty

The decision criteria are based on the decision makers
attitude toward life.
The criteria include the

Maximin Criterion - pessimistic or conservative approach.

Minimax Regret Criterion - pessimistic or conservative approach.
Maximax Criterion - optimistic or aggressive approach.
Principle of Insufficient Reasoning no information about the
likelihood of the various states of nature.
10

Decision Making Under Uncertainty The Maximin Criterion

This criterion is based on the worst-case scenario.
It fits both a pessimistic and a conservative decision
makers styles.

11

TOM BROWN - The Maximin Criterion

Th
eo
The
TheMaximin
MaximinCriterion
Criterion ptim
al Large
Decisions
Large
Decisions
LargeRise
Rise Small
Smallrise
rise No
NoChange
Change Small
SmallFall
Fall
Fall
de LargeFall
-100
100
200
300
Gold
-100
100
200
300 cisio 00
Gold
n
250
200
150
-100
-150
Bond
250
200
150
-100
-150
Bond
500
250
100
-200
-600
Stock
500
250
100
-200
-600
Stock
60
60
60
60
60
C/D
60
60
60
60
60
C/Daccount
account

Minimum
Minimum
Payoff
Payoff

-100
-100
-150
-150
-600
-600
60
60

12

Decision Making Under Uncertainty The Minimax Regret Criterion

13

Decision Making Under Uncertainty The Minimax Regret Criterion

The Minimax Regret Criterion

This criterion fits both a pessimistic and a

conservative decision maker approach.
The payoff table is based on lost opportunity, or
regret.
The decision maker incurs regret by failing to choose
the best decision.
14

Decision Making Under Uncertainty The Minimax Regret Criterion

The Minimax Regret Criterion
To find an optimal decision, for each state of nature:
Determine the best payoff over all decisions.
Calculate the regret for each decision alternative as the
difference between its payoff value and this best payoff value.

For each decision find the maximum regret over all

states of nature.
Select the decision alternative that has the minimum of
these maximum regrets.
15

Investing in Stock generates no

regret when the market exhibits
a large rise

TOM BROWN Regret Table

The
ThePayoff
PayoffTable
Table

Decision
Decision Large
Largerise
rise Small
Smallrise
rise No
Nochange
changeSmall
Smallfall
fall Large
Largefall
fall
-100
100
200
300
00
Gold
-100
100
200
300
Gold
250
200
150
-100
-150
Bond
250
200
150
-100
-150
Bond
500
250
100
-200
-600
Stock
500
250
100
-200
-600
Stock
60
60
60
60
60
C/D
60
60
60
60
60
C/D

The
TheRegret
RegretTable
Table
Decision
Decision Large
Largerise
riseSmall
Smallrise
riseNo
Nochange
changeSmall
Smallfall
fall Large
Largefall
fall
600
150
00
00
60
Gold
600
150
60
Gold
Let
us
build
the
Regret
Table
250
50
50
400
210
Bond
250
50
50
400
210
Bond
00
00
100
500
660
Stock
100
500
660
Stock
16
440
190
140
240
0
C/D
440
190
140
240
0
C/D

TOM BROWN Regret Table

The
ThePayoff
PayoffTable
Table

Decision
Decision Large
Largerise
rise Small
Smallrise
rise No
Nochange
changeSmall
Smallfall
fall Large
Largefall
fall
-100
100
300
00
Gold
-100
100
300 a regret
Gold
Investing 200
in200
gold generates
250
200
150
-100
-150
Bond
250
200
150 the market
-100 exhibits
-150
Bond
of 600 when
500
250
100
-200
-600
Stock
Th rise
500
250
100
-200
-600
Stock
a large
e
60
60
60
60
C/D
op 60
60
60
60
60
60
C/D

500 (-100) = 600

tim
al
de
cis
ion

The
Maximum
TheRegret
RegretTable
Table
Maximum
Decision
Decision Large
Largerise
rise Small
Smallrise
riseNo
Nochange
change Small
Smallfall
fall Large
Largefall
fall Regret
Regret
600
150
00
00
60
600
Gold
600
150
60
600
Gold
250
50
50
400
210
400
Bond
250
50
50
400
210
400
Bond
00
00
100
500
660
660
Stock
100
500
660
660
Stock
17
440
190
140
240
00
440
C/D
440
190
140
240
440
C/D

Decision Making Under Uncertainty The Maximax Criterion

This criterion is based on the best possible scenario.
It fits both an optimistic and an aggressive decision maker.
An optimistic decision maker believes that the best possible
outcome will always take place regardless of the decision
made.
An aggressive decision maker looks for the decision with the
highest payoff (when payoff is profit).
18

Decision Making Under Uncertainty The Maximax Criterion

To find an optimal decision.
Find the maximum payoff for each decision
alternative.
Select the decision alternative that has the maximum
of the maximum payoff.

19

TOM BROWN - The Maximax Criterion

Th
eo
pti
m

al
The Maximax Criterion
Maximum
de
Decision Large rise Small rise No change Small fall Largecisfall Payoff
-100
100
200
300
0 ion
300
Gold
250
200
150
-100
-150
200
Bond
500
250
100
-200
-600
500
Stock
60
60
60
60
60
60
C/D

20

Decision Making Under Uncertainty The Principle of Insufficient Reason

This criterion might appeal to a decision maker who
is neither pessimistic nor optimistic.
It assumes all the states of nature are equally likely to
occur.
The procedure to find an optimal decision.
For each decision add all the payoffs.
Select the decision with the largest sum (for profits).
21

TOM BROWN - Insufficient Reason

Sum of Payoffs

Gold
Bond
Stock
C/D

600 Dollars
350 Dollars
50 Dollars
300 Dollars

Based on this criterion the optimal decision

alternative is to invest in gold.
22

Decision Making Under Risk

The probability estimate for the occurrence of
each state of nature (if available) can be
incorporated in the search for the optimal
decision.
For each decision calculate its expected payoff.

23

Decision Making Under Risk

The Expected Value Criterion
For each decision calculate the expected payoff
as follows:
Expected
Expected Payoff
Payoff == (Probability)(Payoff)
(Probability)(Payoff)
(The summation is calculated across all the states of nature)

Select the decision with the best expected payoff

24

TOM BROWN - The Expected Value Criterion

The

Decision
Gold
Bond
Stock
C/D
Prior Prob.

opt
ima
The Expected Value Criterion l deci
sion

Expected
Value
Large rise Small rise No change Small fall Large fall

-100
250
500
60
0.2

100
200
250
60
0.3

200
150
100
60
0.3

300
-100
-200
60
0.1

0
-150
-600
60
0.1

100
130
125
60

EV = (0.2)(250) + (0.3)(200) + (0.3)(150) + (0.1)(-100) + (0.1)(-150) = 130

25

When to use the expected value

approach
The expected value criterion is useful generally
in two cases:
Long run planning is appropriate, and decision
situations repeat themselves.
The decision maker is risk neutral.

26

Expected Regret Criterion

Expected Regret Approach
1. Determine the best value (maximum payoff or minimum cost) for each
states of nature
2. For each state of nature, the regret corresponding to a decision
alternative is the difference between its payoff value and this best value.
3. Find the expected regret for each decision alternative
4. Select the decision alternative that has the maximum expected regret.

27

Applications-6.3
National foods has developed a new sports beverage it would like to advertise on
Super Bowl Sunday. Nationals advertising agency can purchase either one, two.or
three 30 second commercials advertising the drink. It estimates that the return will be
based on super Bowl viewer ship, which in turn based on fans perception on whether
the game is dull, average, above average, or exciting.
National foods ad agency has constructed the following payoff table giving its
estimate of the expected profit (in $100,000s ) returning from purchasing one, two or
three advertising spots. (Another possible decision is for National foods not to
advertise at all during the Super Bowl). The States of nature of the game being dull,
average, above average or exciting.

28

_____________________________________________________________________
Number of 30

Perceived Game Excitement

Sec. Commercials

______________________________________

Purchased

Dull

Average

Above

exciting

average
______________________________________________________________________
One

-2

13

Two

-5

12

18

Three

-9

13

22

_______________________________________________________________________
a.

What is the optimal decision if the national foods ad manager is optimistic

b.

What is the optimal decision if the national Foods advertising manager is

pessimistic

c.

What is the optimal decision if the National Foods ad manager wishes the minimize
29
the firms minimum regret?

Consider the data given in problem 3 for national Foods. Based on passed super bowl
games, suppose the Decision maker believes that the following probabilities hold
for the states of nature.
P(Dull Game)=0.20
P(Average Game)=.40
P(Above Average game)=.30
P(exciting)=0.10
a.

Using the expected value criterion, determine how many commercials National
Foods should purchase?

b.

Based on the probabilities given here, determine the expected value of perfect
information.

30

6.4 Expected Value of Perfect Information

The gain in expected return obtained from knowing
with certainty the future state of nature is called:

Expected Value of Perfect Information

(EVPI)

31

Expected Value of Perfect Information

Expected

value
of
Perfect

Information

Expected return with

Expected return without

perfect
informatio
n
as

to which state of nature additional information as
to which state of nature

will occur prior to

making decision
will occur prior to making

decision

32

TOM BROWN - EVPI

If it were known with certainty that there will be a Large Rise in the market
Decision
Gold
Bond
Stock
C/D
Probab.

Stock

The
Expected Value of Perfect Information
-100

Large rise
Large
rise
250-100

Small rise

250
500
60
60 0.2

500

100
200
250
60
0.3

No change

200
150
100
60
0.3

Small fall

300
-100
-200
60
0.1

Large fall

0
-150
-600
60
0.1

... the optimal decision would be to invest in...

Similarly,

33

TOM BROWN - EVPI

Decision
Gold
Bond
Stock
C/D
Probab.

The Expected Value of Perfect Information

-100
-100
250

Large rise

250
500
60
600.2

500

Small rise

100
200
250
60
0.3

No change

200
150
100
60
0.3

Small fall

Large fall

300
-100
-200
60
0.1

0
-150
-600
60
0.1

Expected Return with Perfect information =

ERPI = 0.2(500)+0.3(250)+0.3(200)+0.1(300)+0.1(60) = $271
Expected Return without additional information =
Expected Return of the EV criterion = $130

EVPI = ERPI - EREV = $271 - $130 = $141

34

6.5 Bayesian Analysis - Decision Making

with Imperfect Information
Bayesian Statistics play a role in assessing
additional information obtained from various
sources.
This additional information may assist in refining
original probability estimates, and help improve
decision making.
35

Tom Brown Investment Decision (Continued)

Tom has learned that, for only $50, he can receive the results of noted
economist Milton Samuelmans multimillion dollar economic
forecast, which predicts either positive or negative economic
growth for the upcoming year. Samuelman has offered the following
variable statistics regarding the results of his model:
1. When the stock market showed the large rise, the forecast predicted
positive 80% of the time and negative 20% of the time.
2. When the stock market showed a small rise, the forecast predicted
positive 70% of the time and negative 30% of the time.
3. When the stock market showed no change , the forecast was equally
likely to predict positive or negative.
4. When the stock market showed a small fall, the forecast predicted
positive 40% of the time and negative 60% of the time.
36

5. When the stock market showed a large fall, the forecast always

Predicted negative
Tom would like to know whether it is worthwhile to pay $50 for the
result of the Samuelman forecast.

37

TOM BROWN Solution

Using Sample Information
If the expected gain resulting from the decisions made
with the forecast exceeds $50, Tom should purchase
the forecast.
The expected gain =
Expected payoff with forecast EREV
To find Expected payoff with forecast Tom should
determine what to do when:
The forecast is positive growth,
The forecast is negative growth.
38

Conditional Probabilities
P(forecast predictspositive/large rise in the market)=0.80
P(forecast predicts negative/large rise in the market)=0.20
P(forecast predicts positive/ small rise in the market)=0.70
P(forecast predicts negative/small rise in the market)=0.30
P(forecast predicts positive/ no change in the market)=0.50
P(forecast predicts negative/ no change in the market) =0.50
P (forecast predicts positive/ small fall in the market)=0.40
P(forecast predicts negative / small fall in the market)=0.60
P(forecast predicts positive/ large fall in the market)=0

39

TOM BROWN Solution

Using Sample Information
Tom needs to know the following probabilities

P(Large rise | The forecast predicted Positive)

P(Small rise | The forecast predicted Positive)
P(No change | The forecast predicted Positive )
P(Small fall | The forecast predicted Positive)
P(Large Fall | The forecast predicted Positive)
P(Large rise | The forecast predicted Negative )
P(Small rise | The forecast predicted Negative)
P(No change | The forecast predicted Negative)
P(Small fall | The forecast predicted Negative)
P(Large Fall) | The forecast predicted Negative)

40

TOM BROWN Solution

Bayes Theorem
Bayes Theorem provides a procedure to calculate
these probabilities
P(Ai|B) =

P(B|Ai)P(Ai)
P(B|A1)P(A1)+ P(B|A2)P(A2)++ P(B|An)P(An)

Posterior Probabilities
Probabilities determined
after the additional info
becomes available.

Prior probabilities
Probability estimates
determined based on
current info, before the
41
new info becomes available.

Posterior Probability Positive

Forecast for Tom Brown
States of nature

Prior
Probability
P(Si)

Conditional
Joint Probability
Probability
P(positive Si)
P(positive/Si)

P(Si/positive)

LS

0.20

0.80

0.16

0.286

SR

0.30

0.70

0.21

0.375

NC

0.30

0.50

0.15

0.268

SF

0.10

0.40

0.04

0.071

LF

0.10

Total

Si

0.56

P(positive)=0.56

42

Posterior Probability: negative

forecast for Tom Brown
States of nature Si

Prior probability Condl Probability

P(si)
P(negative/Si)

Joint Probability
P(negative
Si)

P(si/ negative)

LS

0.20

0.20

0.04

0.091

SR

0.30

0.30

0.09

0.205

NC

0.30

0.50

0.15

0.341

SF

0.10

0.60

0.06

0.136

LF

0.10

1.00

0.10

0.227

Total

0.44

43

Expected value of sample informtion

If the Samuelmans Forecast is positive economic growth, the revised expected values for the
decision alternatives (rounded to the nearest dollar) are
EV(gold/positive)=$84
EV(Bond/Positive)=$180
EV(Stock/Positive)=$249
EV(C/D/Positive)=$60
Decision: So if the samuelmans forecast is positive then buying the stock would be optimal.

44

Samuelmans forecast is negative

The expected returns are
EV(Gold/ negative)=$120
EV( Bond/ negative )=$67
EV (Stock/ negative)=-$33
EV(C/D/ Negative)=$60

45

Expected value of sample Information

Expected return
Expected Value

Expected return

of Sample Information

without sample

with sample information

information

EVSI ERSI - EREV

46

Decision
ERSI=.56(249.11)+.44(130.45)=$192.50
EREV=$130
EVSI=$192.50-130=$62.50
Decision: Tom should acquire it

47

Extension of Application 6.3

Consider the data given in problems 3 and 4 for National Foods. The firm can hire the
noted sports pundit Jim Worden to give his opinion as to whether or not the Super Bowl
game will be interesting. Suppose the following probabilities holds for Jims
predictions.
P(Jim Predicts game will be interesting /game is dull)=.15,
P(Jim predicts game will be interesting / game is average).25
P(Jim predicts game will be interesting / game is above average)=.50,
P(Jim predicts game will be interesting / game is exciting)=.80,
P(Jim predicts game will not be interesting / game is Dull)= .85
P(Jim predicts game will not be interesting / game is average)= .75
P(Jim predicts game will not be interesting / game is above average)=.50,

48

Questions
a. If Jim predicts the game will be interesting what is the probability
that the game will be dull.
b. What is the Nationals optimal strategy if Jim predicts the game will
be (I) interesting (ii) Not interesting
c. What is the expected value of Jims information.

49

TOM BROWN Conditional Expected Values

The revised expected values for each decision:
Positive forecast

Negative forecast

EV(Gold|Positive) = 84
EV(Bond|Positive) = 180
EV(Stock|Positive) = 250
EV(C/D|Positive) = 60

EV(Gold|Negative) = 120
EV(Bond|Negative) = 65
EV(Stock|Negative) = -37
EV(C/D|Negative) = 60

If the forecast is Positive If the forecast is Negative

Invest in Stock.
Invest in Gold.
50

TOM BROWN Conditional Expected Values

Since the forecast is unknown before it is
purchased, Tom can only calculate the expected
return from purchasing it.
Expected return when buying the forecast = ERSI =
P(Forecast is positive)(EV(Stock|Forecast is positive)) +
P(Forecast is negative)(EV(Gold|Forecast is negative))
= (.56)(250) + (.44)(120) = $192.5

51

Expected Value of Sampling

Information (EVSI)
The expected gain from buying the forecast is:
EVSI = ERSI EREV = 192.5 130 = $62.5
Tom should purchase the forecast. His expected
gain is greater than the forecast cost.
Efficiency = EVSI / EVPI = 63 / 141 = 0.45
52

6.6 Decision Trees

The Payoff Table approach is useful for a nonsequential or single stage.
Many real-world decision problems consists of a
sequence of dependent decisions.
Decision Trees are useful in analyzing multistage decision processes.
53

Characteristics of a decision tree

A Decision Tree is a chronological representation of the
decision process.
The tree is composed of nodes and branches.

Decision
n1
o
i
s
node Deci t 1

Cos
Dec
isio
C os n 2
t2

Chance (S 1)
P
node

P(S2)

P(S
)
3

A branch emanating from a

decision node corresponds to a
decision alternative. It includes a
cost or benefit value.

)
P(S 1 A branch emanating from a state of
P(S2) nature (chance) node corresponds to a
P(S particular state of nature, and includes
3)
the probability of this state of nature.
54

Bill Galen Development Company

The Bill Galen Development Company (BGD) needs a variance from the city
of Kingston, NewYork, in order to do commercial development on a property
whose asking price is a firm $300,000 BGD estimates that it can construct a
shopping center for an additional $500,000 and cell the completed center for
approximately $950,000.
A variance application cost $300,000 in fees and expenses, and there is only
a 40% chance that the variance will be approved. Regardless of the outcome,
the variance process takes two months. If BGD purchases the property and
the variance is denied, the company will sell the property and receive net
proceeds of $260,000. If BGD can also purchase a three month option on the
property for $20,000, which would allow it to apply for a variance. Finally, for
$5000 an urban planning consultant can be hired to study the situation and
render an option as to whether the variance will be approved or denied. BGD
estimates the following conditional probabilities for the consultants opinion.
55

P(consultant predicts approval/approval granted)=0.70

P(consultant predicts denial/approval denied)=0.80
BGD wishes to determine the optimal strategy regarding this parcel of
property.

56

BILL GALLEN - Solution

Construction of the Decision Tree
Initially the company faces a decision about hiring the
consultant.
After this decision is made more decisions follow regarding
Application for the variance.
Purchasing the option.
Purchasing the property.
57

BILL GALLEN - The Decision Tree

n
lu ta

ns
o
c
ih re t = 0
ot
os
n
C
o

Hir
ec
on
su
Co
lt
st
= - ant
50
00

ing
h
t
o
Do n 0
Buy land
-300,000
Pu
rc h
ase
-20
op
,00
tion
0

Le
to t us
no co
t h ns
ire ide
a c r th
on e d
su ec
lta is
nt i on

0
3

Apply for variance

-30,000

Apply for variance

-30,000

58

BILL GALLEN - The Decision Tree

Buy land and
apply for variance
ved
o
r
App .4
0
Den
ied
0.6

12

ove
r
p
Ap
0.4
Den
ied

Build
-500,000

-300000 30000 500000 + 950000 = 120,000

Sell
950,000

Buy land

-300000 30000 + 260000 = -70,000

Sell
260,000
Build
Sell

-300,000

-500,000

950,000

100,000

0.6

Purchase option and

apply for variance

-50,000
59

BILL GALLEN - The Decision Tree

0

Buy land and

apply for variance

Buy land
-300,000

Build
-500,000

-300000 30000 500000 + 950000 = 120,000

Sell
950,000

Buy land

-300000 30000 + 260000 = -70,000

Sell
260,000
Build
Sell

-300,000

-500,000

Apply for variance

-30,000

950,000

100,000

Apply 12
for variance
-30,000
Purchase option and
apply for variance

-50,000
61

This is where we are at this stage

60

Let us consider the decision to hire a consultant

60

ant
t
l
u
s
con
e
r
i
h
ot
Do n
0
Hir
e

Do

ict al
d
e v
Pr pro
Ap

0.4

co
n
-50 sulta
nt
00

Done

-5000

g
thin
o
N

Buy land
-300,000
Pu r
ch a
se o
ptio
-20,
n
000

Apply for variance

-30,000
Apply for variance
-30,000

t
dic
Pre nial
De

0.6

Let us consider the

decision to hire a
consultant

BILL GALLEN
The Decision Tree

othin
N
o
D

Buy land
-300,000
Purc
hase
optio
-20,0
n
00

-5000
Apply for variance
-30,000

Apply for variance

-30,000
61

BILL GALLEN - The Decision Tree

Build
-500,000

ved
o
r
App
?
Den
ied

Sell
260,000

?
Co
ns
ult
an

tp

Sell
950,000

r ed

icts

an

ap
p ro

115,000

-75,000

va
l
62

BILL GALLEN - The Decision Tree

ved
o
r
App
?
Den
ied

Build
-500,000

Sell
950,000

Sell
260,000

115,000

-75,000

The consultant serves as a source for additional information

about denial or approval of the variance.

63

BILL GALLEN - The Decision Tree

ved
o
r
App
?
Den
ied

Build
-500,000

Sell
950,000

Sell
260,000

115,000

-75,000

Therefore, at this point we need to calculate the

posterior probabilities for the approval and denial
of the variance application
64

BILL GALLEN - The Decision Tree

22

ved
o
r
App
?
Den .7
ied

?
.3

23

26

Build
-500,000

24

Sell
950,000

Sell
260,000

115,000

25

-75,000

27

Posterior Probability of (approval | consultant predicts approval) = 0.70

Posterior Probability of (denial | consultant predicts approval) = 0.30

The rest of the Decision Tree is built in a similar manner.

65

The Decision Tree

Determining the Optimal Strategy
Work backward from the end of each branch.
At a state of nature node, calculate the expected value
of the node.
At a decision node, the branch that has the highest
ending node value represents the optimal decision.

66

BILL GALLEN - The Decision Tree

Determining the Optimal Strategy
00
5
0
)=8 00
7
.
)(0 805
0
0
,0 500
5
1
(1 0800
805
ved
o
r
p
58,000 Ap
0.70
?
D
22
enie
-22
d
50
0
(-7 -225 0.30
5,0 00 ?
00
)(0 -22
.3) 500
=22
50
0

115,000

23
-75,000

26

115,000
Build
-500,000
-75,000

115,000

115,000

24

Sell
950,000

-75,000

-75,000

Sell
260,000

With 58,000 as the chance node value,

we continue backward to evaluate
the previous nodes.

115,000

115,000
115,000

25
-75,000

-75,000
-75,000

27

67

BILL GALLEN - The Decision Tree

Determining the Optimal Strategy
$115,000
Build,
Sell

$10,000

Hi
re $20,000

App
r

ove
d

t
o
$20,000 Do n
e
r
i
h

$58,000
icts
d
e
r
P

Buy land; Apply

for variance

val
o
r
p
ap

.4

icts
den
ial

.6

ied
Den

Pre
d

.7

$-5,000

.3
Sell
land

Do nothing

$-75,000
68

BILL GALLEN - The Decision Tree

Excel add-in: Tree Plan

69

BILL GALLEN - The Decision Tree

Excel add-in: Tree Plan

70

71