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# Decision Tree

## Choice of the Best Alternative

Manahan Siallagan
Problems of Choice

C1 O1
D
C2 O2

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

## The information and insight

needed to predict the I can’t 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

3
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
person’s perception of a problem to other individuals.

5
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
6
Structure of Decision Tree
 Decision Node
 Alternatives available for decision maker to choose;
 Situation controllable by decision maker.

Alternatives of actions
7
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

8 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.

9
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. Max’s friends refer to him affectionately as
a wildcatter. However he prefers to think himself as an entrepreneur. He has poured
his life saving’s 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 doesn’t 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
geologist’s 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 Goferbroke’s Case
 Decision:
 Drill or Sell the Land
 SON
 Oil or Dry

## Decision nodes Drill

-100

Sell

90
DT of Goferbroke’s Case
 Event nodes

Oil 0.25
800
Drill

## -100 Dry 0,75

0
Sell

90
DT of Goferbroke’s Case
 Payoff

Oil 0.25
700
800
Drill

## -100 Dry 0,75

-100
0
Sell
90
90
DT of Goferbroke’s 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

23
Process in Revising Decision tree
Prior probability

New information

Posterior probability

24
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

## number of outcomes satisfying A and B

P( A and B) 
total number of elementary outcomes

## 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

## 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.

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)
Goferbroke’s 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
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 Max’s
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│USS)
Oil
P(FSS│Oil) = 0,6 Drill

## P(USS│Oil) = 0,4 P(Dry│USS)

P(USS) Dry
Unfavorable
P(FSS│Dry) = 0,2
1
P(USS│Dry) = 0,8
Sell

Do Survey
P(Oil│FSS)
Oil

Drill

P(Dry│FSS)
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 (cont’d)
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

P(FSS) 0.3
0.3 0.7

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

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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

670

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) = Max’s 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

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

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
Thank You

47
Exercise
 Von Holt was a general marketing manager. He was assigned to assess the prospect of a
new product to be manufactured. The approximately production cost was USD 90,000.
If it had been sold out then it would gain revenue USD 500,000. In other side, if he
didn’t decide to produce then the company would loss nothing. Based on his experience,
he knew that 0.2 was the probability that the market would accept the product. Even
though, he wasn’t sure whether it represented the current data. He had another option
to run market research and collect the last information, but it took investments as
many as USD 10,000. Again, based on experience, he had known that if the customer
accepted the product then the survey would exhibit that the result was favorable with
probability 0.6. However, the probability would reduce to 0.1, if the customer rejected.
 Now, help Holt to decide the best strategy! …. and … don’t forget to :
 Draw the tree diagram.
 Show us how did you get the probability…