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SUMMARY

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
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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.

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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)
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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)
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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:


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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.

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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.

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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
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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
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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.