🌳 What are decision trees?
Big Idea: A decision tree is a diagram that maps out different choices and their possible outcomes, including probabilities and financial values. It helps managers make decisions based on expected value rather than gut feeling! 🎲
Key parts of a decision tree
- Decision node (square □) — a point where the manager makes a choice
- Chance node (circle ○) — a point where different outcomes can happen
- Branches — lines showing different options or outcomes
- Probabilities — the likelihood of each outcome (must add up to 1)
- Expected values — the financial return of each outcome × its probability
✅❌ Benefits and limitations
- ✅ Visual — easy to see all options and outcomes at once
- ✅ Quantitative — uses numbers to compare options objectively
- ✅ Forces managers to consider probabilities and risks
- ✅ Can compare expected values of different choices
- ❌ Probabilities are estimates — they may be wrong
- ❌ Doesn't consider qualitative factors (ethics, reputation, morale)
- ❌ Can be complex for decisions with many options
- ❌ Gives a false sense of precision
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👀 Reading a decision tree
- Start from the LEFT at the decision node (□)
- Follow each branch to see the options
- At chance nodes (○), look at the probabilities and payoffs
- Calculate expected value for each option
- Compare expected values — the highest is usually the best choice
- But always consider qualitative factors too!
Exam tip: When evaluating a decision tree, don't just pick the highest EV — also discuss risk, stakeholders and non-financial factors.