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Decision Tree Example

The document presents a decision tree example involving John Thompson's choices regarding building a new plant, which depends on whether he conducts a $10,000 market survey. The survey can indicate a favorable or unfavorable market, influencing his decision to build a large plant, small plant, or no plant, with associated payoffs and probabilities outlined. The analysis highlights the costs and potential outcomes of each decision, emphasizing the uncertainty inherent in market research.

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1 views1 page

Decision Tree Example

The document presents a decision tree example involving John Thompson's choices regarding building a new plant, which depends on whether he conducts a $10,000 market survey. The survey can indicate a favorable or unfavorable market, influencing his decision to build a large plant, small plant, or no plant, with associated payoffs and probabilities outlined. The analysis highlights the costs and potential outcomes of each decision, emphasizing the uncertainty inherent in market research.

Uploaded by

fatmaeyildirim
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

DECISION TREE EXAMPLE

Let’s say that John Thompson has 2 decisions to make, with the 2nd decision dependent on the
outcome of the 1st. Before deciding about building a new plant, John has the option of
conducting his own marketing research survey, at a cost of $10,000. The information from his
survey could help him decide whether to construct a large plant, a small plant, or not to build
at all. John recognizes that such a market survey will not provide him with perfect information,
but it may help quite a bit nevertheless.
Thompson’s first decision point is whether to conduct the $10,000 market survey. If he
chooses not to do the study, he can either construct a large plant, a small plant, or no plant.
This is John’s 2nd decision point. The market will either be favorable (0.50 probability) or
unfavorable (also 0.50 probability) if he builds. The payoffs for each of the possible
consequences are listed below:

For large plant è favorable market (0.50) è $200,000


è unfavorable market (0.50) è -$180,000

For small plant è favorable market (0.50) è $100,000


è unfavorable market (0.50) è -$20,000

There is a 45% chance that the survey results will indicate a favorable market for storage
sheds. We also note that the probability is 0.55 that the survey results will be negative.

0.78 is the probability of a favorable market for the sheds given a favorable result from the
market survey. Of course, you would expect to find a high probability of a favorable market
given that the research indicated that the market was good. Don’t forget, though, there is a
chance that John’s $10,000 market survey didn’t result in perfect or even reliable information.
Any market research study is subject to error. In this case, there is a 22% chance that the
market for sheds will be unfavorable given that the survey results are positive.

We note that there is a 27% chance that the market for sheds will be favorable given that
John’s survey results are negative. The probability is much higher, 0.73, that the market will
actually be unfavorable given that the survey was negative.

Finally, when we consider the payoffs of conducting the $10,000 market survey, we see that
$10,000, the cost of the marketing study, had to be subtracted from each of the payoffs:

For large plant è favorable market è $200,000 - $10,000 = $190,000


è unfavorable market è -$180,000 - $10,000 = -$190,000

For small plant è favorable market è $100,000 - $10,000 = $90,000


è unfavorable market è -$20,000 - $10,000 = -$30,000

For no plant è -$10,000

With all probabilities and payoffs specified, solve the decision problem by drawing the
decision tree.

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