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Introduction to Probability &

Decision Making Under Uncertainty

By:

Made Rai Laksmi

29113146

49 B

MASTER OF BUSINESS AND ADMINISTRATION

SHOOL OF BUSINESS AND MANAGEMENT

BANDUNG INSTITUTE OF TECHNOLOGY

2014

Decision Making_Made Rai Laksmi_29113146 Page 1

Chapter 4: Introduction to Probability

Each of possible things that can happen is called an outcome. An event consists of one or

more possible outcome. There are three different approaches to deriving probabilities: the

classical approach, the relative frequency approach and the subjective approach. The first two

methods lead to what are often referred to as objective probabilities because, if they have access

to the same information, different people using either of these approaches should arrive at

exactly the same probabilities. In contrast, if the subjective approach is adopted it is likely that

people will differ in the probabilities which they put forward.

The Classical Approach

The classical approach to probability involves the application of the following formula:

The probability of an event occurring

**The Relative Frequency Approach
**

In the relative frequency approach the probability of an event occurring is regarded as the

proportion of times that the event occurs in the long run if stable conditions apply. This

probability can be estimated by repeating an experiment a large number of times or by gathering

relevant data and determining the frequency with which the event of interest has occurred in the

past.

The Subjective Approach

A subjective probability is an expression of an individual’s degree of belief that a

particular event will occur. Of course, such a statement may be influenced by past data or any

other information, but it is ultimately a personal judgment, and as such it is likely that individuals

will differ in the estimates they put forward even if they have access to the same information.

Some people may be concerned that subjective probability estimates are likely to be of poor

quality.

Decision Making_Made Rai Laksmi_29113146 Page 2

Mutually Exclusive and Exhaustive Events

Two events are mutually exclusive (or disjoint) if the occurrence of one of the events precludes

the simultaneous occurrence of the other. However, the events of ‘dollar raises against the yen

tomorrow’ and ‘the Dow-Jones index falls tomorrow’ are not mutually exclusive: there is clearly

a possibility that both events can occur together. If you make a list of the events which can occur

when you adopt a particular course of action then this list is said to be exhaustive if your list

includes every possible event.

The addition rule

In these cases the addition rule can be used to calculate the required probability but, before

applying the rule, it is essential to establish whether or not the two events are mutually exclusive.

If the events are mutually exclusive then the addition rule is:

p(A or B) = p(A) + p(B) (where A and B are the events)

Note that the complete set of probabilities given by the manager sum to 1, which implies that the

list of possible launch times is exhaustive. If the events are not mutually exclusive we should

apply the addition rule as follows:

p(A or B) = p(A) + p(B) − p(A and B)

Complementary Events

If A is an event then the event ‘A does not occur’ is said to be the complement of A. For

example, the complement of the event ‘project completed on time’ is the event ‘project not

completed on time’, while the complement of the event ‘inflation exceeds 5% next year’ is the

event ‘inflation is less than or equal to 5% next year’. The complement of event A can be written

as A (pronounced ‘A bar’).

Since it is certain that either the event or its complement must occur their probabilities

always sum to one. This leads to the useful expression:

p(

̅

) = 1 − p(A)

Decision Making_Made Rai Laksmi_29113146 Page 3

Marginal and conditional probabilities

Marginal probabilities:

p(worker contracts cancer) = 268/1000 = 0.268

Conditional probabilities:

p(worker contracts cancer|exposed to chemical) = 220/335 = 0.620

Independent and Dependent Events

Two events, A and B, are said to be independent if the probability of event A occurring is

unaffected by the occurrence or non-occurrence of event B. If two events, A and B, are

independent then clearly:

p(A|B) = p(A)

because the fact that B has occurred does not change the probability of A occurring. In other

words, the conditional probability is the same as the marginal probability. In the previous section

we saw that the probability of a worker contracting cancer was affected by whether or not he or

she has been exposed to a chemical. These two events are therefore said to be dependent.

The multiplication rule

In many circumstances, we need to calculate the probability that both A and B will occur. The

probability of A and B occurring is known as a joint probability, and joint probabilities can be

calculated by using the multiplication rule. Before applying this rule we need to establish

whether or not the two events are independent. If they are, then the multiplication rule is:

p(A and B) = p(A) × p(B)

If the events are not independent the multiplication rule is:

p(A and B) = p(A) × p(B|A)

Decision Making_Made Rai Laksmi_29113146 Page 4

because A’s occurrence would affect B’s probability of occurrence. Thus we have the probability

of A occurring multiplied by the probability of B occurring, given that A has occurred.

Probability trees

One device which can prove to be particularly useful when awkward problems need to be solved

is the probability tree. The example of probability tree:

Probability distributions

When we are faced with a decision it is more likely that we will be concerned to identify all the

possible events which could occur, if a particular course of action was chosen, together with their

probabilities of occurrence. This complete statement of all the possible events and their

probabilities is known as a probability distribution. This is therefore an example of what is

known as a discrete probability distribution:

Decision Making_Made Rai Laksmi_29113146 Page 5

In contrast, in a continuous probability distribution the uncertain quantity can take on any value

within a specified interval. Because continuous uncertain quantities can assume an infinite

number of values, we do not think in terms of the probability of a particular value occurring.

Instead, the probability that the variable will take on a value within a given range is determined.

Note that the vertical axis of the graph has been labeled probability density rather than

probability because we are not using the graph to display the probability that exact values will

occur. The curve shown is known as a probability density function (pdf). The probability that the

completion time will be between two values is found by considering the area under the pdf

between these two points.

Cumulative distribution function (cdf) gives the probability that a variable will have a value less

than a particular value. Sometimes it is useful to use continuous distributions as approximations

for discrete distributions and vice versa. For example, when a discrete variable can assume a

large number of possible values it may be easier to treat it as a continuous variable.

Decision Making_Made Rai Laksmi_29113146 Page 6

Expected Values

An expected value is a weighted average with each possible value of the uncertain quantity being

weighted by its probability of occurrence. Although an expected value is most easily interpreted

as ‘an average value which will result if a process is repeated a large number of times’, we may

wish to use expected values even in unique situations.

The axioms of probability theory

If you use subjective probabilities to express your degree of belief that events will occur then

your thinking must conform to the axioms of probability theory. These axioms have been

implied by the preceding discussion, but we will formally state them below.

Axiom 1: Positiveness

The probability of an event occurring must be non-negative.

Axiom 2: Certainty

The probability of an event which is certain to occur is 1. Thus axioms 1 and 2 imply that the

probability of an event occurring must be at least zero and no greater than 1.

Axiom 3: Unions

If events A and B are mutually exclusive then:

p(A or B) = p(A) + p(B)

They are generally referred to as Kolmogoroff’s axioms and they relate to situations where the

number of possible outcomes is finite.

Decision Making_Made Rai Laksmi_29113146 Page 7

Chapter 5: Decision Making Under Uncertainty

The maximin criterion

The main problem with the maximin criterion is its inherent pessimism. Each option is assessed

only on its worst possible outcome so that all other possible outcomes are ignored. The implicit

assumption is that the worst is bound to happen while the chances of this outcome occurring may

be extremely small.

The Expected Monetary Value (EMV) criterion

If the food manufacturer is able, and willing, to estimate probabilities for the two possible

levels of demand, then it may be appropriate for him to choose the alternative which will lead to

the highest expected daily profit. If he makes the decision on this basis then he is said to be using

the expected monetary value or EMV criterion.

The probabilities and profits used in this problem may only be rough estimates or, if they

are based on reliable past data, they may be subject to change. We should therefore carry out

sensitivity analysis to determine how large a change there would need to be in these values

before the alternative course of action would be preferred.

Limitations of the EMV criterion

The EMV criterion assumes that the decision maker has a linear value function for money. A

further limitation of the EMV criterion is that it focuses on only one attribute: money. In

choosing the design, we may also wish to consider attributes such as the effect on company

image of successfully developing a sophisticated new design, the spin-offs of enhanced skills and

knowledge resulting from the development and the time it would take to develop the designs. All

these attributes, like the monetary returns, would probably have some risk associated with them.

Single-attribute utility

The attitude to risk of a decision maker can be assessed by eliciting a utility function.

There are several approaches which can be adopted to elicit utilities. The most commonly used

methods involve offering the decision maker a series of choices between receiving given sums of

money for certain or entering hypothetical lotteries. The decision maker’s utility function is then

Decision Making_Made Rai Laksmi_29113146 Page 8

inferred from the choices that are made. The method which we will demonstrate here is an

example of the probability-equivalence approach. In decision theory, an ‘expected utility’ is only

a ‘certainty equivalent’, that is, a single ‘certain’ figure that is equivalent in preference to the

uncertain situations.

Interpreting utility functions

Utility functions having the concave shape provide evidence of risk aversion. Interpreting

the shape of a utility function:

(a). A risk-seeking attitude (or risk proneness). A person with a utility function like this

would have accepted the gamble which offered.

(b). Risk neutrality, which means that the EMV criterion would represent the decision

maker’s preferences.

(c). Both a risk-seeking attitude and risk aversion. If the decision maker currently has assets

of $y then he will be averse to taking a risk. The reverse is true if currently he has assets

of only $x.

It is important to note that individual’s utility functions do not remain constant over time.

They may vary from day to day, especially if the person’s asset position changes. If you win a

large sum of money tomorrow then you may be more willing to take a risk than you are today.

The axioms of utility

This will be true if the decision maker’s preferences conform to the following axioms:

Axiom 1: The complete ordering axiom

To satisfy this axiom the decision maker must be able to place all lotteries in order of preference.

For example, if he is offered a choice between two lotteries, the decision maker must be able to

Decision Making_Made Rai Laksmi_29113146 Page 9

say which he prefers or whether he is indifferent between them. (For the purposes of this

discussion we will also regard a certain chance of winning a reward as a lottery.)

Axiom 2: The transitivity axiom

If the decision maker prefers lottery A to lottery B and lottery B to lottery C then, if he conforms

to this axiom, he must also prefer lottery A to lottery C (i.e. his preferences must be transitive).

Axiom 3: The continuity axiom

The continuity axiom states that there must be some value of p at which the decision maker will

be indifferent between the two lotteries.

Axiom 4: The substitution axiom

Axiom 5: Unequal probability axiom

Axiom 6: Compound lottery axiom

Deriving the Multi-attribute utility function

Assuming that mutual utility independence does exist, we now derive the multi-attribute utility

function as follows.

Stage 1: Derive single-attribute utility functions for overrun time and project cost.

Stage 2: Combine the single-attribute functions to obtain a multi-attribute utility function so that

we can compare the alternative courses of action in terms of their performance over

both attributes.

Stage 3: Perform consistency checks, to see if the multi-attribute utility function really does

represent the decision maker’s preferences, and sensitivity analysis to examine the

effect of changes in the figures supplied by the decision maker.

Further points on multi-attribute utility

Models have also been developed which can handle situations where mutual utility independence

does not exist, but the complexities of these models have meant that they have proved to be of

little practical value. In any case, if mutual utility independence does not exist it is likely that by

redefining the attributes a new set can be found which does exhibit the required independence.

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