Chapter Three

Probability
Distributions
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3.1 Probability and Probability Distributions

Probability:
 is the measure of a chance that something will occur.
 is a numerical measure of the likelihood or chance of
occurrence of an uncertain event in random experiment.

Random experiment
 is a process or course of action that results in one of a
number of possible outcomes.
 The outcomes that occur can not be predicted with
certainty.
 In a random experiment, a variable whose measured value
can change is referred to as a random variable (X).

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 Probability…
A probability is usually expressed in terms of a random
variable.

Random variable can be:

1. Discrete random variable -assume only a finite or
limited set of values- i.e., number of automobiles sold in a
year.
2. Continuous random variable - can assume any one of an
infinite set of values - i.e., temperature, product lifetime.

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 Probability…
Sample Space
 It is a list of all possible outcomes of an experiment
 It denoted by S

The outcomes listed must be:

1. mutually exclusive: no two or more of the outcomes
can occur simultaneously and
2. exhaustive: all the possible outcomes should be
included in the set

 Each element of a sample space representing an

experimental outcome is called a sample point

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Probability…
Event
 Is the set of individual outcomes within a sample space and
having a specific common characteristic.
 For example:
 even numbers turn up when a die is tossed (2, 4, 6) .
 either head or tail occurs in two tosses of a coin
 telephone calls lasting no more than 10 minutes
 sales volume of a retail store more than birr 1000 on a given day

Events are either

 statistically independent (the occurrence of one event has no effect
on the probability of occurrence of the other) or
 statistically dependent (the occurrence of one event gives
information about the occurrence of the other)
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 Probability…
Basic Properties of Probability
property 1: The probability of any event E is a number between
and including 0 and 1.
 Thisrule is denoted by 0  P ( E )  1
 P(E)= 0 represents an impossible event and

 P(E)=1 represents a certain event.

property 2: If the probability that an event E occurs is P (E),

then probability that event will not occur is 1- P (E)
property 3: The sum of the probabilities of each outcome in
the sample space is 1.
property 4: If events A and B are two elements in a sample space
and if occurrence of A implies that B occurs, that is A
is a subset of B, then the probability of A is less than or
equal to the probability of B. That is P( A)  P( B)
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Probability…
Rules of probability
1. Addition Rules
 They are helpful when we have two events and do interest to
know the probability that at least one of the events occurs.
 It seems more meaningful and convenient to see the use of
addition rule for mutually exclusive events and for none
mutually exclusive (overlapping) events
Mutually Exclusive Events
 It is an event if they cannot occur at the same time.
 If the occurrence of one stops the occurrence the other.
 The sets E1 , E2 ,...,Ek are mutually exclusive if the
intersection of any pair is empty. i.e.
 each element is in one and only one of the sets E1 , E2 ,...,Ek .
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Probability…
The addition rule for mutually exclusive (disjoint),
exhaustive, and equally likely events states that
 If two events A and B are mutually exclusive, the probability
of either event A or B or both happening is equal to the sum
of their individual probabilities. That is
 P (A or B) =P (A U B) =P (A) +P (B)
 Generally if we have n events in a sample space that are
mutually exclusive, then the probability of the union of
these events is given by

P( A1UA2U .....UAn )  P( A1 )  P( A2 )  .......  P( An )

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 Probability…
Example: Consider the pattern of arrival of customers at a
service counter during the first hour it is open along with
its probabilities
Number of persons 0 1 2 3 4

probability 0.1 0.2 0.3 0.3 0.1

To understand the probability that 2 or 3 persons will be

there during the first hour, we have
P (2 or 3) =P (2) +P (3) = 0.3+0.3 =0.6

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Probability…
An important special case of this rule is the rule
probability of complementary events or mutually
exclusive (events which can not occur simultaneously).
If events A & B are complementary events, the probability
that either A happens or B happens is given by
P (A or B) =P(A) +P(B) =P(A) + 1-P (A) =1
P (A) =1- P (B)

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 Probability…
Non Mutually Exclusive (Partially Overlapping) Events
If events A and B are not mutually exclusive, it is possible for
both events to occur simultaneously.
This means these events have some sample points in
common.
 Such events are also called joint or overlapping events.
The sample points in common (belong to both events)
represent the joint event A n B (read as A intersection B).
The addition rule in this case is stated as:
 If two events A and B are mutually nonexclusive, then the
probability of either A or B or both happening is equal to the
sum of their individual probabilities minus the probability of
A and B happening together.
 P (A U B) = P (A) + P (B) – P (A n B) when 2 events occurs.
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 Probability…
The above equation can be expanded to include more than two
events.
If there are three events that are not mutually exclusive, then the
probability of the union of these events is given by:
 P (AUBUC ) = P(A)+P(B) +P(C) –P(A n B)- P(B n C)-P(A n C) +P(A n B n C)
Example: Suppose 70 percent of all tourists who come to
Ethiopia visit Gondar, 60 percent will visit Lalibela, and 50
percent of them visit both Gondar and Lalibela. What is the
probability that the tourists will visit Gondar or Lalibela?
Applying the above rule, we have
P (G or L) =P (G) +P (L) – P (G and L) /or=u, and=n/
=0.7 + 0.6 - 0.5 = 0.8
 How about tourists will visit neither Gondar nor Lalibela
P( neither G nor L) = 1- P(either H or L) = 1- 0.8 = 0.20
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 Probability…
2 Multiplication Rules
A. Statistically independent events
 when the occurrence of an event does not affect the occurrence of the other
and it is not affected by the probability of occurrences of any other event.
 Here there are three types of probabilities
a. Marginal probability:
 It happen when outcome of each event that is statistically independent of the outcome
of every other event.
b. Joint probability:
 when probability of two or more independent events occurring together.
 It is equal to the products of their marginal probabilities
 If A and B are independent events:
P(AB) = P(A B) = P (A) X P(B)
c. Conditional probability:
 for statistically independent events A and B ,the conditional probability denoted by
P(A/B) of event A, given that event B has already occurred is simply the probability of A.
P(A/B)=P(A), probability of event A, known that event B has already occurred.

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 Probability…
B. Statistically Dependent Events
 It happen when the probability of an event is dependent upon or affected by the
occurrence of any other event
a. Joint probability :
 If A and B are dependent events, then the joint probability as discussed under statistical
independence case is no longer equal to the product of their respective probabilities.
 The joint probability of events A and B occurring together under statistical dependence is
given by:
P(A B) =P(A) x P(B/A) Or P (A B)= P(B) x P(A/B)
b.Conditional probability:
 under statistical dependence, the conditional probability of event B given that
event A has already happen, denoted by P(B/A), is given by:
P ( A  B)
P (B/A) = P ( A)
 Similarly the conditional probability of A , given that B has occurred, is
P( A  B)
P (A/B) = P( B)
c. Marginal probability:
 the marginal probability of an event under statistical dependence is the same as
the marginal probability of an event under statistical independence.

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 Probability…
Example: the probability of snowing if it rains is 0.32 and the
probability of raining in a given day is 0.5. What is the
probability of snowing in a given day if the probability of
raining given snowing is 0.4?

Solution
Let P(S) probability of snowing
P(R) probability of raining
P(S/R) =0.32
P(R) =0.5
P(R/S) = 0.4
P(S) =?
P (R/S) = P( S  R) equivalently P(S) = P( S  R)
P( S ) P( R / S )

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 Probability…
But we do not have P(S n R),to find it let us use the
formula
P( S  R)
P( R)
P (S/R) =

P(S R) = P (S/R) x P(R)
= 0.32 x 0.5 =0.16
Let us now use the above formula to calculate the
probability of S, P(S).
P( S  R) 0.16
 0.4
P(S) = P( R / S ) = 0.4

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 3.2 Decision Theory
Decision Theory:
 represents a general approach to decision making which is suitable
for a wide range of operations.
Decision:
is the selection process leading to a particular action being taken
 The corresponding action is in fact the realization of a decision
is a choice made between two or more available alternatives
Decision making
is the process of choosing the best alternative for reaching objectives
A good decision
is an action we take that is logically consistent with
 the alternatives we perceive,
 the information we have, and
 the preferences we feel.
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Decision…
Types of Decisions
a. Programmed decisions
 are routine and repetitive, and the organization typically develops
specific ways to handle them
 Determining how products will be arranged on the shelves of a
supermarket
b. non-programmed
 are typically one-shot decisions that are usually less structured than
programmed decisions
 Deciding whether a supermarket should carry an additional type of
bread

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 Elements in a decision situation
There are five elements in a decision situation
1. Decision maker
2. Goals to be served
3. Relevant alternative
4. Ordering of alternatives
5. Choice of alternatives

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 Decision…
1. Decision Maker
Individuals or groups that actually make the choice among alternatives
Ideal decision makers emphasize the realization of the organization’s
potential, and try to use all of their talents when making a decision and are
characterized by reason and sound judgment

2. Goals to be served
The objectives that decision makers seek to attain
In the case of managers, these goals should most often be organizational
objectives
3. Relevant Alternatives
At least two relevant alternatives
A relevant alternative is one that is considered feasible for solving an
existing problem and for implementation
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 Decision…
4. Ordering of Alternatives
The decision situation requires a process or mechanism for
ranking alternatives from most desirable to least desirable
This process can be subjective, objective, or some combination of
the two

5. Choice of Alternatives
The actual choice between available alternatives establishes the
decision as a fact
Managers choose the alternative that maximizes long-term return
for the organization

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Decision-making Process
 The decision-making process comprises the steps the decision
maker takes to arrive at a choice
 The process that a manager uses to make decisions has a
significant impact on quality of decisions that manager makes
Identify List Select Implement
existing Alternative Most Chosen
problem Problem Beneficial Alternative
Solutions Alternative

Gather
Problem
Related
Feedback

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 DM Process…
I. Identifying an Existing Problem
Decision making is essentially a problem-solving process that involves
eliminating barriers to achieving organizational goals
The first step in this elimination process is identifying exactly what the
problems or barriers are

II. Listing Alternative Solutions

Five limitations on developing the solutions
 Authority factors
 Biological or human factors
 Physical factors
 Technological factors
 Economic factors
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 DM Process…
III. Selecting the Most Beneficial Alternative
Decision makers can select the most beneficial solution only
after they have evaluated each alternative very carefully
 list the potential effects of each alternative
 assign a probability factor to each of the potential effects
 compare each alternative’s expected effects and the respective
probabilities of those effects

IV. Implementing the Chosen Alternative

Put the chosen alternative into action
Decisions must be supported by appropriate action if they are to
have a chance of success

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 DM Process…
V. Gathering Problem-Related Feedback
Decision makers must gather feed­back to determine the effect of
the implemented alternative on the identified problem
If the identified problem is not being solved, managers need to
find out and carry on some other alternative

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Characteristics of Decision Theory
The characteristics of Decision Theory are
1. A list of alternatives
2. A list of possible future states of nature
3. Payoffs associated with each alternative/state of
nature combinations
4. An assessment of the degree of certainty of possible
future events
5. A decision criterion

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Characteristics of DT…
1. List of alternatives:
 are a set of mutually exclusive and collectively exhaustive
decisions that are available to the decision maker (some
times, not always, one of these alternatives will be to ‘do
nothing’.)

2. States of nature:
 the set of possible future conditions, or events, beyond the
control of the decision maker, that will be the primary
determinants of the eventual consequence of the decision.
 The states of nature, like the list of alternatives, must be
mutually exclusive and collectively exhaustive.

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Characteristics of DT…
3. Payoffs:
 the decision maker may have different payoffs associated
with different decision alternatives and states of nature
 The payoffs might be profits, revenues, costs, or other
measures of value.
 Usually the measures are financial and are estimated values.
 The more accurate these estimates,
 the more useful they will be for decision making purposes and
 the more likely, the decision maker will choose an appropriate
alternative.
 The number of payoffs depends on the number of
alternative/state of nature combination.
 We can express the payoffs of a given decision by payoff table
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Characteristics of DT…
Payoff table
It is a device a decision maker can use to summarize and
organize information relevant to a particular decision.

It includes a list of alternatives, the possible future states

of nature, and the payoffs associated with each of the
alternative/state of nature combinations.

If probabilities for the states of nature are available, these

can also be listed.

The general format of the table is illustrated in the next

slide:
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Characteristics of DT…
State of Nature (event)
S1 S2 S3
V11 V12 V13
Alternatives A1
V21 V22 V23
A2
V31 V32 V33
A3
where:
Ai = the ith alternative
Sj = the jth states of nature
Vij = the value or payoff that will be realized if alternative i
is chosen and event j occurs.
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 Characteristics of DT…
4. Degree of certainty: -
the approach used by a decision maker often depends on the
degree of certainty that exists.
There can be different degrees of certainty.
 complete certainty
 complete uncertainty
 RISK, probabilities are known for the states of nature.

Knowledge of the likelihood of each states of nature can

play an important role in selecting a course of action.
 Thus, if the decision maker feels that a particular state of nature is
highly likely, this will mean that the pay offs associated with the
state of nature are also highly likely.
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 Characteristics of DT…
5. Decision Criteria:
 The process of selecting one alternative from a list of
alternatives is governed by a decision criterion
 It represents the decision makers attitude toward the
decision and degree of certainty that surrounds a decision.
 Decision maker may
 Have optimistic attitude or pessimistic attitude.
 wants to maximize gains or concerned with protecting
against losses.

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Causes for poor decision
1. Bounded Rationality :
 The limitation caused by costs, human abilities,
time, technology, and availability of information.

2. Suboptimization:
 The result of different departments each
attempting to reach a solution that is optimum
for that department but may be suboptimal to the
organization.

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 Types of Decision Making Environment
In most cases, it is impossible for decision makers to know
exactly what the future consequences of an implemented
alternative (environment) will be.

Because organizations and their environments are

constantly changing, future consequences of implemented
decisions are not perfectly predictable

There are different conditions under which decisions are made.

Each of these conditions is based on the degree to which the

future outcome of a decision alternative is predictable.

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Types of Decision Making Environment…

Decision are made under four types of environment:

1. Decision making under condition of certainty

2. Decision making under condition of uncertainty

3. Decision making under condition of risk

4. Decision Making with Utilities

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A. Decision Making Under Certainty
Decision makers know exactly what the results of an
implemented alternative will be, have complete
knowledge about a decision
List outcomes for alternatives and then choose the
outcome with the highest payoff (e.g. investment on
government bonds)
Most organizational decisions are made outside the
complete certainty situation
Generally here environment in which relevant
parameters have known values

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 DM Under Certainty…
 The simplest of all circumstances occurs when decision making
takes place in an environment of complete certainty

 In this environment , only one state of nature exists for each

alternative i.e., there is complete certainty about the future .

 It is easy to analyze the situation and make good decision.

 Since the decision maker has perfect knowledge about the future

outcomes, he simply choose alternative having optimum payoff.

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 DM Under Certainty…
Example: The following payoff table provides data about profits of the
various states of nature/alternative combination.
S1 S2 S3
4 16 12
A1
5 6 10
A2
-1 4 15
A3

If we know that S2 will occur, the decision maker then can focus on the

first row of the payoff table.

Because alternative A1 has the largest profit (16), it would be selected.

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 B. Decision making under uncertainty
Decision makers have absolutely no idea what the results of an
implemented alternative will be
The complete uncertainty condition would exist, for example, if
there were no historical data on which to base a decision.
Few organizational decisions need to be made in the complete
uncertainty condition
here the environment in which it is impossible to assess the
likelihood of various future events
Under complete uncertainty, the decision maker either is
 unable to estimate the probabilities for the occurrence of the
different states of nature, or
 else s/he lacks confidence in available estimates of probabilities, and
for that reason, probabilities are not included in the analysis.
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DM under uncertainty…
More than one states of nature exists but the decision
maker lacks the knowledge about the probabilities of
their circumstances
 We shall consider five approaches to decision making
under complete uncertainty.
These are:
1. Maximax
2. Maximin
3. Minimax regret
4. Insufficient reason
5. Criterion of realism

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1. Maximax (optimistic ) Criteria
The decision maker selects the decision that will result
in the maximum of the maximum payoffs.
The maximax is very optimistic.
The decision maker assumes that the most favorable
state of nature for each decision alternative will occur.
Note:
 If the pay off table consists of costs instead of profits, the
opposite selection would be indicated: The minimum of
minimum costs (MiniMin).
 For the subsequent decision criteria we encounter, the same
logic in the case of costs can be used

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 Maximax ….
Example: The investor would optimistically assume
that good economic conditions will prevail in the
future. The best payoff for each alternative is
identified, and the alternative with the maximum of
these is the designated decision.
S1 S2 S3 Row Maximum
4 16 12 16* Maximum
A1
A2 5 6 10 10
A3 -1 4 15 15

Decision: A1 will be chosen.

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 2. Maximin Criteria
This approach is the opposite of the previous one i.e. it is
pessimistic.
This strategy is a conservative one; it consists of
identifying the worst (minimum) payoff for each
alternative, and, then, selecting the alternative that has
the best (maximum) of the worst payoffs.
In effect, the decision maker is setting a floor on the
potential payoff by selecting maximum of the minimum;
the actual payoff can not be less than this amount.
 It involves selecting best of the worst.

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Maximin Criteria…
Example:
S1 S2 S3 Row Minimum
A1 4 16 12 4

A2
5 6 10 5*Maximum
A3 -1 4 15 -1

Decision: A2 will be chosen

Note: If it were cost, the conservative approach would
select the maximum cost for each decision and select
the minimum of these costs.

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 3. Minimax Regret
 In order to use this approach, it is necessary to develop an
opportunity loss table.

 The table reflects the difference between each payoff and the
best possible payoff in a column (i.e., given a state of nature).
 Hence, opportunity loss amounts are found by identifying the
best payoff in a column and, then, subtracting each of the
other values in the column from that payoff.
 Therefore, this decision avoids the greatest regret by
selecting the decision alternative that minimizes the
maximum regret.

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Minimax Regret…
Example:
S1 S2 S3
4 16 12
A1
5 6 10
A2
-1 4 15
A3

Opportunity loss table

5-4=1
S1 16-16=0
S2 15-12=3
S3 3*minimum

A1 5-5=0 16-6=10 15-10=5 10

A2
5-(-1)=6 16-4=12 15-15=0 12
A3

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Minimax Regret…
A decision maker could select an alternative that
minimize the maximum possible regret.

This requires identifying the maximum opportunity

loss in each row and, then, choosing the alternative
that would yield the best (minimum) of those
regrets.
Decision: A1 will be chosen

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 4. Insufficient reason
 The principle of insufficient reason offers a method that
incorporates more of the information.
 Here we use Laplace (criteria of rationality)or Baye’s
criteria
 It treats the states of nature as if each were equally likely,
and it focuses on the average payoff for each row,
selecting the alternative that has the highest row
average.

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 Insufficient reason…
Example
S1 S2 S3 S4 S5 Row average
28 28 28 28 4 23.2*maximum
A1
5 5 5 5 28 9.6
A2
5 5 5 5 28 9.6
A3

Decision: A1 is selected

The basis for the criterion of insufficient reason is that under complete uncertainty,

the decision maker should not focus on either high or low payoffs, but should treat

all payoffs (actually, all states of nature), as if they were equally likely.

Averaging row payoffs accomplishes this.

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5. Hurwitz Criterion (Criterion of realism)
 This criterion strikes a compromise between the maximax and
maximin criterion.
 The principle underlying this decision criterion is that the decision
maker is neither totally optimistic, nor totally pessimistic.
 With Hurwitz criterion, the decision payoffs are weighted by a
coefficient of optimism, a measure of a decision maker’s optimism.
 The coefficient of optimism, which is defined as , is between zero
and one (0<  <1). If  = 1, then the decision maker is said to be
completely optimistic, if  = 0, then the decision maker is
completely pessimistic. Given this definition, if  is coefficient of
optimism, 1-  is coefficient of pessimism.
 The Hurwitz criterion requires that for each alternative, the
maximum payoff is multiplied by  and the minimum payoff be
multiplied by 1- .

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 Hurwitz Criterion…
Example
S1 S2 S3 Max row
A1 4 16 12 16

A2 5 6 10 10

A3 -1 4 15 15

If  = 0.4 for the above example,

A1 = (0.4x16) + (0.6x4) = 8.8
A2 = (0.4x10) + (0.6x5) = 7
A3 = (0.4x15) + (0.6x-1) = 5.6
Decision: A1 is selected

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Hurwitz Criterion …
 A limitation of Hurwicz criterion is the fact that  must be
determined by the decision maker.
 Regardless of how the decision maker determines , it is still
a completely a subjective measure of the decision maker’s
degree of optimism.
 Therefore, Hurwicz criterion is a completely subjective
decision making criterion /not objective/.

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C. Decision Making Under Risk
 The decision making criteria just presented previously
were based on the assumption that no information
regarding the likelihood of the states of the nature was
available.
 Thus, no probabilities of occurrence were assigned to the
states of nature, except in the case of the equal likelihood
criterion.
 It is often possible for the decision maker to know enough
about the future state of nature to assign probabilities to
their occurrences.
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 Decision Making Under Risk…
The term risk is often used in conjunction with partial
uncertainty, presence of probabilities for the occurrence of
various states of nature.
 The probabilities may be subjective estimates from
managers or from experts in a particular field, or they may
reflect historical frequencies.
If they are reasonably correct, they provide the decision maker
with additional information that can dramatically improve the
decision making process.

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 Decision Making Under Risk…
 Decision makers have only enough information about the
outcome of each alternative to estimate how probable the
outcome will be.
 Most decisions in organizations have some amount of risk
associated with them
 The lower the quality of information about the outcome of
an alternative,
 the closer the situation is to complete uncertainty and
 the higher is the risk of choosing that alternative
Given that probabilities can be assigned, several decision
criteria (approaches) are available to aid the decision maker.

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 I. Expected Monetary Value (EMV)
 The EMV approach provides the decision maker with a value which

represents an average payoff for each alternative.

 The best alternative is, then, the one that has the highest EMV.

 The average or expected payoff of each alternative is a weighted average:

Where:
EMVi = the EMV for the ith alternative
Pi = the probability of the ith state of nature
Vij = the estimated payoff for alternative i under state of nature j.
Note: the sum of the probabilities for all states of nature must be 1.

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 EMV…
Example
Probability 0.20 0.50 0.30
S1 S2 S3 Expected payoff
4 16 12 12.40*maximum
A1
A2 5 6 10 7

A3 -1 4 15 6.3

Decision: A1 will be chosen

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II. Expected Opportunity Loss (EOL)
The table of opportunity loss is used rather than a
table of payoffs.
Hence, the opportunity losses for each alternative are
weighted by the probabilities of their respective state
of nature to compute a long run average opportunity
loss
Then alternative with the smallest expected loss is
selected as the best choice.

03/08/2023
 EOL…
Example
S1 S2 S3
4 16 12
A1
5 6 10
A2
-1 4 15
A3

EOL (A1) = 0.20(1) + 0.50(0) + 0.30(3) = 1.10 *minimum

EOL (A2) = 0.20(0) + 0.50(10) + 0.30(5) = 6.50
EOL (A3) = 0.20(6) + 0.50(12) + 0.30(0) = 7.20

Note: The EOL approach resulted in the same alternative as the EMV
approach (Maximizing the payoffs is equivalent to minimizing the
opportunity losses).
03/08/2023
3. Expected Value of Perfect Information (EVPI)
 It can some times be useful for a decision maker to
determine the potential benefit of knowing for certain
which state of nature is going to prevail.
 The EVPI is the measure of the difference between the
certain payoffs that could be realized under a condition
involving risk.
 If the decision maker knows that S1 will occur, A2 would
be chosen with a payoff of $5. Similarly for S2 $16 (for A1)
and for S3, $15 (with A3) would be chosen.

03/08/2023
 EVPI…
 Hence, the expected payoff under certainty (EPC) would be:
EPC = 0.20(5) + 0.50(16) + 0.30(15) = 13.50

 The difference between this figure and the expected payoff under
risk (i.e., the EMV) is the expected value of perfect information.
Thus:
EVPI = EPC - EMV
= 13.50 -12.40 = 1.10

 Note: The EVPI is exactly equal to the EOL.

 The EOL indicates the expected opportunity loss due to imperfect
information, which is another way of saying the expected payoff that
could be achieved by having perfect information.

03/08/2023
D. Decision Making with Utilities
 Thus far, we have assumed that the expected payoff in monetary terms is
the appropriate measure of the consequences of taking an action.
 However, in many situations this assumption is inappropriate.

 For example, suppose that an individual is offered the choice of

1. accepting a 50:50 chance of winning $100,000 or nothing or
2. receiving $40,000 with certainty.
 Many people would prefer the $40,000 even though the expected payoff on the 50:50
chance of winning $100,000 is $50,000.

 A company may be unwilling to invest a large sum of money in a new product

even when the expected profit is substantial if there is a risk of losing its
investment and thereby becoming bankrupt.
 People buy insurance even though it is a poor investment from the viewpoint of
the expected payoff.
 This scale is called the utility function for money.
 It can be illustrated using a decision tree

03/08/2023
Decision Trees
 It is a graphic decision-making tool typically used to
evaluate decisions involving a series of steps
 It enables a decision maker to decompose a large complex
decision problem into several smaller problems
 Few decisions are taken in isolation in the sense that an
action is selected in order to optimize a single immediate
outcome
 people must make a series of decisions at different points in time
 Decisions are more complicated & involve a series of steps
 These steps (sequential decisions) are interdependent

03/08/2023
 Decision Trees
 It is a schematic representation of the available
alternatives and their possible consequences.
 Is a chronological representation of the decision problem.

 Each decision tree has two types of nodes;

1. round nodes correspond to the states of nature
2. square nodes correspond to the decision alternatives.
 The branches leaving each round node represent the
different states of nature
 the branches leaving each square node represent the
different decision alternatives.
 At the end of each limb of a tree there are the payoffs
attained from the series of branches making up that limb

03/08/2023
 Drawing a Decision Tree
Example: Plant building decision
A company must decide whether to build a small or large plant to
manufacture a new product with an expected life of 10 years
A large plant
A small plant

If build a large plant, the company will face three future situations: high
product demand, low product demand, or high initial and then low
demand
If build a small plant, the company faces either initially high or initially
low product demand
 If a small plant is built and there is high product demand during an initial two-year
period, manager has chance to choose whether to expand the plant or not
 Whether expand or not, manager will then face either high or low product demand
in the future
03/08/2023
 Drawing a Decision Tree
 To adequately compare these consequences, manager should
 Estimate of investment amounts necessary for building a large plant, for
building a small plant, and for expanding a small plant
 Weight the probabilities of facing different product demand levels for
various decision alternatives
 Consider the income yields for each decision alternative

 Analysis of the expected values & net expected gain for each decision
alternative helps manager to decide on an appropriate choice
Net expected gain is defined as the expected value of an
alternative minus the investment cost
 If building a large plant yields the highest net expected gain, the company
should decide to build the large plant
03/08/2023
 Drawing a Decision Tree
To draw a decision tree
that represents the
plant building problem,
we begin at the present
and proceed toward
future events and
decisions
A decision tree is
constructed with two
kinds of nodes:
 decision nodes and
 event nodes
 Drawing a Decision Tree

 A decision node (denoted by □)

represents a time point when the
decision-maker has to make a
decision

A Build large plant

B Build small plant

 Each branch originating from a

decision node represents a possible
decision
03/08/2023
 Drawing a Decision Tree
An event node (denoted by O) is
drawn when outside forces
determine which of several random
events will occur
0.6
Initial high demand

0.4
Initial low demand

 Each branch of an event node

represents a possible outcome, and the
number on each branch represents the
probability that the event will occur
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Drawing a Decision Tree

A branch of a
decision tree is a
terminal branch
if no nodes
emanate from
the branch

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Drawing a Decision Tree
After the various possible
alternatives related to this
decision have been
outlined, the financial
consequences of each
different course of action
must be compared

03/08/2023
 Example
 Assume that ABC Real Estate planed to built either of the three
alternatives investment activities (Apartment building, office
building or warehouse)
 The payoff for each alternative investment is given as follow.
State of Nature
Good economic poor economic
Decision conditions (0.6) conditions(0.4)
(Purchase)_______________________________

Apartment building 50,000 30,000

Office building 100,000 -40,000
Warehouse 30,000 10,000
Required : based on the given, draw the decision tree and
determine the best strategy
03/08/2023
Drawing Decision Tree

Good economic 50,0000

conditions (0.6)

Poor economic 30,000

Apartment Building conditions (0.4)
2

Good economic conditions (0.6) 100,00

Office building

1
3
Poor economic -40,000
conditions (0.4)

Good economic conditions (0.6 ) 30,100

Warehouse

4 Poor economic
conditions (0.4)
10,000

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 Determining the best decision
 Determining the best decision using a decision tree involves
computing the expected value at each probability node.
 This is accomplished by starting with the final outcomes
(payoffs) and working backward through the decision tree
toward node 1.
 First, the expected value of the payoffs is computed at each
probability node.
EMV(node 2) = .60($ 50,000) + .40($ 30,000) = $42,000
EMV(node 3) = .60($100,000) + .40($-40,000) = $44,000
EMV(node 4) = .60($ 30,000) + .40($ 10,000) = $22,000
 As we compared the three alternatives the higher value derived
from the office building. Therefore the ABC Real Estate should
invest on the office building.
03/08/2023 74
Individual Assignment 1
1. If there is an increase in capital investment next year, the probability
that the price of structural steel will increase is 0.90. If there is no
increase in such investment, the probability of an increase is 0.40.
Overall we estimate that there is a 60 percent chance that capital
investment will increase next year. (3 Pts.)
a. What is the overall probability of an increase in structural steel price
next year
b. Suppose that during the next year structural steel price in fact increase,
what is the probability that there was an increase in capital

2. The probability that a trainee will remain with a company is 0.6 and the
probability that an employee earns more than 10,000 birr per month is
0.5. The probability that an employee who is a trainee remained with the
company or who earns more than 10,000 birr per month is 0.7.what is
the probability that an employee earns more than 10,000 per month
given that he is a trainee who stayed with the company? (3 Pts.)
03/08/2023 BY AMARE MABRIE (ASS. PROFESSOR)
 Count...
4. ABC Company currently has assets of Birr 200,000 and wants
to decide whether to market a new chocolate-flavored soda,
and has the following alternatives (4 Pts.)
Alternative 1: Perform a market study. Test market Chocolate
locally, then utilize the results of the market study to determine
whether or not to market Chocolate nationally
Alternative 2: Immediately (without test marketing) market
Chocolate nationally
Alternative 3: Immediately (without test marketing) decide not to
market Chocolate nationally

03/08/2023 76
 Count...
 In the absence of a market study, Chocolate has a 55% chance of being a
national success and a 45% chance of being a national failure
 For a national success, Allan's asset position will increase by $300,000
 For a national failure, Allan's asset position will decrease by $100,000

If a market study is performed (at a cost of $30,000)

 a 60% chance that the study will yield favorable results (a local success)
 a 40% chance that the study will yield unfavorable results (a local failure)

If a local success is observed

 85% chance that Chocolate will be a national success
If a local failure is observed
 Only a 10% chance that Chocolate will be a national success
If Allan is risk-neutral, i.e., he wants to maximize his expected
final asset position, then what strategy should he adopt?
03/08/2023 77