Multi-stage Decision
Making
Decision Tree
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.
2
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.
3
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.
4
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.
5
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.
6
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
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
8
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
9
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
10
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
11
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.
12
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
13
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.
14
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.
15
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
16
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
17
BILL GALLEN - The Decision Tree
Excel add-in: Tree Plan
18
BILL GALLEN - The Decision Tree
Excel add-in: Tree Plan
19
