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Basic Probability Concepts

(These slides are meant to cover probability concepts at the level required in this course.
For those interested in learning more, you may want to take IDS 570. I am happy to
point you to additional references as well)
IDS 532
Instructor: Selva Nadarajah

Uncertainty and Random Variables

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BUSINESS

We are interested in an event where the outcome is uncertain

The outcome of the stochastic event is associated with a numeric value
Therefore, the stochastic event is called a random variable and each of its outcomes
has both a value and a probability
Examples:
1. Demand for a product:

Outcomes: Demand equals a value in set {0 units, 20 units,., 100 units}

Values: Number of units of demand corresponding to the outcome

2. Reward from good or bad decisions

Outcomes: good or bad

Values: $100 if the outcome is good and -$40 if out come is bad

3. Time before next patient arrival

Outcome: Time equals any number between 1 and 60 mins

Values: Time corresponding to outcome

Selva Nadarajah

Discrete Vs. Continuous Random Variables

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Random variables corresponding to a stochastic event can either take discrete values
or continuous values

Demand for a product is a discrete random variable

Time before next patient arrival is a continuous random variable

For analysis, it may be convenient to model a stochastic event with discrete outcomes
using continuous random variables

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What is a Random Model?

A random model specifies the possible outcomes for a random variable (e.g. demand)
and the probability of these outcomes.
Traditional distributions from statistics can be used as random models:
e.g., the normal, gamma, Poisson distributions
GAMMA

POISSON

Probability

Probability

NORMAL

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50

100
Demand

150

200

9 10

Demand
4

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Density Function?

We will use ( )to

denote density
functions

Probability

The density function tells you the probability of a particular outcome occurring.
Density functions can take all kinds of shapes (they dont always have to look like a
bell curve)
For discrete random variables the density function is usually called a probability mass
function e.g. the probability demand will be exactly 5 units.

0
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50

100
Demand

150

200
5

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Distribution Function?

The distribution function tells you the probability the outcome will be a particular
value or smaller.
e.g. the probability demand will be 5 or fewer units.
Distribution functions always start low and increase towards 1.0
1.00
0.80

We will use F( )to

denote density
functions

0.60

Probability

We will most often

work with distribution
functions.

0.40
0.20
0.00
0

Selva Nadarajah

50

100
Demand

150

200
6

Expected Value

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It is the probability weighted average of the outcomes of a random variable

Example:

Suppose a random variable models the reward from the outcome of a decision being good or bad.
A good decision results in a reward of $100, where as a bad outcome results in a loss of $40.
The good and bad outcomes occur with probabilities 0.25 and 0.75, respectively
What is the expected value of the decision?

$100
 good decision + $40
 bad decision

= $100 0.25 + 40 0.75 = $5

In short, we computed the expected value by multiplying the probability of an outcome

with the value of each outcome and summing all these calculations

Selva Nadarajah

General expressions for expected value

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The notation E(D) is typically used to denote the expectation of a random variable D
Discrete random variables

Assume the random variable  takes values  ,  , ,  with probabilities
  ,   , , ( )

  =  ( )

Continuous random variables

Assume the random variable  takes values from to + and has the probability
density function (
)

  = 



When moving from discrete to continuous random variables we have replaced the sum by
an integral in the definition of the expectation

Selva Nadarajah

Normal Distribution (Continuous)

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All normal distributions are characterized by two parameters: mean () and standard
deviation ()
Mean is the expected value of the random variable (also loosely referred to as the
average)
Standard deviation measures the dispersion from the mean

All normal distributions are related to the standard normal that has zero mean and
standard deviation equal to 1.
Selva Nadarajah

Computing Probabilities Using Normal Distributions

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Let be some quantity, and (, ) the parameters of the normal distribution used to
model demand.
Required: Prob demand is or lower
Prob demand is or lower = Prob(the outcome of a standard normal is z or lower)
Referred to as
the z-statistic

z=

or = +

Compute the desired probability using Excel:

Prob(the outcome of a standard normal is z or lower)=NORMSDIST()

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10

UIC
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Poisson Distribution (Discrete)

0.60

0.20
5

0.18
Density function probability

Six Poisson density

functions with means
0.625, 1.25, 2.5,
5,10 and 20

Density function probability

0.50
0.625
0.40
1.25
0.30
0.20

2.5

0.10

0.16
0.14

10

0.12
0.10

20

0.08
0.06
0.04
0.02

0.00

0.00
0

6
Q

10

10

20

30

Defined only by its mean (standard deviation = square root(mean))

Does not always have a bell shape, especially for low demand.
Discrete distribution function: only non-negative integers
Good for modeling demands with low means (e.g., less than 20)

Selva Nadarajah

11

Computing Probabilities Using Poisson Distributions

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Let be some nonnegative quantity, and be the mean of the Poisson distribution
used to model demand.
Required: Prob demand is or lower
Compute the desired probability using Excel:
Prob demand is or lower = POISSON(, , 1)

Selva Nadarajah

12

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Expected Loss
Loss for random variable D is define as follows:
D
=
0

, if D
, if D <

= max{0, D }

Expected loss (EL) is then max 0, (see slide 8)

Relevance to operations? When the random variable denotes demand and is the
number of units of an item in stock, expected loss is the same as expected lost sales

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13

Computing Expected Loss

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For normally distributed demand with mean and standard deviation , we have

EL = , where =
; = (1 )

Now lets assume we have poisson distributed demand, D, taking values , , ,

with probabilities , , , ( ), respectively. To compute expected loss, we
use the definition on slide 8:

= max 0, ( )

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14

Independence and Correlation

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Two random variables are independent if the outcome of one of the random variables
has no effect on the outcome of the other

Example, a high demand outcome for one variable provides no information about whether
the second variable will have a high or low demand outcome

Two random variables are correlated if the outcome of one variable provides
information about the outcome of the other

Positively correlated: If one variable is high, then the other tends to be high, and if one
variable is low then the other also tends to be low

Negatively correlated: If one variable is high, then the other tends to be low, and if one
variable is low then the other tends to be high

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15

Sum of Independent Normal and Poisson Random Variables UIC

BUSINESS
Suppose we have independent normal or Poisson random variables , , ,
The mean and standard deviation of the i-th random variable are and ,
respectively
We are interested in the mean and standard deviation of the sum of these random
variables, that is, = + + +
The mean and standard deviation of are
= + + +
=

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+ + +

16

Sum of Two Correlated Normal Random Variables

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Suppose we have two dependent normal random variables and with means
and and standard deviations and
The dependence between these two random variables is modeled by a number
between -1 and 1 referred to as the correlation coefficient
We are interested in the mean and the standard deviation of the sum of these two
random variables, that is, = +
= +
=

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+ 2 +

17