Decision tree analysis

with Posterior Probabilities

Using New Information to Update the Probabilities

• The prior probabilities of the possible states of

nature often are quite subjective in nature. They
may only be rough estimates.

• It is frequently possible to do additional testing or

surveying (at some expense) to improve these
estimates. The improved estimates are called
posterior probabilities.

9-2
Seismic Survey for Goferbroke
• Goferbroke can obtain improved estimates of the chance of oil by
conducting a detailed seismic survey of the land, at a cost of $30,000.
• Possible findings from a seismic survey:
• FSS: Favorable seismic soundings; oil is fairly likely.
• USS: Unfavorable seismic soundings; oil is quite unlikely.
• P(finding | state) = Probability that the indicated finding will occur,
given that the state of nature is the indicated one.

P(finding | state)
State of Nature Favorable (FSS) Unfavorable (USS)
Oil P(FSS | Oil) = 0.6 P(USS | Oil) = 0.4
Dry P(FSS | Dry) = 0.2 P(USS | Dry) = 0.8

9-3
Calculating Joint Probabilities
• Each combination of a state of nature and a finding will have a joint
probability determined by the following formula:

P(state and finding) = P(state) P(finding | state)

• P(Oil and FSS) = P(Oil) P(FSS | Oil) = (0.25)(0.6) = 0.15.

• P(Oil and USS) = P(Oil) P(USS | Oil) = (0.25)(0.4) = 0.1.
• P(Dry and FSS) = P(Dry) P(FSS | Dry) = (0.75)(0.2) = 0.15.
• P(Dry and USS) = P(Dry) P(USS | Dry) = (0.75)(0.8) = 0.6.

9-4
Probabilities of Each Finding
• Given the joint probabilities of both a particular state of nature and a
particular finding, the next step is to use these probabilities to find
each probability of just a particular finding, without specifying the
state of nature.

P(finding) = P(Oil and finding) + P(Dry and finding)

• P(FSS) = 0.15 + 0.15 = 0.3.

• P(USS) = 0.1 + 0.6 = 0.7.

9-5
Calculating the Posterior Probabilities
• The posterior probabilities give the probability of a particular state of
nature, given a particular finding from the seismic survey.

P(state | finding) = P(state and finding) / P(finding)

• P(Oil | FSS) = 0.15 / 0.3 = 0.5.

• P(Oil | USS) = 0.1 / 0.7 = 0.14.
• P(Dry | FSS) = 0.15 / 0.3 = 0.5.
• P(Dry | USS) = 0.6 / 0.7 = 0.86.

9-6
Probability Tree Diagram
Prior Conditional Joint Posterior
Probabilities Probabilities Probabilities Probabilities
P(state) P(finding | state) P(state and finding) P(state | finding)

0.15 = 0.5
0.25(0.6) = 0.15 0.3
0.6 Oil and FSS Oil, given FSS
FSS, given Oil

0.4
0.25 USS, given Oil 0.1 = 0.14
Oil 0.25(0.4) = 0.1 0.7
Oil and USS Oil, given USS

0.15 = 0.5
0.2 0.75(0.2) = 0.15 0.3
0.75 Dry, given FSS
Dry FSS, given Dry Dry and FSS

0.8 0.6 = 0.86

USS, given Dry 0.75(0.8) = 0.6 0.7
Dry and USS Dry, given USS

Unconditional probabilities: P(FSS) = 0.15 + 0.15 = 0.3

P(finding) P(USS) = 0.1 + 0.6 = 0.7

9-7
Posterior Probabilities
P(state | finding)

Finding Oil Dry

Favorable (FSS) P(Oil | FSS) = 1/2 P(Dry | FSS) = 1/2

Unfavorable (USS) P(Oil | USS) = 1/7 P(Dry | USS) = 6/7

9-8
Decision Tree for the Full Goferbroke Co. Oil

Problem Drill
f

Dry

c
Unfavorable Sell

Oil
b g
Drill Dry
Do seismic survey
Favorable
d
a Sell

Oil
h
No seismic survey Drill
Dry

e
Sell

9-9
The Final Decision Tree -15.7
Oil (0.143)
Payoff
670
800
f
0
Drill
-100 Dry (0.857) -130
60
c
Unfavorable 90
Sell 60
0
123 Oil (0.5) 670
270
b g 800

0 Drill -100 0
Do seismic survey Dry (0.5) -130
-30 Favorable (0.3) 270
d
123 90
a Sell 60
Oil (0.25) 700
0 100 800
h
No seismic survey Drill 0
-100 Dry (0.75) -100
100
e
90
Sell 90

9-10