PAN African e Network Project

DBM
Quantitative Techniques in Management

Semester - 1
Session - 7

Dr. Sarika Jain

STATISTICAL DECISION
THEORY

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.

Introduction to Decision
Analysis

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
Payoff table analysis can be applied when:
There is a finite set of discrete decision alternatives.
The outcome of a decision is a function of a single future event.

In a Payoff table The rows correspond to the possible decision alternatives.

The columns correspond to the possible future events.
Events (states of nature) are mutually exclusive and collectively
exhaustive.
The table entries are the payoffs.

TOM BROWN INVESTMENT

DECISION
Tom Brown has inherited $1000.
He has to decide how to invest the money
for one year.
A broker has suggested five potential
investments.

Gold
Junk Bond
Growth Stock
Certificate of Deposit
Stock Option Hedge

TOM BROWN
The return on each investment depends
on the (uncertain) market behavior during
the year.
Tom would build a payoff table to help
make the investment decision

TOM BROWN - Solution

Construct a payoff table.
Select a decision making criterion,
and apply it to the payoff table.
Identify the optimal decision.
Evaluate the
solution.

S1 S2 S3 S4
D1 p11 p12 p13 p14
D2 p21 p22 p23 P24
D3 p31 p32 p33 p34

Criterion

P1
P2
P3

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
-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

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

The stock option alternative is

dominated by the bond alternative

Decision Making Criteria

Classifying decision-making criteria
Decision making under certainty.
The future state-of-nature is assumed known.

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.

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.

Decision Making Under

Uncertainty - The Maximin
Criterion

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.
A pessimistic decision maker believes that the worst
possible result will always occur.
A conservative decision maker wishes to ensure a
guaranteed minimum possible payoff.

TOM BROWN - The Maximin

Criterion
To find an optimal decision
Record the minimum payoff across all states of nature for
each decision.
Identify the decision with the maximum minimum payoff.

-100
-100
250
250
500
500
60
60

100
100
200
200
250
250
60
60

200
200
150
150
100
100
60
60

300
300
-100
-100
-200
-200
60
60

00
-150
-150
-600
-600
60
60

Minimum
Minimum
Payoff
Payoff

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

e
o
pt
i
m
al
d
ec
i
s
ion

Decisions
Decisions
Gold
Gold
Bond
Bond
Stock
Stock
C/D
C/Daccount
account

The
TheMaximin
MaximinCriterion
Criterion
Large
LargeRise
Rise Small
Smallrise
rise No
NoChange
Change Small
SmallFall
Fall Large
LargeFall
Fall

Decision Making Under

Uncertainty - The Minimax
Regret Criterion

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.

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.

TOM BROWN Regret Table

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 Let us build
60
Gold
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
440
190
140
240
00
C/D
440
190
140
240
C/D

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
Gold
Investing in
gold generates
-100
100
200
300 a regret00of
Gold
250
200
150
-100
Bond
250
200 600 when
150the market
-100exhibits-150
-150
Bond
a
large
rise
500
250
100
-600
Stock
500
250
100 The -200
-200
-600
Stock
op 60
60
60
60
60
C/D
60
60
60
60
C/D
ti 60
500 (-100) = 600

al
de
ci s

io
The
Maximum
n
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
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).

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.

TOM BROWN - The Maximax

Criterion
Th
e

op
tim

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

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).

TOM BROWN - Insufficient Reason

Sum of Payoffs
Gold 600 Dollars
Bond 350 Dollars
Stock 50 Dollars
C/D 300 Dollars

Based on this criterion the optimal

decision alternative is to invest in gold.

NEW PRODUCT Example. A firm is

considering a final GO decision on a new
product. If the product is introduced and it
is successful, the profit is $500,000 and if it
is unsuccessful the loss is $300,000. There
is no profit or loss if the product is not
introduced. The management believes that
there is a 0.20 probability (the odds are 2 to
8) that the product will be successful.

(i)
Based on the above information and under a variety of other criteria
(like maxmin, minmax etc), should the firm introduce the product?
(ii)
A consulting firm specializing in new product introduction has offered
its services to firm. Its betting average in similar situations is as follows.
(i) When advice was given (either by client firm or by others in the
market place) on products that later proved to be successful, then firm gave
GO advice eight times out of ten.
(ii) When advice was given (either by client firm or by others in the
market place) on products that later proved to be unsuccessful, then firm
gave STOP advice fifteen times out of twenty.

The Firm charges $5,000 as consulting

fee to give advice. Should the firm be
hired in order to maximize the expected
profit?

PAY-OFF TABLE-1

PAY-OFF TABLE-1

EVENTS OR STATES OF NATURE

ACTIONS

Successful

Unsuccessful

GO

$500

STOP

$0

.2

.8

Prior Probs.

-300

DIFFERENT DECISION MAKING CRITERIA without using Probability

Maxi-max Criterion (Optimistic View): In the maximax criterion the decision
maker selects the decision that will result in the maximum of maximum
payoffs; an optimistic criterion.

For each action choose max. profit.

Choose the action which has the max. of these max. profits.

PAY-OFF TABLE-2
EVENTS OR STATES OF NATURE
ACTIONS
Successful
Unsuccessful
MV
GO
$500
-300
$500
STOP
$0
0
$ 0
Answer: Max-max Action = Go, Optimal Profit = $500,000
For Go Max payoff is $500
For Stop max payoff is $0
Maximum of these above
mentioned maximum values is
$500 so choice is GO decision

2. Min-max Criterion (Pessimists View): Always expecting

the worst, the decision makers judgement work as follows:

For each action choose min. profit.

Choose the action which has the max. of

these min. profits.

PAY-OFF TABLE-3

For Go Max payoff is $500

For Stop max payoff is $0
Minimum of these above mentioned maximum values is $0
so choice is Stop decision

3. Maxi-min Criterion (Optimistic View): In the

maximin criterion the decision maker selects the
decision that will reflect the maximum of the minimum
payoffs; a pessimistic criterion.
For each action choose min. profit.
Choose the action which has the max. of these
min .profits.

For Go Min payoff is - $300

For Stop min payoff is $0
Maximum of these above mentioned
maximum values is $0 so choice is Stop
decision

Mini Max regret criterion: Regret is the

difference between the payoff from the best
decision and all other decision payoffs.
The decision maker attempts to avoid
regret by selecting the decision alternative
that minimizes the maximum regret

Payoff table 5

EVENTS OR STATES OF NATURE

ACTIONS

Successful

GO

$500

STOP

$0

Unsuccessful
-300
0

ACTIONS
GO
$300
STOP

EVENTS OR STATES OF NATURE

Successful
Unsuccessful
$500- $500 =0

$0 - -300 =

$500 - $0 = $500

$0 -$ 0 = $0

Maximum Regret for Go decision is $300

Maximum regret for stop decision is $500 so
We minimize the maximum regret and choose Go

The equal likelihood ( or Laplace) criterion multiplies the decision

payoff for each state of nature by an equal weight, thus assuming that the
states of nature are equally likely to occur.
Decision
Values
Go
$500(.5) - 300(.5) = 100
Stop
$0(.5) + 0$(.5) = 0

The Hurwicz criterion is a compromise between the maximax and

maximin criterion.
A coefficient of optimism, , is a measure of the decision makers
optimism.
The Hurwicz criterion multiplies the best payoff by and the worst payoff
by 1- ., for each decision, and the best result is selected. For alpha
value of 0.4 calculations are performed here.
Decision
Values
Go
$500(.4) - 300(.6) = $20
Stop
$0(.4) - 0(.6) = $0

Practice Problem.

Find the optimal act using Maxi-Max criteria

Find the optimal act using Mini-Max criteria
Find the optimal act using Maxi-Min criteria
Find the optimal act using Min-Max regret table
The equal likelihood ( or Laplace) criterion
The Hurwicz criterion with alpha value of 0.4

Solution to practice problem

Criterion
(Purchase)
Maximax (100000)
Maximin (30000)
building
Minimax regret (50000)
building
Hurwicz(38000)
building
Equal likelihood (40000)
building

Decision
Office building
Apartment
Apartment
Apartment
Apartment

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.

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

TOM BROWN - The Expected Value

Criterion
Th

Decision
Gold
Bond
Stock
C/D
Prior Prob.

eo

ptim

al d
Criterion ecisio
n

Expected
The Expected Value
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

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

100
130
125
60

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.

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)

TOM BROWN - EVPI

If it were known with certainty that there will be a Large Rise in the market

The-100
Expected Value of Perfect Information
Large
Decision Large rise
rise Small rise No change Small fall
Large fall
250
Gold
-100
100
200
300
0
Bond
Stock
C/D
Probab.

Stock

250
500
60
600.2

500

200
250
60
0.3

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

Similarly,

150
100
60
0.3

-100
-200
60
0.1

-150
-600
60
0.1

TOM BROWN - EVPI

Decision
Gold
Bond
Stock
C/D
Probab.

The-100
Expected Value of Perfect Information

Large rise

250
-100
250
500
60
600.2

500

Small rise

100
200
250
60
0.3

No change

Small fall

200
150
100
60
0.3

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

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.

TOM BROWN Using Sample

Information
Tom can purchase econometric forecast
results for $50.
The forecast predicts negative or
positive
Should
Tomeconometric
purchasegrowth.
the Forecast
Statistics regarding the forecast are:

When the stock market showed a...

The Forecast
predicted

Large Rise Small Rise No Change

Positive econ. growth

Negative econ. growth

80%
20%

70%
30%

50%
50%

Small Fall

40%
60%

When the stock market showed a large rise the

Forecast predicted a positive growth 80% of the time.

Large Fall

0%
100%

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.

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)

TOM BROWN Solution

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

P(B Ai)P(Ai)

Posterior Probabilities
Probabilities determined
after the additional info
becomes available.

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

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

TOM BROWN Solution

Bayes Theorem

The tabular approach to calculating posterior

probabilities for positive economical forecast
States of

Nature
Large Rise
Small Rise
No Change
Small Fall
Large Fall

Prior
Prob.

0.2
0.3
0.3
0.1
0.1

Prob.
(State|Positive)
X

0.8
0.7
0.5
0.4
0

Joint
Prob.

0.16
0.21
0.15
0.04
0

The Probability that the

forecast is positive and the
stock market shows Large

Posterior
Prob.

0.286
0.375
0.268
0.071
0.000

TOM BROWN Solution

Bayes Theorem

The tabular approach to calculating posterior

probabilities for positive economical forecast
States of

Nature
Large Rise
Small Rise
No Change
Small Fall
Large Fall

Prior
Prob.

0.2
0.3
0.3
0.1
0.1

Prob.
(State|Positive)
X

0.8
0.7
0.5
0.4
0

Joint
Prob.

0.16
0.21
0.15
0.04
0

Posterior
Prob.

0.286
0.375
0.268
0.071
0.000

The probability that the stock market

shows Large Rise given that
the forecast is positive

0.16
0.56

TOM BROWN Solution

Bayes Theorem
The tabular approach to calculating posterior
probabilities for positive economical forecast
States of

Nature
Large Rise
Small Rise
No Change
Small Fall
Large Fall

Prior
Prob.

0.2
0.3
0.3
0.1
0.1

Prob.
(State|Positive)

Joint
Prob.

0.8 = 0.16
0.7
0.21
Observe the revision in
0.5
0.15
the prior probabilities
0.4
0.04
0
0

Posterior
Prob.

0.286
0.375
0.268
0.071
0.000

Probability(Forecast = positive) = .56

TOM BROWN Solution

Bayes Theorem
The tabular approach to calculating posterior
probabilities for negative economical forecast
States of

Nature
Large Rise
Small Rise
No Change
Small Fall
Large Fall

Prior
Prob.

0.2
0.3
0.3
0.1
0.1

Prob.
Joint
(State|negative) Probab.

0.2
0.3
0.5
0.6
1

0.04
0.09
0.15
0.06
0.1

Posterior
Probab.

0.091
0.205
0.341
0.136
0.227

Probability(Forecast = negative) = .44

Expected Value of Sample Information

EVSI
This is the expected gain from making
decisions based on Sample Information.
Revise the expected return for each
decision using the posterior probabilities
as follows:

TOM BROWN Conditional Expected

Values
Decision
Gold
Bond
Stock
C/D
P(State|Positive)
P(State|negative)

The revised probabilities payoff table

Large rise Small rise No change Small fall Large fall

-100
250
500
60
0.286
0.091

100
200
250
60
0.375
0.205

200
150
100
60
0.268
0.341

300
-100
-200
60
0.071
0.136

EV(Invest in.
GOLD Positive forecast) =
=.286(-100 )+.375(100 )+.268( 200 )+.071(300 )+0( 0

) =

$84

EV(Invest in .
GOLD Negative forecast) =
=.091(-100 )+.205( 100 )+.341(200 )+.136(
)+.227( 0 ) =
$120
300

0
-150
-600
60
0
0.227

TOM BROWN Conditional Expected

Values

The revised expected values for each decision:

Positive forecast
Negative forecast
EV(Gold|Positive) = 84
EV(Gold|Negative) = 120
EV(Bond|Positive) = 180
EV(Bond|Negative) = 65
EV(Stock|Positive) = 250
EV(Stock|Negative) = -37
EV(C/D|Positive) = 60
EV(C/D|Negative) = 60

If the forecast is PositiveIf the forecast is Negative

Invest in Stock.
Invest in Gold.

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

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

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

Characteristics of a decision
tree

A Decision Tree is a chronological representation

of the decision process.
The tree is composed of nodes and branches.
Chance
node
Decision
node

n1
o
i
is
c
e
1
D
t
s
o
DeC
cis
Cos ion 2
t2

)
S
1
(
P
P(S2)

A branch emanating from a

decision node
corresponds to a decision
P(S
alternative. It includes a
)
3
cost or benefit value.
)
S
1
P(
A branch emanating from a state
P(S2)of nature (chance) node
P(S corresponds to a particular state
3 ) of nature, and includes the
probability of this state of nature.

BILL GALLEN DEVELOPMENT

COMPANY
BGD plans to do a commercial development on a property.
Relevant data
Asking price for the property is 300,000 dollars.
Construction cost is 500,000 dollars.
Selling price is approximated at 950,000 dollars.
Variance application costs 30,000 dollars in fees and expenses
There is only 40% chance that the variance will be approved.
If BGD purchases the property and the variance is denied, the
property can be sold for a net return of 260,000 dollars.
A three month option on the property costs 20,000 dollars, which
will allow BGD to apply for the variance.

BILL GALLEN DEVELOPMENT

COMPANY
A consultant can be hired for 5000 dollars.
The consultant will provide an opinion about the approval of the
application
P (Consultant predicts approval | approval granted) = 0.70
P (Consultant predicts denial | approval denied) = 0.80
BGD wishes to determine the optimal strategy
Hire/ not hire the consultant now,
Other decisions that follow sequentially.

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.

BILL GALLEN - The Decision Tree

nt
a
lt

su
n
co
e
0
ir
=
h
t
t
no Cos
o

Hi
re
c
Co ons
ult
st
an
=
t
-5
00
0

ing
h
t
no
Do
0
Buy land
-300,000
Pu
rch
as
-20
,00 e op
tio
0
n

Le
to t us
no c
t h on
ire sid
a er
co th
ns e d
ul ec
ta
nt isio
n

0
3

Apply for variance

-30,000

Apply for variance

-30,000

BILL GALLEN - The Decision Tree

120,000
Buy land and
apply for
variance ved
pr o
p
A
0.4
De
ni e
d
0.6
v ed

12

pro
p
A
0.4
De
nie
d
0.6

Purchase option
and
apply for variance

Build
-500,000

-300000 30000 500000 + 950000 =

Sell
950,000

Buy land

-70,000
-300000 30000 + 260000 =
Sell
260,000
Build
Sell

-300,000

-500,000

950,000
100,000

-50,000

BILL GALLEN - The Decision Tree

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

ltant
u
s
con
e
r
i
th
o
n
Do
0

co

-5 nsu
00
lta
0
nt

N
Do

ict al
d
e rov
r
P pp
A

0.
4

Hi
re

Done
ng
i
h
ot

Buy land
-300,000
Pur
cha
se
opt
-20
ion
,00
0

-5000

Apply for variance

-30,000
Apply for variance
-30,000

ict
ed
Pr nial
De

0.6

Let us consider the

decision to hire a
consultant

BILL GALLEN
The Decision Tree

ing
h
t
o
Do N

Buy land
-300,000
Pur
c ha
se o
ptio
-20
n
,000

-5000
Apply for variance
-30,000

Apply for variance

-30,000

BILL GALLEN - The Decision Tree

Build
-500,000

ed
v
o
pr
p
A
?
De
nie
d

Sell
260,000

Co

ns

ul t
an

Sell
950,000

tp

re

di c

ts
a

ap

pr
ov
al

115,000

-75,000

BILL GALLEN - The Decision Tree

ed
v
o
pr
p
A
?
De
nie
d

Build
-500,000

Sell
950,000

Sell
260,000

The consultant serves as a source for additional information

about denial or approval of the variance.

115,000

-75,000

BILL GALLEN - The Decision Tree

ed
v
o
pr
p
A
?
De
nie
d

Build
-500,000

Sell
950,000

Sell
260,000

Therefore, at this point we need to calculate the

posterior probabilities for the approval and denial
of the variance application

115,000

-75,000

BILL GALLEN - The Decision Tree

d
ove

22

23

pr
p
A
?
.7
De
nie
d

?
.3

26

Build
-500,000

24

Sell
950,000

Sell
260,000

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.

115,000
25

-75,000
27

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.

BILL GALLEN - The Decision Tree

Determining the Optimal Strategy
0
50
0
8
115,000
115,000 115,000
=
)
7
115,000
.
115,000
115,000
)(0
0
0
,0
Build
Sell
5
1
25
23
24
(1
d
-500,000
950,000
e
ov
r
p
58,000 Ap
0.70
?
D
-75,000 -75,000
-75,000
-75,000
22
eni
-75,000 -75,000
ed
Sell
(-7
26
0.30
?
27
5,
260,000
00
0)
(0
.3
)=
-2
25
00
With 58,000 as the chance node value,
we continue backward to evaluate
the previous nodes.

BILL GALLEN - The Decision Tree

Determining the Optimal Strategy
$115,000
Build,
Sell

Hi
re

$20,000

Ap
pr

ot
n
$20,000 o
D ire
h

ove
d

$10,000

$58,000
l
rova

Buy land; Apply

for variance
n
De

.3

ied

pp
a
s
ict
d
e
r
P
.4
Pre
di c
ts d
$-5,000
eni
.6
al

.7

Sell
land

Do nothing

$-75,000

Please forward your query

To: sjain@amity.edu