Decision Trees

Introduction
First of all it is interesting introduce some denition. Assume there is a lottery with payos xL = 2 with
probability 0.5 and xH = 10. The expected payo is equal to
x = 0:5(10 + 2) = 6
Let dene U (x) the utility associated with the expected payo, while E(U (x)) = 0:5(U(10) + U (2)) is the
expected payo associated with the lottery.
We say that an agent participating to the lottery is risk avers if
U (x) > E(U (x))
an agent is risk neutral if
U (x) = E(U (x))
and nally is risk lover if
U (x) < E(U (x))
The certain equivalent is the amount an agent is ready to accept for not participating to the lottery. In the
case of the risk avers the certain equivalent CE corresponds to the amount xCE such that E(U (x)) = U (xCE ).
In the case of the risk avers agent xCE x.

Decision trees, example 1

Assume you have to ship a gift, but there is a probability 0.4 that the shipment fails. In this case you have a
loss of 80. Your total wealth is 100$. You have the opportunity to insure the gift and the insurance premium
costs 30.
Generally you are asked to nd the Expected Monetary Value with uncertainty of this problem. How to
attack the problem?
Recall here, with uncertainty, its like the real life. There is a probability that something can happen,
then you compute the payo for each alternative and then the expected value of each scenario. Finally you
make a decision. Here is the same.
1. Payo: case insured/no fail =100-30=70;
2. Payo: case insured/fail=100-80+80-30=70;
3. Payo: case not insured/no fail=100;
4. Payo: case not insured/fail=100-80=20;
Expected payo of 1and 2, that is being insured, is equal to 70, while the expected payo of not being
insured is equal to 68.
Comparing the expected return we can say what we prefer. Specically we choose to be insured. The
Expected Monetary Value under uncertainty is then equal to 70.
Another frequent question is how much we are willing to pay in order to know what is going on before
choosing.
To solve this problem we have to compute the Expected Monetary Value under perfect information. The
point here is to look at the best strategy under the dierent cases if we were able to know the state of the
nature (no fail or fail). It follows that if fail then insurance (100-30), while if no fail then no insurance (payo
100). Then, we multiply these payos by the probabilities we have in the case of uncertainty: fail (0.4) and
no fail (0.6). This leads to a expected return of 88. The dierence between Expected Monetary Value under
perfect information - Expected Monetary Value under uncertainty gives us
the price of the information = 88

70 = 18

Decision trees, example 2

Dierent risky investment plans.
Plan A: prob. high market 0.8 payo associated 100; prob. low market 0.2 payo associated 20.
Plan B: prob. bad event 0.2 payo 10; prob. nothing change event 0.5 payo 60; prob. good event 0.3
payo 100.
For computing EMV under uncertainty we do as before. Specically, it is equal to 84.
This example is dierent than the previous one because there exist two sources of uncertainty. Assume
we want to know how much we are willing to pay in order to eliminate uncertainty in plan A. The mechanism
to be apply is a little bit dierent.
First, for plan B (the plan where uncertainty is not solved) we take the expected value of the plan (62).
For plane A, we have that if high than 100 if low then 20. Then we have to compare the payos of the two
alternatives (A and B) under the dierent state of the nature we are controlling for (High or Low), taking
each time the highest. Case plan B vs plan A (high) we prefer plan A that gives us a payo of 100, while in
case plan B vs plan A (low) we prefer plan B (62). EMV under perfect info is equal to
EM VP I = 100 0:8(prob:high) + 62 0:2(prob:low) = 92:4
The price ready to pay is equal to
price = EM VP I

EM Vuncert = 92:4

84 = 8:4

It is clear that the price for solving uncertainty is dierent if we focus on plan B. In this case, we have three
alternative to compare:
1. B-low vs plan A (we prefer A with an expected return of 84);
2. B-average vs plan A (again we prefer plan A with an expected return of 84)
3. B-high vs plan A (we prefer B with a return of 100)
EMV under perfect info is equal to
EM VP I = 84 0:2(prob:low) + 84 0:5(prob:average) + 100 0:3(prob:high) = 88:8
The price ready to pay is equal to
price = EM VP I

EM Vuncert = 88:8

84 = 4:8