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# Decision Tree

Yes NO
Introduction
• Decision theory is a set of techniques which are used for making
decision in the decision- environment of uncertainity and risk
• In a decision tree, we describe the choices and uncertainties facing a
single decision-making agent.
• This usually means a single decision maker, but it could also mean a
decision-making group or a company.
Decision Tree
• Three types of “nodes”
• Decision nodes - represented by squares (□)
• Chance nodes - represented by circles (Ο)
• Terminal nodes - represented by triangles (optional)
• Solving the tree involves pruning all but the best decisions at decision
nodes, and finding expected values of all possible states of nature at
chance nodes
• Create the tree from left to right
• Solve the tree from right to left
Using Decision Trees
• Can be used as visual aids to structure and solve sequential decision
problems
• Especially beneficial when the complexity of the problem grows
• Decision trees are commonly used in operations research, specifically
indecision analysis, to help identify a strategy most likely to reach a
goal.
• Another use of decision tree is as a descriptive means for calculating
conditional probabilities
What they look like ?

## • Works like a flow chart

• Looks like an upside down tree
• Nodes
• appear as rectangles or circles
• represent test or decision
• Lines or branches - represent outcome of a test
• Circles - terminal (leaf) nodes
• Top or starting node- root node
• Internal nodes - rectangles
Types Of Decision making Environment
Certainty

## • A state of certainty exists when a decision maker knows, with reasonable

certainty, what the alternative are and what conditions are associated with
each alternative

## • Very few organizational decisions, are made under these conditions

Risk

• A state of Risk exists when a decision maker makes decisions in which the
availability of each alternative and its payoffs and cost are all associated with
probability estimate

## • Decision such as these are based on past experiences, relevant information,

the advice of others and one’s own judgment

## • Decision is calculated on the basis of which alternative has the highest

probability of working effectively
Uncertainty

• A state of Uncertainty exists when a decision maker does not known all of the
alternatives, the risk associated with each or the consequences of each
alternative is likely to have
• Most of the major decision making in today’s organizations is done under these
conditions
• To make effective decision under these conditions, managers must secure as
much relevant information as possible
• The Maximax payoff criterion seeks the largest of the maximum
payoffs among the actions.
• The maximin payoff criterion seeks the largest of the minimum
payoffs among the actions.
• The minimax regret criterion seeks the smallest of the maximum
regrets among the actions.
Risk Averse Organization
• Most of organizations are cautious in situations where they think they might be vulnerable to large losses.
• These organizations may shy away from project decisions which, if they were to fail, would expose the organization to large
losses, even if such project decisions might also offer a possibility of large gains associated with success. This behaviour is called
“risk-averse.”
• Decisions made by risk-averse organizations’ tend to maximize their E(U) rather than EMV, and that utility may give serious
(negative) weight to the possibility of large losses.
• Most decision tree software allows the user to design a utility function that reflects the organization's degree of aversion to
large losses.
Risk Neutral Organization
Risk neutral organization evaluates alternatives decisions using expected monetary
value, calculated by multiplying the value of each possible result by its probability
of occurring and adding the probability – weighted values of all possible result.
This is equivalent to applying a linear utility function.
Generally if the value of a decision calculated this way is not large enough the
organization will not do it.
Difference
Risk Averse
• Risk Averse generally choose the guaranteed payment.
• Believes in Something is better than Nothing.
• Risk-averse investors tend to choose safer investments to place their assets

Risk Neutral
• Risk neutral normally selects the investment with the highest expected return
• It preferences simply wants to maximize their expected value
• Risk neutral is indifference to risk.
UNCERTAIN PARAMETERS

## • Uncertain parameters become known only after a decision is made.

• When a parameter is uncertain, we treat it as if it could take on two
or more values, depending on influences beyond our control.
• These influences are called states of nature, or more simply, states.
• In many instances, we can list the possible states, and for each one,
the corresponding value of the parameter.
• Finally, we can assign probabilities to each of the states so that the
parameter outcomes form a probability distribution.
PAYOFF TABLES AND DECISION CRITERIA

## • For each action-state combination, the entry in the table is a measure

of the economic result.
• Typically, the payoffs are measured in monetary terms, but they need
not be profit figures.
• They could be costs or revenues in other applications, so we use the
more general term payoff.
INCORPORATING PROBABILITIES

## • We can immediately translate this information into probability

distributions for the payoffs corresponding to each of the potential
actions.
• We use the notation EP to represent an expected payoff (e.g., an
expected profit).
• Note that the expected payoff calculation ignores no information: all
outcomes and probabilities are incorporated into the result.
Example
• A glass factory specializing in crystal is experiencing a substantial
backlog, and the firm's management is considering three courses
of action:
• A) Arrange for subcontracting (S1)
• B) To begin overtime production (S2)
• C) Construct new facilities (S3)

## • The correct choice depends largely upon future demand, which

may be low, medium, or high. By consensus, management
estimates the respective demand probabilities as 0.10, 0.50, and
0.40. A cost analysis reveals the effect upon the profits.
Demand Probability Course of Action

S1 S2 S3
(SUBCONTRACTING (BEGIN (CONSTRUCT
) OVERTIME) FACILITIES)
low (L) 0.10 10 -20 -150

## High (H) 0.40 50 100 200

4 0.10 x 10 = 01 (in '000 Rs)

1 M1 (p= 0.50
5 0.50 x 50 = 25
EMV=46
6 0.40 x 50 = 20
46
7 0.10 x -20 = -02
S2: Begin overtime M2 (p= 0.50
0 2 8 0.50 x 60 = 30

EMV=68
9 0.40 x 100 = 40

68

## 10 0.10 x -150 = -15

11 0.50 x 20 = 10
3
12 0.40 x 200 = 80
EMV=75
75
Decision Tree used in
different fields
Choosing Investments
Product Launch
Strategy
Granting loans by Banks
• Simple, Understanding-brief explanation
• Value- Hard data, Important insights- experts describing
• Helps in determining
• White box
• Combined- other decision techniques
• Unstable
• Relatively inaccurate
• Information gain in decision trees is biased
• Calculations-complex
Summary
• A decision tree is a specialized model for recognizing the role of
uncertainties in a decision-making situation.
• Trees help us distinguish between decisions and random events, and
more importantly, they help us sort out the sequence in which they
occur.
• Probability trees provide us with an opportunity to consider the
possible states in a random environment when there are several
sources of uncertainty, and they become components of decision
trees.
• The key elements of decision trees are decisions and chance events. A
decision is the selection of a particular action from a given list of
possibilities.
• A chance event gives rise to a set of possible states, and each action-
state pair results in an economic payoff.
• In the simplest cases, these relationships can be displayed in a payoff
table, but in complex situations, a decision tree tends to be a more
flexible way to represent the relationships and consequences of
• The choice of a criterion is a critical step in solving a decision problem
when uncertainty is involved.
• There are benchmark criteria for optimistic and pessimistic decision
making, but these are somewhat extreme criteria. They ignore some
available information, including probabilities, in order to simplify the
• The more common approach is to use probability assessments and
then to take the criterion to be maximizing the expected payoff,
which in the business context translates into maximizing expected
profit or minimizing expected cost.
Thank You
Reference
• https://www.slideshare.net/macjones25/decision-tree-10164318
• https://www.mindtools.com/dectree.html
• https://www.slideshare.net/anandarora/decision-tree-analysis-
slideshare
• https://en.wikipedia.org/wiki/Decision_tree
• https://education2research.com/decision-making-definition-types-
and-decision-making-environments/
• https://www.wisdomjobs.com/e-university/quantitative-techniques-
for-management-tutorial-297/decision-making-under-uncertainty-
10067.html