Decision Tree Analysis
The decision tree traces the sequence of events and/or decisions that lead to each outcome. Such a diagram shows two or more branches at each point where a decision or event (i.e., a state of nature) leads to various outcomes. These branches are similar to those on a tree. The 'construction' of the decision tree starts from left with the earliest decision and moves forward in time to the right through a series of subsequent events and decisions. Next strategies are formulated by assuming competitors, reaction followed by analysis of the strategy under different types of macroeconomic environment. The 'analysis' / 'backward induction' of a tree begins at the right end of the sequence and works backward left.
Suppose the Jones Corporation has to decide whether or not to raise the price of its automobile tyres. The decision tree will help in visualising the relevant choices. It represents a decision problem as a series of choices, each of which is depicted by a fork or a branching point. A decision fork is a controllable fork as this is a juncture representing a choice where the decision maker is in control of the outcome. A chance fork is a juncture where chance controls the outcome. It is an uncontrollable event of the firm. Therefore, probabilities are assigned to each possible price of competitors. To differentiate between the two, a small square is placed at the decision fork.
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