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Decision Tree Analysis

Dr. T. T. Kachwala

What is a Decision Tree?


Decision Tree is a pictorial
representation

of

the

decision process.
It represents the State of
nature with the associated
probability and strategies
with the associated payoff.

Slide 3

How to draw a Decision Tree?


Decision Tree comprises of two basic elements
1.Nodes
2.Branches.
Nodes: There are two types of nodes:
1.The Decision node is represented by a square
2.The Chance node is represented by a circle

D
C

Slide 4

How to draw a Decision Tree?


The decision node

represents a point on the decision

tree where a decision maker takes a decision.


The chance node
represents a point on the decision
C
tree where a decision maker evaluates the outcome of his
decision.

Slide 5

How to draw a Decision Tree?


Branches: are lines or segments that connect the nodes.
D

There are three types of branches:


Decision Branch

(i)Decision branch
signifies the branch that commences from the
decision node. It signifies the strategy the decision
maker selects at that point.
D

Slide 6

How to draw a Decision Tree?


Chance Branch

(ii) Chance branch


signifies the branch that commences from the
chance node. It signifies the state of nature that
occurs at that point.
C

(iii) Terminal branch signifies the last branch of the


decision tree. It is not followed by either
decision or chance node. The terminal branches
are mutually exclusive & collectively exhaustive
at that point.

Diagram of a representative Decision Tree

Ch

c
De

is

a
Br
n
io

eB
c
n

c
ran

Terminal Branch

h
nc

Terminal Branch

Terminal Branch

Slide 8

Objective of drawing a Decision Tree


The objective of drawing a decision tree is multiple
stage decision analysis.
The calculation starts with the terminal branch. Starting
from the terminal branch we calculate the position
value progressively at each node & roll back to the
earlier node till we reach the initial node.

Slide 9

Decision Tree - Roll back Technique


The position value at the chance node is the EMV at
that point. The position value at the decision node is
the maximum payoff amongst the branches at that
point.
In the process of rolling back to the initial node, we
identify a series or sequence of optimum strategies
that maximizes the payoff at the initial node.

Decision Tree - Roll back Technique


Roll back

EMV

maximum
payoff

Use of TreePlan (Excel Add-Ins)

Bayesian Approach to Decision Making


Bayesian Approach is an amalgamation of two theoretical
disciplines Bayes Theorem & Decision Tree Analysis
The so called Bayesian approach to the problem
addresses itself to the question of determining the
probability of some event Ai given that another event B has
been observed, i.e. determining the value of P(Ai/B).

Bayes Theorem - Introduction


One of the most interesting applications of the results of the probability
theory involves estimating unknown probabilities and making decisions
on the basis of new (sample) information.
Decision theory is another field of study, which is based on Bayes
theorem. This theorem consists of a method of calculating conditional
probabilities.
Thomas Bayes developed a simple rule for calculating Posterior or
Revised Probability given the Prior Probabilities & Conditional
Probabilities popularly referred as Bayes Theorem

Bayes Theorem Given Data


Let A1 and A2 be a set of events
which are mutually exclusive
and collectively exhaustive as
indicated in the Venn diagram (i)

Let B be a simple event


such that it intersects with
both A1 and A2 as
indicated in the Venn
diagram (ii)

Bayes Theorem - Calculation of Posterior (Revised)


probability P(Ai/B)
P(A1) and P(A2) are the prior probabilities (simple probabilities
prior to occurrence of event B).
P(B/A1) is the conditional probability of B given that A1 has
occurred.
P(B/A2) is the conditional probability of B given that A2 has
occurred.
Given the values of P(A1), P(A2), P(B/A1) and P(B/A2) the
following table on the next slide explains the calculations of
P(Ai / B) using Bayes Theorem.

Bayes Theorem - Calculation of Posterior (Revised)


probability P(Ai/B)
Event

Prior
Probability

Conditional
Probability

Joint
Probability

Posterior
Probability

(1)

(2)

(3)

(4) = (2) x (3)

(5) = (4) P (B)

A1

P (A1)

P (B/A1)

P (A1B)

P (A1/B)

A2

P (A2)

P (B/A2)

P(A2B)

P(A2/B)

P (B)