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.
Deciding Whether or Not to Launch a Product Early
From the last worked example, you should now have a good understanding of the basics of how decision trees work. In this next example in Activity 6, you will meet a more complex decision tree with more than just the initial decision node. In other words, more than one decision will be needed. Thus, as well as providing an initial decision (what to do now), the decision tree will also provide a strategy for future decisions depending on the outcomes of various chance events.
Activity 6 Example of a complex decision tree: considering the early launch of a product
A company is planning on launching a new product. It was thinking of launching in June of next year, but it believes that a rival is also considering launching a similar product around that time. The company is considering bringing the launch forward to the end of this year. This will cost an extra €3M to carry out, and the company believes it will have a 0.8 probability of beating the rival to the market. If, however, they wait until June, the probability of beating the rival falls to 0.2.
To make the decision easier, the company assumes that sales will be either high, medium, or low. If the company launches before its rival, the probability of high sales is 0.6, and the probability of medium sales is 0.25. If it launches after its rival, the probability of high sales falls to 0.35, and medium sales rise to 0.45. If the rival launches first, the company could undertake a sales promotion, costing €1.5M, but would change the probabilities of high sales to 0.5 and medium to 0.4.
The financial impacts are that high sales would be worth €9M, medium would be worth €5M and low, €1M.
Using a decision tree analysis, calculate what the company's investment strategy should be. You can use pen and paper, an Excel spreadsheet, or record your calculations in the text box below.
Once you have arrived at a solution, watch Video 5 for the feedback on this activity.
In the next subsection, you will consider another example of a complex decision tree, this time related to the launch of a new pharmaceutical drug.