Decision Trees. Introduction Decision trees enable one to look at decisions: with many alternatives...
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Transcript of Decision Trees. Introduction Decision trees enable one to look at decisions: with many alternatives...
Decision TreesDecision Trees
Introduction
Decision trees enable one to look at decisions:
• with many alternatives and states of nature
• which must be made in sequence
Decision Trees
A graphical representation where:
a decision node from which one of several alternatives may be chosen
a state-of-nature node out of which one state of nature will occur
Thomson Case
• Thomson lumber a profitable company located in Portland, Oregon.
• Step 1: John Thomson to identify whether to expand his product line. He then try to find alternatives to define a course of action or strategy that a decision maker can use.
Thomson Case (Cont.)
• Step 2: Thomson decides that there are 3 alternatives. 1. to build a large new plant 2. a small plant 3. no plant at all.
• Step 3: He determines that there are only 2 possible outcomes : The market for new product could be favorable (high demand for the new product) or unfavorable (low demand).
• Step 4: Thomson wants to maximize his profit to evaluate each consequence. He evaluated the potential profits with the various outcomes. For favorable market, the new large plant will yield a net profit of $200,000 while if the market unfavorable will turn to a net loss of $180,000. A small plant will yield a net profit of $100,000 under favorable market and a net loss of $20,000 for unfavorable market. Finally if he does nothing would result in $0 profit in either market.
Thomson Case (Cont.)
• Step 5 &6 : The last two steps are to select a decision theory model and apply it to the data to help making decision. Selecting the model depends on the environment in which you are operating and the amount of risk and uncertainty involve.
Thomson Case (Cont.)
State of Nature
Alternative Favorable market
Unfavorable market
Construct a large plant
200,000 -180,000
Construct a small plant
100,000 -20,000
Do nothing 0 0
Thompson’s Decision Tree Fig. 4.1
1
2
A Decision Node
A State of Nature Node Favorable Market
Unfavorable Market
Favorable Market
Unfavorable Market
Constr
uct
Large
Pl
ant
Construct Small Plant
Do Nothing
Five Steps toDecision Tree Analysis
1. Define the problem2. Structure or draw the decision tree3. Assign probabilities to the states of nature4. Estimate payoffs for each possible combination of
alternatives and states of nature5. Solve the problem by computing expected
monetary values (EMVs) for each state of nature node.
Thompson’s Decision Tree Fig. 4.2
A Decision Node
A State of Nature Node Favorable
Market (0.5)
Unfavorable Market (0.5)
FavorableMarket (0.5)
Unfavorable Market (0.5)
Constr
uct
Large
Plan
t
Construct Small PlantDo Nothing
$200,000
-$180,000
$100,000
-$20,000
0
EMV =$40,000
EMV=$10,000
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2