Dealing with Uncertainty
A decision tree is a model of decisions and their outcomes. It has found widespread application because of its ease of implementation. Additionally, its compact tree representation is often useful for visualizing the breadth of possible outcomes.
Decision Trees
Sometimes decisions can be complex and require a number of stages to arrive at a final outcome. Such a final outcome may be dependent on earlier, intermediate decisions. Alternatively, the final decision may be dependent on a series of uncertain, intermediate outcomes. Dealing with these types of decisions may appear, on the face of it, quite difficult. However, the technique of decision trees that you are going to explore in this section will help to simplify this process.
The best way to illustrate the technique is by a worked example in Activity 5. Before doing so, it is important to point out the meaning of two symbols that will be used in the decision trees.
Where a branch appears on your tree, this point will be called a node. A node may appear for one of two reasons. The first is that a decision is required. In other words, the node represents a series of choices. This type of node will be called a decision node, and a square will be used to denote it. The second type of node is a chance node. Here, there is a range of possible events or outcomes of varying probabilities. Such nodes are denoted with a circle.
In Videos 3 and 4, you will be introduced to the powerful technique of decision trees. This technique allows you to incorporate probabilities into a range of potential outcomes, which may themselves be conditional on other outcomes.
You may wish to watch the videos a few times and make notes in the text boxes to ensure that you understand the concept of decision trees, as well as to answer the questions.
Part 1
A company (MKOU) is assessing two outsourcing bids, A and B. Company A is more expensive but is reckoned to have a higher probability of delivering a high-quality good than B. This is important as the higher the quality the more MKOU can charge and the less it will need to refund dissatisfied customers. The data may be summarised as shown in Table 7.
Table 7 Possible financial benefits of using companies A and B
| Company | Probability of acceptable service level | Net financial benefit if acceptable £M | Net financial cost if not acceptable £M |
|---|---|---|---|
| A | 80% | 120 | -30 |
| B | 55% | 160 | -10 |
Part 2
A company is considering launching a new product. It can either launch immediately or in one year's time. If it launches immediately, there is a 0.75 chance of the launch being successful. If it is unsuccessful, then the launch will be halted at a cost of £1M and relaunched in a year's time. If the company launches immediately, it may opt to also have a promotion, which has a 0.6 chance of success. If the promotion is successful, the financial benefit is £10M, if not £2M. If the company does not do the promotion, the benefit is £5M. If the company launches in a year's time, the benefit is £6M. What should the company do?
Now that you have watched the videos on decision trees, you will consider potential decisions faced by businesses. In the next section, you will see some more applied examples of how decision trees are used in making business decisions.
Source: The Open University, https://www.open.edu/openlearn/money-business/decision-trees-and-dealing-uncertainty/content-section-4
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