Decision Tree Basics

Decision trees are used to select the best course of action in situations where you face uncertainty. Many business decisions fall into this category. For example, a manufacturer must decide how much inventory to build before knowing precisely what demand will be. A litigant must choose between accepting an out-of-court settlement or risking a trial. A speculator must decide to buy an asset before knowing if it can be sold for a profit.

In all of these cases, the decision-maker faces an unknown that seems to make it impossible to choose the right option with any certainty. Although the decision-maker does not know what the outcome of the unknown will be, he or she generally has some knowledge about what the possible outcomes are and how likely each is to occur. This information can be used to select the option that is most likely to yield favorable results. Decision trees make this type of analysis easy to apply.

See Also

Expected Monetary Value

Decision Diagrams

Incremental Values