Overview

Decision Trees

Basic analytical tool of decision making Non-strategic decisions Strategic decisions

Decision rules follow from decision trees The concept of economic profit

Decisions

Degree of interdependence

Non-strategic Direct consequences of your decision depend only upon your own behavior, not that of others Strategic Agents actions interact to determine direct consequences for all

Uncertainty

Low Linkages between actions and consequences are well understood and completely specified High Linkages are partially understood and/or incompletely specified

Types of Decisions
Degree of Interdependence with others actions
High How hard to study What to bid Market entry

Which MBA What to wear Whether to do an MBA Extreme sports High

Low

What to have for lunch

Low

Degree of Uncertainty

Decision Trees

The basic tool for decision making is a decision tree

Idea: a traveller comes to a fork in the road. She must make a decision whether to go right or left.

L R

Example (non-strategic under certainty)

= Decision Node: indicates a point at which an action must be taken (one path for each possible action)

Entry decision

$120,000

$150,000

$0 Location decision

Changs Dilemma in 2003

Sarah Chang is the owner of a small electronics company. There is a proposal for the provision of an electronic timing system for the 2004 Olympic Games. For several years, Changs company has been developing a new microprocessor, a critical component in a timing system that would be superior to any product currently on the market. Progress has been slow and Chang is unsure about whether the new product will be developed on time. If the R&D succeeds, then there is an excellent chance her company will win the $1m Olympic contract; awarded solely on the basis of quality. If it does not succeed, they might still win the contract with their original, but inferior, system for which there are closer substitutes. The costs involved in continuing R&D are $200,000. Developing a proposal itself will cost Changs company $50,000. Finally, the costs of producing the product should they win the contract will be $150,000. Should Chang continue R&D or not?

Framing the Decision: Step I

Changs decision is between two alternatives to continue R&D or to abandon the project
Take risk on developing the new technology at an additional cost of $200,000 and reconsider proposal

Continue

Abandon

Perhaps make proposal with inferior technology at an additional cost of $50,000

Step II

Continue Proposal Abandon Not

$0 Expend $50,000 and perhaps win

Uncertainty in a decision tree

Chang must assess the probability of success Objective based upon data or specific knowledge Subjective based upon experience & judgement Suppose the probability of winning the contract with the old product is only 5% = 0.05 This implies probability of losing is 95%
= Random Event Node: point at which Nature takes an action of her own (one path for each possible outcome)

Step III

Continue Proposal Abandon Not

$0

Win 0.05 0.95 Lose

$800,000

-$50,000

Step IV
Expend $50,000 and have a good chance of winning

Succeed

0.5

0.5

Continue

Fail

Expend $50,000 and perhaps win

Win 0.05

$800,000

Proposal Abandon
Lose 0.95 -$50,000

Not

$0

Step V
$600,000 W

Prop
L -$200,000 W 0.5 Fail

0.9 0.1

Succeed

0.5

No

-$250,000 $600,000 0.05

Prop
0.95 L -$200,000 $800,000 W 0.05 0.95 L -$50,000 -$250,000

Continue

No

Abandon

Prop
$0

No

Optimal decision plan

While we built the tree by adding branches the way to solve it is to start at the end and roll back. Looking forward and working backwards is a key skill in economic decision-making

Example (non-strategic under certainty)

$120,000

$150,000

$0

First, solve a node furthest to the right

Decision node: Pick the best choice Nature node: Calculate the average value

Solve next node to the left Continue

Solving at a node with uncertainty: Expected value

Chang wants to know, is R&D a risk worth taking? Easy to solve, so long as Chang is risk-neutral;

Risk-neutral agents prefer decisions with highest average payoff Good assumption when agent is a firm, poor for individuals (investors can diversify their own portfolios)

Example: Flip a coin,

Heads you get $2.10 Tails you lose $1.00

1000 flips: roughly 500 heads, 500 tails an average of ?

per flip.

Expected value: = (Probability of heads)(Payoff if heads) + (Prob of tails)(Payoff if tails) = x 2.1 + x (-1.00) = x (2.1 1.00) = $ 0.55

Solving the Tree

Expected value =
0.05 ($800,000) + 0.95 (-$50,000) = - $7,500

Continue

?
Win 0.05 $800,000

Proposal Abandon Not

$0 Lose

0.95 -$50,000

Solving the Tree

Choose the branch with the best payoff ?
Proposal Abandon Not
$0 -$7,500

Continue

Solving the Tree

Win

$600,000
0.9 0.1

Proposal
Succeed

0.5

Not

Lose -$200,000 Win 0.05 0.95

-$250,000 $600,000

Continue
Fail

0.5

Proposal

Not

Lose -$200,000

-$250,000

Abandon

$0

Solving the Tree

Win

$600,000
0.9 0.1

Proposal
Succeed

0.5

Not

Lose -$200,000

-$250,000

Continue
Fail

0.5

Proposal Not

-$207,500

-$200,000

Abandon

$0

Solving the Tree

Proposal
Succeed $515,000

0.5

Not
-$200,000

Continue
Fail

0.5 -$200,000

Abandon

$0

Solving the Tree

$515,000 Succeed

0.5

Continue
Fail

0.5 -$200,000

Abandon

$0

Solving the Tree

1. Never make proposal if dont have newer technology 2. Choose to take risk and continue R&D
$157,500

Continue

Abandon

$0

Indys Choice
Example (from Dixit & Nalebuff): Indiana Jones in the climax of the movie Indiana Jones and the Last Crusade.

Indiana Jones, his father, and the Nazis have all converged at the site of the Holy Grail. The two Joneses refuse to help the Nazis reach the last step. So the Nazis shoot Indianas dad. Only the healing power of the Holy Grail can save the senior Dr. Jones from his mortal wound. Suitably motivated, Indiana leads the way to the Holy Grail. But there is one final challenge. He must choose between literally scores of chalices, only one of which is the cup of Christ. While the right cup brings eternal life, the wrong choice is fatal. The Nazi leader impatiently chooses a beautiful gold chalice, drinks the holy water, and dies from the sudden death that follows from the wrong choice. Indiana picks a wooden chalice, the cup of a carpenter. Exclaiming Theres only one way to find out he dips the chalice into the font and drinks what he hopes is the cup of life. Upon discovering that he has chosen wisely, Indiana brings the cup to his father and the water heals the mortal wound.

Framing the Decision

What alternatives does Indy have?

Drink himself

Give drink to Snr

Framing the Decision

Do you need more information?

Right Jnr & Snr Live

Drink himself
Wrong Right Jnr & Snr Die Jnr & Snr Live

Give drink to Snr

Wrong

Snr Dies but Jnr Lives

Uses of Decision Trees

Decision Trees are used in situations that may be too complex to think through in your mind
In Decision Analysis: used in situations where there is uncertainty, multiple decisions In Managerial Economics: used in situations where

The payoffs are not so obvious The alternative choices are not so obvious Several players have to make choices

Being systematic helps you to see though complexity and to remember all your alternative choices

Economic Cost = opportunity foregone

The true cost of one choice is giving up the benefits associated with your next-best choice

Example: What is the cost of doing an MBA? Besides the price, there is an opportunity cost = what you would have earned, using the resource (your time) for another opportunity Costs that do not change with your decision are irrelevant

Consider this situation

Mita runs petrol stations and express stores at several highway exits. Until recently, she didnt sell any drinks. She brought in a new line of drinks, Fizzies, which have proved unpopular. She has 10,000 Fizzies left. She thinks she can sell half of the remaining drinks for $1.00, but only 15% of the drinks at the standard price of $2.50. If she paid $0.30 per drink, how much should she charge? What about if she paid $1.05 per drink?

Mita cannot return unsold stock of Fizzies, but must throw the stock out.

Definition: Sunk Cost

A cost is considered sunk with respect to a specific decision if, no matter what you decide, that cost does not change
On a decision tree, a sunk cost appears on all leaves (payoffs)

sell at $2.50 Mita sell at $1.00

$3750 - cost
$5000 - cost

Economic benefit of charging $1 rather than $2.5 is $1,250 (cost is the same in all cases it is sunk & irrelevant)

Definition: *** Economic Profit ***

The economic profit of a decision is the cash you earn from one decision, minus that from the best alternative decision
Decision tree: $ from best choice, minus $ from next best choice

sell at $2.50 Mita sell at $1.00

$3750 - cost
$5000 - cost

Economic profit = $1,250