Mathematics For Management

7/14/2021 Mathematics for Management
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Mathematics for Management

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Introduction
During your business degree program, you will use mathematics in many situations. In your economics courses, you will have to determine how
demand is related to price. You might even use basic calculus to come up with a profit-maximizing price. In your statistics course, you might be
expected to know the basic laws of probability. In your finance courses, you will need to understand the mathematics behind valuing cash flows.
Most of your professors will expect you to know how to solve simple equations and do basic manipulations of algebraic formulas. You may not have
used algebra, calculus, probability, and statistics for five or ten years. If you are an undergraduate English or music major now entering a graduate
business program, you may have never studied calculus or basic probability and statistics.
The purpose of our course is to help level the playing field by giving you the analytic background you need to hit the ground running and complete
a top MBA program successfully. We will try to make the concepts as interesting and easy to learn as possible. You may find it useful to refer to the
Mathematics for Management Concept Summary while taking the course. Let's get started!
Setting
Algebra
INTRODUCTION
You probably remember studying algebra in high school. Algebra is simply a generalization of arithmetic in which letters are used to represent
numbers or quantities (such as price, demand, cost, revenue, and so on). Algebraic principles enable us to examine relationships among those
quantities. For example, given the price of a commodity and an understanding of the relationship between price and demand, algebraic techniques
allow us to compute the demand for that commodity. We can also use algebra to determine the monthly production quantity needed to break even
— that is, to have monthly revenues just cover monthly operating costs.
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Variables
WHAT IS A VARIABLE?
Many quantities in business are unknown. An unknown quantity, usually called a variable, is typically represented by a letter. Often the value
of a variable depends on the value of one or more other variables. Let's look at some important business variables.
EXAMPLES OF VARIABLES
Here are several examples of business variables.
The monthly cost y (let y = monthly cost in dollars) of operating Vivian Hoffman's Happytail Vet Clinic depends on the number of
patients x seen during a given month (let x = patients seen during a month).
The number of lasagna dinners q sold in a month (let q = number of lasagna dinners sold in a month) at Smalltown's PastaQuick Italian
restaurant depends on the price p (let p = price in dollars) of a dinner.
The number of tourists t who visit Smalltown in a year (let t = number of tourists visiting Smalltown in a year) depends on the U.S. Gross
National Product g (let g = GNP in trillions of dollars) and the national unemployment rate u (let u = unemployment rate).
The average time W (let W = average number of hours spent at the clinic) that a person spends at Happytail Clinic depends on the
average time S that Vivian spends with a patient (let S = average hours Vivian spends with a patient) and the average number of patients
A that arrive each hour to her office (let A = average number of patients arriving per hour).
In business, it is often crucial to understand how variables are related. In the next section, we discuss how mathematicians describe relationships
among variables.
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Functions of One Variable

INTRODUCTION
A function of one variable is a rule by which the numerical value of a single variable (the independent variable) yields a numerical output value
(the dependent variable). The independent variable is usually called x, and the dependent variable is usually called y. The expression y = f(x) is
used to indicate that the value of the dependent variable y is determined from the variable x by the function f. However, these particular letters
are not set in stone. The notation q = g(p) might mean, for example, that demand q is determined from the price p by the function g. Let's look at
specific examples of functions of one variable.
ESTIMATING OPERATING COST

Let y = the monthly cost of operating Vivian's office and x = the number of patients seen during the month. Then y = f(x) might be expressed by
f(x) = 20,000 + 35x. Not surprisingly, this functional relationship indicates that an increase in the number of patients seen increases Vivian's
operating costs. For example, if Vivian sees 400 patients during a month, her monthly operating cost is f(400) = 20,000 + 35(400) = $34,000. If
Vivian sees 500 patients during a month, her monthly operating cost would be higher, because f(500) = 20,000 +35(500) = $37,500.
ESTIMATING DEMAND FOR LASAGNA DINNERS

Let q = the number of lasagna dinners sold during a month at the PastaQuick restaurant, p = the price of a lasagna dinner, and D = the demand.
Suppose that q = D(p) = 400
p
. This functional relationship indicates that a higher price results in a lower demand for dinners. For example, if
PastaQuick charges $4 per dinner, the demand is represented by D(4)=
400
p
=200
.
What would happen to demand if they charged $14 for a
lasagna dinner?
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WHAT IS A LINEAR FUNCTION?

A function of one variable of the form f(x) = ax + b is called a linear function. Here a and b are simply numbers (called constants). In short, a
function of a single variable is linear if x is multiplied by a constant (and not, for example, squared or manipulated in some other fashion).
Linear functions are discussed extensively later in this chapter.
In the examples given so far, Vivian's monthly operating cost is a linear function of the number of patients seen, whereas

PastaQuick's monthly demand for lasagna dinners is not a linear function of price. That's because price is not merely multiplied by a constant in
the demand function 400
p
.
EXERCISES
(1) The annual salary (let y = annual salary) of an assistant at Clooney's Dreamhome Realty is $20,000 plus $1,500 times the assistant's years of
experience (let x = years of experience). Express y as a function of x. What would be the salary for an assistant with 10 years of experience? Is
salary a linear function of experience?
(2) The total time in minutes (let y = total time) that Owen's assistant, Britney Swift, needs to complete a stack of closings is 200 times the
square root of the number of closings (let x = number of closings). Express y as a function of x. How long would it take Britney to complete 16
closings? Is the time needed a linear function of the number of closings?
Functions of More Than One Variable
INTRODUCTION
To express the dependence of a dependent variable on more than one independent variable, you need to use a multivariate function. For
example, if y depends on the independent variables x1, x2, and x3, you can write y = f(x1, x2, x3). Let's look at two examples of multivariate
functions.
ESTIMATING TOURIST VISITS

The number of tourists to visit Smalltown in a year (let t = tourists visiting in a year) may depend on the U.S. Gross National Product (let g =
GNP in trillions of dollars) and the national unemployment rate (let u = unemployment rate), as represented by this multivariate function: t =
f(g, u) = 10,000 + 1000g - 2000u. This function implies that a $1 trillion increase in GNP will increase Smalltown's annual tourist count by 1000
people and that a 1% increase in the unemployment rate will decrease Smalltown's annual tourist count by 2000. As a complete example, let's
imagine a year in which the GNP is $14 trillion and the unemployment rate is 7%. The tourist count would then be rendered as follows:
t = f(14,7) = 10,000 + 1000(14) - 2000(7) = 10,000.
ESTIMATING AVERAGE TIME SPENT

Applying a principle you will learn in operations class to this example, you can see that the average time (let W = average number of hours a
patient spends at Vivian Hoffman's veterinary office) depends on the following variables:
S, or the average number of patients Vivian can see in an hour

A, or the average number of patients who arrive at the office per hour
This dependence can be expressed by the following multivariate function:
W⁡
=
f⁡
S
,
A
=
1
S
-
A
Note that this function is valid only if S > A. If S were equal to A, one would have to divide by zero, and division by zero is not defined. If S were
less than A, the function would yield a negative expected time, which is not possible.
EVALUATING A FUNCTION
As an example of how to determine the average time (W) given our function, suppose that an average of 3 clients arrive each hour and that
Vivian spends an average of 12 minutes with each patient. On average, how many hours will a patient spend in the office?
The important point here is that if W is to be expressed in hours per patient, A and S must be expressed in patients per hour. Then the function
will yield a value in hours per patient (because S and A are in the denominator of the function, the units of W will be hours/patient).
LINEAR MULTIVARIATE FUNCTIONS

A multivariate function f(x1, x2, ...xn) of variables x1, x2, ...xn is a linear function if there exist numbers a, b1, b2, ...bn (often called constants) such
that f(x1, x2, ...xn) = a + b1x1 + b2x2 + ...bnxn. Earlier in this section, we found that the number of tourists visiting Smalltown during a year was a
linear function depending on the GNP and unemployment rate. We also found that the average time a patient spends in Vivian's veterinary office
was not a linear function of the arrival rate and average service time. That's because
S and A appear in the denominator of 1
S
-
A
.
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EXERCISE 1
Suppose that you want to determine the number of digital cameras Smalltown's local electronics store should order from its Las Vegas
warehouse. Let
h = the cost of holding one digital camera in inventory for a year;

D = the annual demand for digital cameras; and
K = the cost of placing an order for digital cameras with a supplier.
The famous Economic Order Quantity formula (which you will study in operations class) dictates that each time

the store orders digital cameras, it should order a quantity q such that q
=
f⁡
h
,
D
,
K
=
2
K
D
h
.
Suppose that it costs $100 to place an order and that the store sells an average of 400 digital cameras per month. If it costs $5 to hold a camera
in inventory for a year, how many cameras should be ordered? Is the order quantity a linear function of D, K, and h?
EXERCISE 2
Tina is opening a lemonade stand to make money to pay for her trip to the state soccer championship. At the supermarket, Tina buys lemons for
10 cents each and sugar for $2.50 per pound — her only lemonade-related expenses. If Tina buys L lemons and S pounds of sugar, write a
function that expresses Tina's expenses. If Tina buys 40 lemons and 10 pounds of sugar this month, what are her monthly expenses? Are her
expenses a linear function of lemons and sugar purchased?
Linear Equations: One Variable
WHAT IS AN EQUATION?
An equation is simply a mathematical statement that equates two quantities. For example, in economics class, you will learn that the
equilibrium price in a market is the price that makes supply and demand equal. By setting supply and demand equal to each other, we can find
the equilibrium price.
In this section of this online tutorial, you will learn how to solve linear equations involving a single variable (call it x). An equation in a single
variable is linear if each term in the equation is either a constant or the variable x multiplied by a constant. For example, 13x = 5x + 16 is a linear
equation of one variable, whereas 9x2 + 4 = 85 is not a linear equation.
SOLUTIONS TO EQUATIONS
Also consider the nonlinear equation 9x2 + 4 = 85. It has two solutions: x = 3 and x = -3. Each makes the two sides of the equation equal.
SOLVING LINEAR EQUATIONS

The key to solving an equation is to perform mathematical operations on both sides of the equation that simplify it but do not change the set of
solutions to it. If you can perform mathematical operations on both sides of an equation that isolate all terms involving the variable on one side
of the equation, the equation is usually easy to solve. To solve linear equations, use the following rules:
Rule 1: Adding the same quantity to both sides of an equation does not change the set of solutions to that equation.
Rule 2: Multiplying or dividing both sides of an equation by the same nonzero number does not change the set of solutions to that
equation.
FINDING THE BREAKEVEN POINT

Recall that the monthly cost of operating Hoffman's Happytail Vet Clinic is 20,000 + 35x, where x = the number of patients seen during the
month. Suppose that Vivian charges each patient $75 and wants to know how many patients to see during a given month in order to ensure that
her monthly revenues cover her monthly costs. In short, she wants to know the value of x that satisfies the equation 75x = 20,000 + 35x.
As a check, substitute x = 500 into the original equation to find that each side is equal to 37,500.
75(500) = 20,000 + 35(500) = 37,500
FINDING THE EQUILIBRIUM PRICE

Let p = the price in dollars per gallon of gasoline in Smalltown. Suppose that the daily demand for gas in Smalltown (in thousands of gallons) is
500 - 10p and that the daily supply of gasoline in Smalltown is 400 + 20p. At what price for gasoline would daily supply and demand be equal?
To find out, solve for the value of p in the equation 500 - 10p = 400 + 20p. Begin by adding 10p to both sides, which yields 500 = 400 + 30p.
Next, add -400 to both sides of the equation, which yields 100 = 30p. Finally, divide both sides by 30 to obtain 100/30 = p, or p = 10/3.
Therefore, p is approximately $3.33.
Again, you can check your solution by substituting 10/3 into the equation: 500 - 10(10/3) = 400 + 20(10/3) = 1400/3. The substitution verifies
that a price per gallon of approximately $3.33 brings supply and demand into equilibrium; therefore, p = 10/3 is the solution to the equation.
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EXERCISES
(1) Refer back to the assumptions outlined in the section on finding the breakeven point. How many patients would Vivian have to see in a
month to earn a profit of $10,000?
(2) Gregory can mow the family's lawn in 3 hours, and Jennifer can mow it in 4 hours. If they team up to mow the lawn together, how long will it
take to finish mowing the lawn? Hint: If they mow for x hours, Gregory will mow a fraction of the lawn that can be expressed as x/3.
The Cartesian Plane
INTRODUCTION
Graphing the function y = f(x) requires choosing values of x and finding the value of y for each value of x. Each pair of values (x, y) is a
coordinate that you can plot on the x-y, or Cartesian plane (named after French mathematician and philosopher René Descartes).
GRAPHING POINTS
In the first (upper right) quadrant of the Cartesian plane, x and y are both positive. In the second (upper left) quadrant, x is negative and y is
positive. In the third (lower left) quadrant, both x and y are negative. In the fourth (lower right) quadrant, x is positive and y is negative.
EXERCISES
(1) Graph the point (-3, -5).
(2) Graph the point (2, -4).
(3) Graph the point (1, 2).
(4) Graph the point (-3, 2).
Straight Lines
INTRODUCTION
Many relationships between variables are best expressed using straight lines. For example, straight lines have been used to model the following
relationships:
How does monthly operating cost depend on units produced?

How does demand depend on price?
How does the price of a home depend on the size of that home?
In this segment, you will learn how to graph a straight line and to interpret equations and functions involving straight lines.
SLOPE INTERCEPT FORM

The defining feature of a straight line is that for any value of x, the line has the same slope. Essentially, the slope of a function for a given value of
x is the change in y when x increases by 1 (when you get to the calculus section, this principle will be defined more rigorously). The equation of a
straight line can be written in the slope intercept form as y = mx + b, where m and b are constants.
The constant m is the slope of the line, because whenever x increases by 1, y increases by an amount m. When m is positive, an increase in x
increases y, whereas if m is negative, an increase in x decreases y.
The constant b is called the y intercept because the point (0, b) is the point where the line intersects the y axis. Here are some examples of
straight lines.
SLOPE INTERCEPT FORM OF A LINE
SLOPE INTERCEPT FORM OF A LINE: LINE GOES THROUGH (0,0)

Consider the line y = 10x. For this line, b = 0, and the point (0, 0) is both the x intercept and the y intercept. To graph this line, you need to
locate a point on it other than (0, 0). For example, if you set x equal to 1, you find that the point (1, 10) is on the line. Enter any integer between
-6 and +6 into the input box below, and click the apply button to produce a straight line that intersects with point (0, 0) and extends in both
directions.
MEANING OF SLOPE
The value of a line's slope — independent of its sign, positive or negative — represents the line's steepness. For example, a line with a slope of 6 is
steeper than one with a slope of 2. A line with slope of -6 is steeper than one with a slope of -2 and also steeper than one with a slope of 2. In the
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two figures below, the lines with slopes of 6 and -6, respectively, are the steepest, even though they lean in different directions. Similarly, the
lines with slopes of 2 and -2 are the least steep.
PARALLEL LINES
Two lines with the same slope are said to be parallel. Parallel lines never intersect. The following figure shows the three parallel lines y = 3x + 4,
y = 3x - 2, and y = 3x - 8 . The figure below makes it clear that these lines will never meet. For any value of x, the y coordinate for y = 3x + 4 will
always be 6 units larger than the y coordinate for the line y = 3x - 2 and so on.
USING TWO POINTS TO FIND A LINE

How do you find the equation of a line when you know two points on the line? First, find the line's slope by computing m = slope = change in
y/change in x. Now suppose that one of the two points is (x0, y0). Then you can find the equation of the line using the point slope form of the
line equation:

y
-
y
0
x
-
x
0
=
m
After multiplying both sides of this equation by x - x0, you can easily write a straight line equation in the form y = mx + b.
ESTIMATING A LINEAR DEMAND CURVE

Suppose that Tina is opening a lemonade stand and wants to determine how the demand for a glass of lemonade depends on its price. In this
example, the price p will play the role of x, and the demand q will play the role of y. Tina thinks that if she charges 50 cents per glass, she can sell
20 glasses per day, but that if she charges 75 cents, she will sell only 10 glasses per day. Let's assume that a straight line represents the
relationship between price and demand. Tina believes that the points (50, 20) and (75, 10) are on her demand curve for lemonade. Upon moving
from the first point to the second point, q decreases from 20 to 10 and p increases from 50 to 75. Therefore, the slope of the demand curve is
expressed by
(10 - 20)/(75 - 50) = -0.40.
HORIZONTAL AND VERTICAL LINES

A line with the equation y = a, where a is a constant, is a horizontal line. Horizontal lines have a slope of zero. A line with the equation x = a is a
vertical line, which has an undefined slope. The graphs show the lines y = 4 and x = 3.
GENERAL FORM OF A LINE EQUATION: ax+ by = c

It is often convenient to express a line in the form ax + by = c, where a, b, and c are constants. This is called the general form of the line
equation. Suppose that Jennifer has $200 to purchase stock. If she buys Company B (x) at $10 per share and Company A (y) at $20 per share,
the points on the line 10x + 20y = 200 in the first quadrant represent her budget constraint (focus only on the first quadrant because the number
of shares must be nonnegative). Any point on this line, or inside the triangle bounded by the line and the x and y axes, represents a set of shares
that Jennifer can purchase. The easiest way to graph a line from its general-form equation is to find the line's x and y intercepts. Setting x equal
to zero and solving 20y = 200 reveals that (0, 10) is the y intercept. Setting y equal to zero and solving 10x = 200 reveals that (20, 0) is the x
intercept. The set of points representing the possible share purchases is shown below.
If Jennifer instead had $300, her budget constraint would be a line passing through points (30, 0) and (0, 15), parallel to her current budget
constraint.
EXERCISES
(1) Demand for a product is 500 units, and the price is $100. If the price increases to $101, estimated demand will drop to 490 units. Assuming a
straight line relationship between supply and demand, graph the equation of the line relating supply and demand.
(2) Workers in Fredonia can produce either 20 gallons of wine per day or 50 pounds of cloth per day. Let x = gallons of wine produced per day
and y = pounds of cloth produced per day. If there are 1000 workers, what straight line (together with the x and y axes) delineates the boundary
of the combinations of wine and cloth that can be produced if the workforce is fully utilized? Graph the region in the x-y plane that represents all
combinations of wine and cloth that can be produced.
(3) If the number of workers were increased, what would happen to your answer to exercise 2?
(4) If the workers in Fredonia became more efficient at producing wine, what would happen to the slope of the line in exercise 2? If Fredonian
workers instead became more efficient at producing cloth, what would happen to the slope of the line in exercise 2?
(5) Michael Johnson is thinking about joining a country club that charges $5000 per year for membership and $30 per round of golf. Draw the
straight line that expresses (for x ≥ 1) the relationship between rounds of golf played, or x, and the annual amount, y, that Michael must pay to
the country club. Why aren't all the points on the straight line relevant to expressing this relationship?
Finding Solutions: Two Equations
INTRODUCTION
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In business, you often have two variables or unknowns (call them x and y) that are related by two equations. To find the values of the
unknowns, you must find the values of x and y that satisfy both equations. In this section, you will learn how to use the methods of substitution
and elimination, and the graphical approach to solve two linear equations involving two variables. In finance class, you will have to solve linear
equations to use the arbitrage approach for determining the price of put and call options and of other securities.
A RIDDLE
Gregory has just returned home from a flag football game. His two sisters, Tina and Jennifer, ask him what the score was. Gregory is annoyed
that they missed the game, so he answers them with the following riddle: "In all, 45 points were scored. If you double my team's score and add 10
points, you get triple the other team's score." How can Tina and Jennifer determine the score of the game?
Begin by defining variables representing the unknown quantities. Let x = points scored by Gregory's team and y = points scored by the opposing
side. Next, try to find the two equations suggested by Gregory in terms of x and y. In all, 45 points were scored, so x + y = 45. Given that
doubling Gregory's team's score and adding 10 points equals triple the other team's score, 2x + 10 = 3y. Therefore, you must find the values of x
and y that simultaneously satisfy x + y = 45 and 2x + 10 = 3y.
THE GRAPHICAL APPROACH

Conceptually, the simplest way to solve two linear equations with two unknowns is to graph the lines corresponding to each equation. The point
where the lines intersect yields the solution to the system of equations.
One problem with the graphical approach is that it is difficult to precisely identify the coordinates where the two lines intersect.
HOW MANY SOLUTIONS?

Given two lines, one of the following must be true:
The lines intersect at a single point. That implies that the two equations defined by the lines have a unique solution, as in Gregory's
football riddle.
The lines are parallel and thus do not intersect. For example, x + y = 2 and 2x + 2y = 5 are parallel (both lines have slopes of -1).
Therefore, the two linear equations x + y = 2 and 2x + 2y = 5 have no solution.
The two lines are the same line and intersect in an infinite number of points. For example, the two lines x + y = 2 and 2x + 2y = 4 are the
same line, so the system of equations x + y = 2 and 2x + 2y = 4 has an infinite number of solutions.
Even if system of linear equation involves more than two variables, the system of equations will still have either no solution, a unique solution or
an infinite number of solutions. This is true no matter how many variables and how many equations there are.
SOLVING BY SUBSTITUTION
Reconsider the problem of solving the equations x + y = 45 and 2x + 10 = 3y. You can add -x to both sides of the first equation and solve for y in
terms of x (y = 45 - x). If you substitute 45 - x for y in the equation 2x + 10 = 3y, you can easily solve for x. Given that y = 45 - x, you also know y
and, therefore, are finished. This approach is called the substitution method for solving linear equations.
SOLVING BY ELIMINATION
It is often easiest to solve a system of two equations by adding a multiple of one equation to the other equation in order to eliminate a variable
from one of them. For example, consider Gregory's riddle, which required solving x + y = 45 and 2x + 10 = 3y. Multiplying both sides of the first
equation by -2 yields -2x - 2y = -90. Adding this equation to 2x + 10 = 3y yields 10 - 2y = 3y - 90.
Now you can solve for y. Add 2y to both sides of the equation to get 10 = 5y - 90. Adding 90 to both sides yields 100 = 5y. Then dividing both
sides by 5 yields y = 20. Substituting y = 20 into x + y = 45 reveals that x + 20 = 45. Adding -20 to both sides yields x = 25. Therefore, as before,
x = 25 and y = 20 is the solution to the system of equations.
EXERCISES
(1) Tina is trying to determine the prices in dollars she should charge for lemonade (PL) and orange juice (PO) at her lemonade stand. She
believes she can sell 50 + 10(PL) - 20(PO) glasses of orange juice per day and 100 - 30(PL) + 10(PO) glasses of lemonade per day. If Tina wants
to sell 20 glasses of orange juice per day and 90 glasses of lemonade per day, what prices should she charge?
(2) Owen and Sarah's pre-tax income is $100,000. Suppose that state income tax is 10% of taxable state income and that federal income tax is
10/19 of taxable federal income. Taxable federal income is $100,000 less state income tax. Taxable state income is $100,000 less federal income
tax. How much will Owen and Sarah pay in state and federal income tax? Hint: Let TF = taxable federal income and TS = taxable state income.
Linear Inequalities: One Variable
INTRODUCTION
A linear inequality in one variable looks like ax + b < cx + d, ax + b > cx + d, ax + b ≤ cx + d, or ax + b ≥ cx + d. Here x is a variable, and a, b, c,
and d are constants. Often you want to find the values of x that satisfy a linear inequality. You can use the following rules to do that:
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If you add the same number to both sides of an inequality, the resulting inequality has the same direction as the original inequality. For
example, if the original inequality were a "less than" inequality, the resulting inequality would also be a "less than" inequality.
If you multiply or divide both sides of an inequality by the same positive number, the resulting inequality has the same direction as the
original inequality. For example, if the original inequality were a "less than" inequality, the resulting inequality would also be a "less
than" inequality.
If you multiply or divide both sides of an inequality by the same negative number, the resulting inequality has the opposite direction as
the original inequality. For example, if the original inequality were a "less than" inequality, the resulting inequality would be a "greater
than" inequality.
You can use these rules to simplify the inequality so that x is on one side and constant terms are on the other side. Then you can easily find the
set of values for x that satisfy the original inequality.
EXAMPLES OF SOLVING LINEAR INEQUALITIES

Let's find the values of x that satisfy the inequality 3x + 2 < x + 9.
EXERCISES
(1) Find all values of x that satisfy 4x - 3 ≥ 13.
(2) Find all values of x that satisfy -3x + 4 < 4x - 24.
Linear Inequalities: Two Variables

INTRODUCTION
In several of your courses (probably operations, economics, and quantitative methods), you will have to graph the set of points satisfying a
linear inequality in two variables of the form ax + by ≤ cx + dy or ax + by ≥ cx + dy. Here a, b, c, and d are constants, and x and y are variables.
To graph the set of points satisfying such a linear inequality, you add the same amount to both sides of the inequality until all the variable terms
are on the left side and all the constant terms are on the right side. Then the inequality looks like a'x + b'y ≤ c' or a'x + b'y ≥ c', where a', b', and c'
are constants.
Now graph the line a'x + b'y = c'. Choose any point P not on the line (the point [0, 0] is usually easiest to check), and determine whether P
satisfies the original inequality. If P satisfies the original inequality, the line and all points on the same side of the line as P satisfy the original
inequality. Otherwise, all points on the line and on the side of the line not containing P satisfy the original inequality.
GRAPHING A LINEAR INEQUALITY: TWO VARIABLES

Financial planner Sarah Lopez Clooney is trying to allocate $100,000 of a client's money between stocks and bonds. She wants to put at least as
much of the client's money in stocks as in bonds. Help Sarah graph the set of possible allocations. Assume that it is not necessary to invest the
entire $100,000 in stocks and bonds. If x = thousands of dollars allocated to stocks and y = thousands of dollars allocated to bonds, then Sarah
should graph the set of points satisfying the following inequalities: x ≥ 0, y ≥ 0, x + y ≤ 100, and x ≥ y.
We begin by graphing the set of points where x ≥ 0.
EXERCISES
(1) Graph the set of points satisfying 2x - y ≥ 4.
(2) Sarah and Owen have a 100-acre farm in California on which they can grow cotton and grapes. It takes 4 hours of labor to plant an acre of
cotton and 10 hours of labor to plant an acre of grapes. They have 500 hours of labor available for planting crops. Graph the set of points
representing the set of possible allocations of land between grapes and cotton.
Polynomials and Quadratic Functions
WHAT IS A POLYNOMIAL?
A polynomial is a function in the form f(x) = a 2 n

0 + a1x + a2x + ... anx , where n is a positive integer. The highest power of x with a nonzero
coefficient is called the degree of the polynomial. A straight line is a first-degree polynomial. A second-degree polynomial is called a quadratic
function, and a third-degree polynomial is called a cubic function. For example, f(x) = 2x2 + x + 1 is a quadratic function, and f(x) = 2x3 - x2 +
2x is a cubic function.
Polynomial functions are often used in economics to represent the cost of producing x units or the profit associated with charging a price x.
Polynomial functions are evaluated just like any other function. Just remember that xn (x to the nth power) means x multiplied by itself n times.
For example, 34 = 81, 23 = 8, etc. For example, suppose Gregory Clooney works at Smalltown Bagels (STB). If the cost in dollars of baking x
bagels is given by c(x) = 10 + 0.001x2 + 0.2x, what is the cost of baking 100 bagels? Simply evaluate c(100) = 10 + 0.001(100)2 + 0.2(100) = 10 +
0.001(10,000) + 20 = $40.
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GRAPHING QUADRATIC FUNCTIONS

A quadratic function is usually written as y = f(x) = ax2 + bx + c, and its graph is called a parabola. If a < 0 , then as x increases to the value -
b/2a, the value of the quadratic function will increase, and after -b/2a is reached, the value of the function will decrease. If a > 0, then as x
increases to -b/2a, the value of y will decrease, and then increase. Any parabola is symmetric about the line x = -b/2a. That is, if x is k larger than
-b/2a and k smaller than -b/2a, the function has the same value for both these values of x. Here's how to graph a parabola.
Assume that if STB charges p dollars for bagels, its profit in hundreds of dollars is given by f(p) = -p2 + 4p - 3. Now graph STB's profit as a
function of price. Here a = -1 (i.e., 2a = -2) and b = 4. Since a < 0, the profit will increase for a price less than -b/2a = -4/-2 = $2, and it will
decrease when p > 2. Therefore, for p = 2, the parabola will assume its maximum value. When p = 2, f(p) = -22 + 4(2) - 3 = 1. Therefore, the point
(2, 1) is on the parabola. If p = 1, then f(1) = -12 + 4(1) - 3 = 0. Because of the principle of symmetry, you know that the points (1, 0) and (3, 0) will
be on the parabola. You can also find f(0) = -(0)2 + 4(0) - 3 = -3. Therefore, (0, -3) and (4, -3) are also on the parabola. Drawing a smooth curve
to connect these five points yields the following graph.
When you want to maximize profit in economics or you want to find an Internal Rate of Return in finance, you often have to find the roots, or
solutions, of a quadratic equation of the form ax2 + bx + c = 0. The quadratic formula dictates that the root(s) of a quadratic equation are
expressed by
-
b
±
b
2
-
4ac
2a
If b2 - 4ac > 0, the equation has two roots; if b2 - 4ac = 0, the equation has one root; if b2 - 4ac < 0, the equation has no real roots (in this case,
the quadratic equation has what are called "imaginary roots"). As an example of how to use the quadratic formula, find all solutions to x2 - 5x + 6
= 0. In this equation, a = 1, b = -5, and c = 6. You can find the solutions as follows:
-
-
5
±
-
5
2
-
4
1
6
2
x
1
=
5
±
1
2
This yields x = 3 and x = 2.
You can verify that x2 - 6x + 9 = 0 has the unique solution x = 3, whereas the quadratic equation x2 + 3x + 6 = 0 has no real roots.
MULTIPLYING BINOMIALS
You may remember from high school algebra the FOIL method. Consider the function f(p) = (3 - p)(1 - p). Often we need to multiply terms
involving a variable to represent a function as a polynomial. We will now learn to multiply expressions involving two terms (an expression that
contains two terms is called a binomial). Thus (3 - p) and (1 - p) are binomials. To express f(p) as a polynomial, you need to multiply two
binomials. You may remember from high school algebra the FOIL method for multiplying binomials: First, Outer, Inner, Last.
EXERCISES
(1) What is the degree of the following polynomial: x5 - 4x3 + 2x2?
(2) Graph the curve f(x) = x2 - 6x + 2.
(3) Find all roots of the equation 2x2 - 5x + 2 = 0.
(4) It costs $0.30 for Tina to produce a glass of lemonade. If she charges p dollars for one glass, she believes she can sell 50 - p glasses of
lemonade in a day. Find a quadratic function that gives Tina's daily profit as a function of price. Then graph Tina's profit as a function of price.
Powers and Exponents
INTRODUCTION
In business, you will often see expressions such as xn, where x is the base and n is the exponent. When n is a positive integer, xn simply means
multiply x by itself n times. For example, 34 = 3 × 3 × 3 × 3 = 81 and (-3)2 = -3 × -3 = 9. When the exponent is

a positive fraction — say, a/b — then xa/b = b

x
a
. We read this expression as the bth root of x raised to the a power. For example, when a = 1 and
b = 3, this expression yields the cube root of x. For example, 93/2 = 2
9
3
= 27. You will soon learn how to work with negative exponents.
RULES FOR DEALING WITH EXPONENTS

As long as x is not equal to zero, you can use the following rules for exponents:
Power Function
DEFINITION
A function of the form y = f(x) = axn, where a is a constant, is known as a power function. (In most business applications, a > 0, so let's assume
that here.) If n > 1, then the graph of the power function will show the function is increasing, and the graph will get steeper. For example, in y
= 2x2, n = 2 and the graph is as follows:
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POWER FUNCTION AND COST CURVES

Cost curves where f(x) = the cost of producing x units are often described by the sum of power functions and a constant. For example, f(x) = x2
+ 3x + 2 might represent the cost of producing x units.
THE POWER CURVE AND DIMINISHING RETURNS

If 0 < n < 1, the graph of the power function will show that the function increases as x increases, but the graph eventually gets flatter. For
example, for the power function f(x) = 2x.5, n = .5, and the graph is as follows:
Often a power curve with 0 < n < 1 is used to model the response to a marketing effort, because the response to a marketing effort usually
exhibits diminishing returns. For example, f(x) = 2x.5 might represent the number of units (in thousands) sold of a drug when x hundred sales
calls to physicians are made.
THE POWER CURVE AS A DEMAND CURVE

If n < 0, the power curve will decrease as x increases, but the graph eventually gets flatter. For example, the graph of f(p) = 1000p-.5 is as
follows:
A power curve with n < 0 often represents a demand curve. For example, f(p) = 1000p-.5 might be the demand (in thousands of days of
therapy) if a price of p dollars is charged for a prescription.
Cobb-Douglas Function
THE COBB-DOUGLAS PRODUCTION FUNCTION

The Cobb-Douglas production function uses exponents and is commonly used to model how the number of units produced depends on two
inputs (usually K = capital and L = labor). The Cobb-Douglas function is expressed as f(K, L) = KaL1-a,
where 0 < a < 1.
For example, if Tina spends K dollars buying supplies for lemonade and works L minutes making lemonade, she can produce
f(K, L) = K3/4L1/4 glasses of lemonade. This function is a special case of the Cobb-Douglas production function, with a having the
value 3/4. Using Tina's Cobb-Douglas function, suppose that she spends $81 on supplies and 16 minutes making lemonade.
She can then produce f(81, 16) = (81)3/4(16)1/4. Using Rule 4, (81)3/4 = (811/4)3. When n is an integer, x1/n is simply n
x
.
Thus, (81)1/4 = 4
81
= 3, and (81)3/4 = 33 = 27. Similarly, (16)1/4 = 4
16
= 2. Thus, f(81, 16) = 27 × 2 = 54 glasses of lemonade.
Incidentally, the U.S. economy is thought to follow a Cobb-Douglas production function with a = 0.3.
Exercises
EXERCISES
(1) Evaluate 16-1/4.
(2) Evaluate 93/2.
(3) Simplify (x3)2 × (x4).
(4) Simplify x
3
2
3
x
2
.
(5) Simplify x4 × (x3).
(6) When a price of p dollars is charged, the demand for a product is 1000p-1/4. If the price is $16, what will be the demand for the product?
(7) Suppose that the number of units produced of a product is given by K1/3L2/3, where K = dollars spent on capital and L = hours of labor
available. If $27 is spent on capital and 64 hours of labor are used, how many units can be produced?
(8) Suppose that production follows a Cobb-Douglas production function. If the quantity of available capital and labor is doubled, what will
happen to total output?
Order of Operations
INTRODUCTION
When working with mathematical expressions, the order of operations is important. For example, in the expression 40 - 12/4, should you take
40 - 12 and then divide by 4, or should you first divide 12 by 4? In this section, you will master the rules that govern the order in which
mathematical operations are performed.
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Use the PEMDAS rule to determine the order of operations in mathematical expressions.
P (Parentheses): If the expression contains parentheses, first evaluate all expressions with parentheses, working from the innermost set
of parentheses out.
E (Exponents): Next, perform all operations involving exponents.
MD (Multiplication and Division): Next, perform all multiplication and division calculations from left to right.
AS (Addition and Subtraction): Finally, perform all addition and subtraction calculations from left to right.
Using the first letters of these operations, we get PEMDAS, from which we derive the most famous of all mathematical mnemonics:
Please Excuse My Dear Aunt Sally.
EXAMPLES OF ORDER OF OPERATIONS

Here are some examples of expressions that may look identical at first glance but that yield different results when the order of operations is
properly followed.
EXERCISES
Evaluate the following expressions:
(1) 20 - 2 × 32
(2) (8 - 5) × (7 - 3)
(3) 10/(4 - 2) + 5
(4) 10/4 - 2 + 5
Entering Formulas and Graphing Functions in Excel

ENTERING FORMULAS IN EXCEL
You will often need to use a financial calculator or Microsoft Excel to perform calculations. In this course, we use Excel. Entering formulas in
Excel is a snap if you remember the following rules:
All formulas must begin with an equals sign (=).

Use * for multiplication, / for division, and ^ for raising a number to a power.
Excel uses PEMDAS to determine the order of operations.
Please download the file Orderofoperations.xlsx. In the file Orderofoperations.xlsx, you will find the Excel formulas needed to complete the
calculations described in the previous section.
Note that the #NUM error indicates that there is no real square root of -9. (In reality, the square root of -9 is 3i or -3i, where i is the square root
of -1.)
GRAPHING FUNCTIONS IN EXCEL

Once you know how to enter formulas in Excel, you can easily use it to create graphs of functions. Simply enter the values of x that you want to
plot in one column; then enter the formula for the function that you want to graph one column to the right of the first listed x value; then copy
the formula down to find the y value corresponding to the last value of x. Select the set of x values and corresponding function outputs (y values).
Finally, on the Insert tab, choose Scatter. This graphs the selected coordinates and renders the graph of the function.
Here is an example of how to graph a function in Excel. Suppose that a price p is charged for a product and that demand for the product is given
by 1000p-.4. Let's graph the relationship between price and demand as price varies between $1 and $10. Please download the file
Demandgraph.xlsx.
EXERCISES
(1) Suppose that Tina's neighbor, Jessica Spears, is opening a lemonade stand. If Tina charges a price (in dollars) of p1 and Jessica charges a
price p2, then Tina will sell 100p1/(p1 + p2) glasses of lemonade. If p1 is in cell A2 and p2 is in cell B2, write a formula that yields the number of
glasses of lemonade Tina will sell.
(2) Use Excel to graph the function f(x) = -x2 + 4x - 3.
(3) Suppose that the number of units produced follows a Cobb-Douglas production function with f(K, L) = K1/5L4/5. If K is entered into cell B1
and L is entered into cell C1, write a formula that will yield units produced. If K = 100 and L = 50, how many units will be produced?
(4) Suppose that the cost of producing x units is given by c(x) = 500 + 2x3 - x2 + 2x. Graph the relation between units produced and production
cost. Assume that x can range between 0 and 100.
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Inverse Functions
INTRODUCTION
Suppose that demand q is a function of price. That relationship is frequently expressed as q = f(p). Often in economics class you will instead
need to find p as a function of q or p = g(q). Such a function g is called the inverse function (or, in this case, the inverse demand curve) of f.
In this section, you will learn how to find the inverse demand curve in several situations.
FINDING INVERSE DEMAND CURVES

Jennifer has just gotten a job cooking at the local, independently owned OutaBurger fast food restaurant. The restaurant's estimated daily
demand for milk shakes is expressed as q = f(p) = 400 - 10p, where p is the price of milk shakes in dollars.
So far you have seen demand curves graphed with p on the x axis and q on the y axis. Economists, however, usually graph q on the x axis and p
on the y axis. To do that, you must solve for p as a function of q. First, isolate all terms that include p on one side of the equation and solve for p.
Add -400 to both sides of q = 400 - 10p to get q - 400 = -10p. Then divide both sides of this equation by -10 to get -q/10 + 40 = p. To graph this
function set p equal to 0 in order to find the q-axis intercept: (400, 0). Then set q equal to 0 to find the p-axis intercept: (0, 40). The graph of the
inverse demand function is as follows:
INVERTING A MORE COMPLEX DEMAND CURVE

Suppose that the daily demand for milk shakes is given by q = 100p-.5. To invert this demand function, you need to solve for p as a function of q.
To get p on one side of q = 100p-.5, you can first multiply both sides of this equation by p.5. This yields qp.5 = 100. Dividing both sides of this
equation by q yields p.5 = 100/q. Squaring both sides of this equation yields p = 10,000/q2. Thus, g(p) = 10,000/q2 is the inverse demand
function. Using values of q ranging from q = 1 to q = 100, we obtain the following graph of the inverse demand function.
EXERCISES
(1) Suppose that the demand curve for a product is q = 500 - 2p. Invert this demand curve.
(2) Suppose that the demand curve for a product is q = 200p-.25. Find the inverse demand curve.
Ratios and Percentages
INTRODUCTION
The ratio of two numbers reflects their relative sizes. For example, if you want to divide an inheritance in the ratio 2:3 between two siblings, the
first sibling will get 2/3 as much as the second sibling or, equivalently, the second sibling will get 3/2 as much as the first sibling. A percentage is
simply mathematical shorthand for one hundredth. For example, if a bookstore marks up the price of a book 40% over the wholesale price, you
can compute the retail price by adding forty hundredths (or 0.4) times the wholesale price to the wholesale price. In this section, you will learn
how ratios and percentages can be used to solve business problems.
EXAMPLES OF RATIO PROBLEMS

Suppose that the Clooneys are going holiday shopping. They want to spend $1000 on gifts for Tina, Gregory, and Jennifer in the ratio 2:3:5. How
much will they spend on each child? For some number x, the Clooneys will spend 2x on Tina, 3x on Gregory, and 5x on Jennifer. Therefore 2x +
3x + 5x = 1000 or 10x = 1000. Dividing both sides of this equation by 10 yields x = 100. Therefore, the Clooneys will spend 2x = $200 on Tina, 3x
= $300 on Gregory, and 5x = $500 on Jennifer. Use the box below to alter the amount the Clooneys spend and watch the gift amounts change
based on the same ratio of 2:3:5.
Assume that Smalltown Bagels sells chocolate chip cookies and that every 50-cookie recipe uses 2 cups of sugar. If STB wants to bake 200
cookies today, how many cups of sugar will it need?
Let x = cups of sugar needed. Then, x/200 = 2/50. Note that the right side of the equation is expressed in cups of sugar/number of cookies; the
left side must have the same units, where x represents cups of sugar and 200 is the number of cookies. Multiplying both sides of this equation by
200 yields x = 2(200)/50 = 8.
A BEGINNING PERCENTAGE EXAMPLE

Remember that a percentage is shorthand for 1/100 or .01. Thus, 40% is the same as 0.4, and 120% is the same as 1.2. To convert a fraction or
decimal to a percentage, simply multiply the fraction or decimal by 100.
Suppose that Gregory is practicing his free throw shooting. If he shot 50 free throws and made 84% of them successfully, how many free throws
did he make? The answer is simply 0.84 times 50 or (0.84) × (50) = 42 free throws.
If Gregory is going to take 45 more free throws and hopes to raise his overall successful free throw percentage to at least 90%, how many free
throws would he have to make?
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PERCENTAGES AND CORPORATE GROWTH

Companies often set their growth targets in terms of percentage growth. For example, suppose that Smalltown Bagels's sales during the current
year (2012) are $3 million. Its goal is to grow sales revenues by 20% per year. What revenues does the company need to generate during each of
the next two years?
To grow by 20% during 2013, STB needs revenues to increase by (0.2) × 3 = $.6 million, for a target of $3.6 million.
Then, to grow by 20% during 2014, assuming revenues of $3.6 million in 2013, STB will need to increase revenues by (0.2) × (3.6) = $.72
million, for a 2014 target of 3.6 + 0.72 = $4.32 million.
Note that meeting the 20% growth target for 2014 required more revenue growth than was needed to meet the 20% growth target for 2013.
That's because the revenue figure was larger in 2013 than in 2012, and 20% of a bigger number is bigger than 20% of a smaller number. Many
new companies (such as Cisco and Microsoft in their early years) grow at high rates such as 30% a year. Once these companies become large,
however, it is hard for them to continue growing at 30% a year because 30% of the current revenue will be much larger than 30% of the
company's initial revenue level.
COMPUTING ANNUAL STOCK RETURNS

Sarah Lopez Clooney bought some Company A stock in February 2009 when the stock was worth $20 a share. When she sold the stock, it was
worth $24 a share. What percentage profit did Sarah make on her investment in Company A?
On each share of Company A, Sarah made $4 ($24 - $20). That gain of $4 is a fraction (4/20 = 0.2) of the original price. You can convert a
fraction to a percentage by multiplying it by 100. Therefore, Sarah earned a profit of 100 × (0.2) or 20%.
PERCENTAGES IN RETAIL MARKETING

Often retailers compute a product's retail price by marking up from a wholesale price. Also, retailers will often mark down a product's price at
the end of the product's lifecycle. Let's look at some uses of percentages in retail.
Suppose that Smalltown's bookstore buys a book from a publisher for $12 and sells the book for $20. What is the percentage markup over the
publisher's price?
The bookstore has increased the price by $8 ($20 - $12), so the price has increased by a fraction 8/12 = .6667 over the publisher's price.
Multiplying .6667 by 100 reveals that the bookstore has marked up the publisher's price 66.67%.
Suppose that a clothing store marks up the wholesale price on a bathing suit by 50%. Then, at the end of the summer, the retail price is marked
down 40%. Answer the question below to determine whether the final price is above or below cost.
EXERCISES
(1) Michael Johnson has $100,000 to invest in stocks, bonds, and gold. He would like to allocate his portfolio in the ratio 5:4:1. How much
money should he invest in each asset class?
(2) The ratio of wins to losses for Gregory's AAU basketball team was 11:9. They played 40 games. What was their win-loss record?
(3) During 2011, Smalltown Bagels earned $2 million in revenues. Its profit margin is 30% of revenue. Revenues are estimated to increase by
10% per year. Estimate STB's revenues and profits for the years 2012 through 2014.
(4) The Smalltown Inn is Smalltown's best hotel. The base price for a room is $100 per day. The inn marks up the base rate by 20% on Friday
and by an additional 25% (over Friday's rate) on Saturday. What will the room rates be on Friday and Saturday? If the inn wants to return to the
base rate on Sunday, by what percentage will it have to reduce Saturday's rate?
(5) Gregory's AAU basketball team has a 12-8 record. They will play a total of 80 games, of which they need to win 70% to qualify for the AAU
National Tournament. What percentage of their remaining games do they need to win?
Elasticity of Demand
INTRODUCTION
In your marketing and managerial economics classes, you will surely discuss pricing. When a business determines what price to charge for a
product, it must look at how sensitive the demand for the product is to the product's price. The concept of Elasticity of Demand helps a business
understand the relationship between a product's price and demand.
DEFINITION OF DEMAND ELASTICITY

The demand elasticity (E) for a product is the percentage change in demand that results from a 1% increase in the product's price. To illustrate
the computation of demand elasticity, let's suppose that for a price of $10 or less, the daily demand q for lasagna dinners at Smalltown's Italian
restaurant is given by q = 100 - 10p, where p = the price of a lasagna dinner. Let's determine the price elasticity if the current price of a lasagna
dinner is $4.
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Note that the demand elasticity for a linear demand curve depends on the current price, as shown in the following table.
ELASTIC AND INELASTIC DEMAND

If E < -1, the demand for a product is said to be elastic; if E > -1, the demand for a product is said to be inelastic. If product demand is elastic, a
small increase in price will decrease revenue; if product demand is inelastic, a small increase in price will increase revenue. Conversely, if
product demand is elastic, a small decrease in price will increase revenue; if product demand is inelastic, a small decrease in price will decrease
revenue. Recall that if $4 is charged for lasagna, then E = -.667. Therefore, when the lasagna price is $4, demand for lasagna is inelastic, and a
small price increase would increase revenue. To verify this insight, we can compare revenues at the $4 and $4.04 prices.
Revenue if price is $4 = $4(q) = $4(100 - 10(4)) = $240

Revenue if price is increased by 1% to $4.04 = $4.04(q) = $4.04(100 - 10(4.04)) = $240.78
Now suppose that the price of a lasagna dinner is $8. It can be shown (see the table on the previous page) that when p = $8, E = -4. Therefore,
when the lasagna price is $8, demand is elastic and a price increase will decrease revenue.
Revenue if price is $8 = $8(q) = $8(100 - 10(8)) = $160

Revenue if price is increased by 1% to $8.08 = $8.08(q) = $8.08(100 - 10(8.08)) = $155.14
Necessities like salt and innovative pharmaceutical products are known to exhibit inelastic demand, whereas products that are not necessities,
such as foreign travel, exhibit elastic demand.
A CONSTANT ELASTICITY DEMAND CURVE

As we have seen, demand elasticity varies greatly along a linear demand curve. Economists often like to model demand with a function that
exhibits constant elasticity. If demand q=ap-b (for an example, see "The Power Curve as a Demand Curve" page in the Powers and Exponents:
Power Function section), then it can be shown that for any price, demand elasticity equals -b. For example, if we model daily demand for
lasagna dinners by q=1000p-2, then the demand elasticity is -2. This means that for any price, a 1% increase would reduce demand by 2%. Of
course, if b < -1, then demand is elastic while if -1 < b < 0, then demand for lasagna is inelastic.
EXERCISES
(1) Again suppose that the demand for lasagna is q = 100 - 10p, where p = price in dollars. Show that demand is inelastic when the price is $3.
(2) Again suppose that the demand for lasagna is q = 100 - 10p, where p = price in dollars. Show that demand is elastic when the price is $9.
(3) Suppose that the daily demand for mocha coffees at Fourbucks is governed by the demand function q = 1000p-3. What is the demand
elasticity for mocha coffees? Is the demand elastic or inelastic? Verify your answer from the definition of elasticity when p = 3 and p = 6.
Logarithms
INTRODUCTION
Logarithms are convenient tools that reduce a multiplication problem to an addition problem. They also simplify problems involving exponents
to much simpler multiplication problems. Logarithms may be used in your economics and finance courses, where you'll need them to properly
price put and call options, for example.
LOGARITHM DEFINITON
Assuming a positive number b, the logarithm of a number x to the base b is the power to which b must be raised to result in the number x— i.e.,
the logarithm of x to the base b is c if bc = x. In this case, we write Logb x = c. For example, the logarithm of 100 to the base 10 is 2, because 100 is
10 squared. The logarithm of 1048576 — the number of rows supported in Excel 2007 — to the base 16 is 5, because 1048576 is 16 raised to the
5th power. (Base 16, or hexadecimal, is commonly used in computer science and can often be used in describing the characteristics of computer
applications.)
In business, b is usually set equal to 10 or to e, which is a number that is approximately 2.7182. When b = e, rather than Loge, Ln is used and the
base is omitted. Therefore, Loge x = c and Ln x = c are considered equivalent statements. The logarithm of a number x to base e is often called the
natural logarithm of x.
EXAMPLES OF LOGARITHMS
Here are some examples to clarify the definition of a logarithm.
What is log10 1,000? We simply need to determine the power to which the base (10 in this case) must be raised to give 1000.
What is log10.01? Since 10-2 = .01, Log10.01 = -2.

Using Excel (see tab 5) or a table of logarithms, you can find that Ln 20 = 2.996. By the definition of logarithms, e2.996 = 20.
Using Excel (see tab 5) or a table of logarithms, you can find that Ln(.005) = -5.30. By the definition of logarithms, e-5.3 = .005.
Alternatively, the natural logarithm of .005 is -5.30.
RULES INVOLVING LOGARITHMS
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The following rules involving logarithms can greatly simplify many mathematical problems. Note that Rules 1 and 2 allow you to reduce a
multiplication problem to an addition problem and that Rule 3 allows you to simplify a problem involving exponents to a multiplication
problem.
Rule 1: Logb x + Logb y = Logb x*y.
For example, Log10 100,000 = Log10 (100*1000) = Log10 100 + Log10 1000 = 2 + 3 = 5. Since 105 = 100,000, we know that Log10 100,000 = 5 and
that Rule 1 is valid for this example.
Rule 2: Logb x - Logb y = Logb x/y.
For example, Log10 10,000/100,000 = Log10 10,000 - Log10 100,000 = 4 - 5 = -1. Since 10-1 = .1 = 10,000/100,000, we know that Rule 2 is valid
for this example.
Rule 3: Logb xc = c*Logb x.
For example, to find Log10 1005, we can use b = 10, x = 100, and c = 5 and find that
Log10 1005 = 5 * Log10 100 = 5*(2) = 10.
Since Log10 1005 = Log10 (102)5 = Log10 1010 = 10, we see that Rule 3 is valid for this example.
USING EXCEL TO COMPUTE LOGARITHMS

There are three Excel functions that are often used in business to compute logarithms. Please download the file Logs.xlsx.
LOG10(x) returns Log10 x.

Log(x,b) returns Logb x. Of course, Log(x,10) would return Log10 x.
Ln(x) returns the natural logarithm of x. Therefore, we use the Ln function to compute natural logarithms.
The file contains some examples of the use of these functions.
In column I, we list the formulas used in column G while in column J we list the formulas used in Column H.
WORD PROBLEMS INVOLVING LOGARITHMS

The logarithm rules described earlier in this section can be useful in solving many business problems. Here is an example.
Sarah Lopez Clooney is thinking of investing in an Internet firm, BitsAreUs, which currently has $2 million in annual revenue and $5 million in
annual expenses. Sarah believes the firm's expenses will grow at 20% a year and their revenues will grow at 50% per year. How long will it take
for BitsAreUs to reach a breakeven level where costs and revenues are equal?
Let x = years until revenues and expenses are equal. In x years, BitsAreUs will have revenues of 2(1.5)x and expenses of 5(1.2)x. Therefore, to find
the time until BitsAreUs breaks even, you must solve
2(1.5)x = 5(1.2)x.
Dividing both sides of this equation by 2 yields

1.5x = 2.5(1.2)x.
Then, dividing both sides of the equation by (1.2)x you obtain

(1.5/1.2)x = 2.5 or 1.25x = 2.5.
To solve for x, we use Rule 3 and take the natural logarithm of both sides of this last equation.
First, you obtain x*Ln(1.25) = Ln(2.5). Dividing both sides of this equation by Ln(1.25) yields Ln(2.5)/Ln(1.25) = x.
Using the Excel LN function you find that Ln(2.5) = .916 and Ln(1.25) = .223 so x = .916/.223 = 4.11 years.
Therefore, BitsAreUs will break even in an estimated 4.11 years. As a check, note that in 4.11 years expenses will equal 5(1.2)4.11 = $10.58 million
and that revenues will equal 2(1.5)4.11 = $10.58 million.
EXERCISES
(1) Find Log10 10,000.
(2) Find Ln e6.
(3) Solve for b if Logb 81 = 4.
(4) Suppose that the daily demand q (in hundreds of cups) for mocha coffees at Fourbucks follows the equation q = 1000p-.5, where p = price in
dollars. If we graphed Ln p on the x axis and Ln q on the y axis, what type of graph would we obtain? Hint: Take logarithms of both sides of the
demand curve.
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(5) Suppose that the Happy Tail veterinary clinic earns $200,000 in profits this year. If its profits grow at 25% per year, how many years will
pass before its annual profit is $1 million?
Index Numbers
INTRODUCTION
Most of us are familiar with the U.S. government's Consumer Price Index (CPI). The government lists the following levels for the CPI since
1997.
The website http://www.inflationdata.com/Inflation/Consumer_Price_Index/HistoricalCPI.aspx shows that the base year currently used for
the CPI is 1982 and that the CPI for 1982 = 100. In effect, the CPIs in the above table are relative to the 1982 base-level CPI. For example, the
2007 CPI is 2.02416 times as high as it was in 1982. Essentially, an index number indicates the percentage change in a quantity, relative to a
base level that is assigned a value of 100. As another example, the 2005 CPI was 1.907 times (or 90.7%) higher than the CPI in 1982.
CHANGING THE BASE YEAR

If you were to keep 1982 as the base year and if inflation were to continue, eventually the CPI might become a large number such as 500. In such
cases, you can change the base year to a more recent year in order to prevent the price indexes from becoming too large. If the government
decides to use 2000 as the base year, what would the CPIs be for the years 2004 through 2008? Since the CPI for 2000 is 168.8, simply scale all
the listed CPIs relative to 168.8 rather than 100. For example, the 2005 CPI would be 100 x (190.7/168.8) = 1.13. The CPIs for the years 2000
through 2008, relative to the base year of 2000, are listed to the right.
EXERCISE
(1) For the years 2000 through 2008, compute the CPI index relative to a base year of 2005.
Calculus
INTRODUCTION TO DIFFERENTIAL CALCULUS
In the algebra chapter, you learned that a straight line has the same slope at every point on it. For example, at every point on y = 2x + 1, the slope
is 2. Therefore, whenever x increases by 1, y increases by 2.
A nonlinear function, on the other hand, does not have a consistent slope. For example, the graph of y = x2 (below) shows that for values of x that
are less than zero, the function decreases as x increases, so the slope of the curve is negative; for values of x that are greater than zero, the function
increases as x increases, so the slope of the curve is positive.
Differential calculus is primarily concerned with rigorously defining the slope of a function and computing the slope of that function at any point
on it.
Motivation for Differential Calculus

WHY CARE ABOUT DIFFERENTIAL CALCULUS?
In business, you often need to figure out how to maximize or minimize a function. For example, Smalltown Bagels may want to identify what
price will maximize its profit from selling bagels. The local electronics store may want to identify the order quantity for digital cameras that
minimizes the sum of annual ordering and inventory costs. In many business situations, the maximum or minimum value of a function is the
point at which the slope of the curve is zero.
The first graph below shows that the maximum value of y = -x2 + 6x + 5 occurs at x = 3. That is also the point at which the curve has a slope of
zero.
Similarly, in the second graph, the minimum value of y = x2 - 6x + 5 occurs at x = 3, again where the slope is zero. The next section will more
rigorously define the slope of a function for a given value of x.
Determining the Slope of a Function

HOW TO DEFINE THE SLOPE OF A FUNCTION
Consider the function y = x . What is its slope at x = 1? To approximate the slope of this, or any other, function at x = 1, increase x by
2
successively smaller amounts — say, .1, .01, .001, and .0001 — and look at the ratio of the change in y to the change in x. As the change in x
approaches zero, the ratio of the change in y to the change in x approaches the slope of the curve at x = 1.
In generic terms, if you start at point x on a function and increase x by a small amount, represented by Δx, you approximate the slope of the
function at x by calculating the slope of the line joining (x, f(x)) and (x + Δx, f(x+Δx)). As Δx approaches zero, you find the slope, or first
derivative, of the function f(x) at the point x.
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APPROXIMATING THE SLOPE OF y = x² FOR x = 1

Here we continue to illustrate our search for the slope of y = x2 at x = 1, using even smaller values for Δx.
For x = 1 and Δx = .1, approximate the slope of y = x2 at x = 1 by calculating
f⁡
1.1
-
f⁡
1
1.1
-
1
=
1
.
1
2
-
1
2
0.1
=
2.1
2
For x = 1 and Δx = .01, approximate the slope of y = x at x = 1 by calculating
f⁡
1.01
-
f⁡
1
1.01
-
1
=
1
.
01
2
-
1
2
0.01
=
2.01
For x = 1 and Δx = .001, approximate the slope of y = x2 at x = 1 by calculating
f⁡
1.001
-
f⁡
1
1.001
-
1
=
1
.
001
2
-
1
2
0.001
=
2.001
As you "shrink" Δx so that it approaches zero, your estimate of the slope will approach 2. In that sense, a small change of Δx at x = 1 yields a
change in y of approximately 2Δx.
Slope and Tangent Lines
TANGENT LINES
The slope of a function at a given point can be shown visually by drawing a line such that it touches the function only at that point. That line is
called a tangent. In the graph below, the function y = x3 + 3x2 is shown in black, and its tangent line at x = -1 is shown in blue.
The slope of a function at a point is the slope of a tangent line that touches the function at only that point.
SLOPES AND TANGENT LINES

In the previous section, you learned how to approximate the slope of a function by "shrinking" Δx so that it approached zero. Now let's illustrate
that graphically.
First, draw a straight line passing through two points on the graph of the function y = x3 + 3x2. You can click and drag these points to move
them. As you move one of the points closer to the other along the graph of the function, the line drawn between the two points begins to
approximate the tangent line.
In effect, you are graphically changing Δx; in the previous section, that was done mathematically. When the two points come together, Δx
becomes zero, the line becomes a tangent line, and the slope of the function at that now-single point is revealed.
TANGENT LINES AND THE SIGN OF A FUNCTION'S SLOPE

In the animation below, tangent lines along a function's graph are shown progressively for different points on the graph. Where the slope of the
tangent line is positive, the line is shown in green; where the slope is negative, the line is shown in red; where the slope is zero, the line is shown
in black.
The point where the function shifts from increasing values of y to decreasing values of y (or from decreasing values of y to increasing values of y)
is where the slope of the tangent line equals zero — i.e., where the tangent line is horizontal. In a subsequent section, you will learn how to find
this point for specific types of functions that are of interest in business.
Rules for Computing Derivatives

RULES FOR COMPUTING THE FIRST DERIVATIVE
Given y = f(x), let dy/dx denote the derivative, or slope, of f(x). Sometimes the derivative of a function is denoted as y' or f'(x). Now you will
learn several rules that, when used in concert, allow you to determine the derivatives of many important functions, particularly polynomials.
Keep in mind that if f'(x) > 0, the function is increasing at x, and that if f'(x) < 0, the function is decreasing at x.
RULE 1: IF f(x) = k, WHERE k IS A CONSTANT, THEN = 0
The graph of y = k is simply a horizontal line. Given that y never changes, dy/dx = 0. For example, for each of the functions y = 5, y = 0, and y =
-4, dy/dx = 0.
RULE 2: IF f(x) = xⁿ WHERE n IS ANY NUMBER, THEN
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Here are some examples of Rule 2:
If f(x) = x3, then n = 3 and dy/dx = 3x2. Since 3x2 is never negative, x3 is always an increasing function of x.
If f(x) = x2, then n = 2 and dy/dx = 2x. Note that for x > 0, y' > 0; and that for x < 0, y' < 0. Thus, x2 is decreasing for x < 0 and increasing
for x > 0, as shown in the following graph.
Finally, for y = x-1 = 1/x, n = -1. Thus, where x ≠ 0, dy/dx = (-1)x-2 = -1/x2, which is always less than zero. Thus, for any value of x that
does not equal zero, this function is decreasing. Given that y = x-1 is not defined for x = 0, dy/dx is not defined for x = 0.
Here are some examples of Rule 3:
If f(x) = 3x2, then k = 3 and g(x) = x2. From Rule 2, you know that g'(x) = 2x. Applying Rule 3, y' = 3(2x) = 6x.
If f(x) = 6x4, then k = 6 and g(x) = x4. From Rule 2, you know that g'(x) = 4x3. Applying Rule 3, f'(x) = 6(4x3) = 24x3.
RULE 4: IF f(x) CAN BE WRITTEN AS THE SUM OF TWO FUNCTIONS,

g(x) AND h(x), THEN f'(x) = g'(x) + h'(x)
Here is an example of Rule 4:
If f(x) = 3x3 + 2x5 - 3, you can write g(x) = 3x3 and h(x) = 2x5 - 3. Using Rules 2 and 3, you find that g'(x) = 3(3x2) = 9x2. Applying Rules 1,
2, and 3, h'(x) = 2(5x4) + 0 = 10x4. Finally, f'(x) = g'(x) + h'(x) = 9x2 + 10x4.
In combination, Rules 1 through 4 allow you to easily find the derivative of any polynomial. You will apply these rules as you do the exercises at
the end of this section.
EVALUATING AND INTERPRETING A FUNCTION'S DERIVATIVE

A function's derivative is itself a function and may be evaluated for any value of x. For example, recall the function given at the beginning of this
section, y = x2. If f(x) = x2, then f'(x) = 2x. Of course, f'(2) = 2(2) = 4. Therefore, the slope of y = x2 at the point where x = 2 is 4. That implies that
if you increase x from a value of 2 by a small amount (Δx), then f(x) will increase by approximately 4Δx. For example, if you increase x from 2 to
2.1 (Δx = 0.1), you can estimate that f(x) will increase by 4(0.1), or 0.4, to a value of 4.4.
Of course, f(x) actually increases to f(2.1) = 2.12 = 4.41. Thus, your estimate that f(x) will increase by 0.4 is off by only 0.01.
EXERCISES
Find the derivatives of these functions:
(1) y = 3x2 - 2x + 7. Evaluate y' for x = 2.
(2) y = -x3 + 2x2 - 3x + 2. Evaluate y' for x = 3.
(3) y = (x - 2)(x - 3). Evaluate y' for x = 2.
(4) y = 5 + 2 . Evaluate y' for x = 4.
(5) Suppose that L workers produce a product and that the number of units produced is given by f(L) =100L.5. The principles of economics hold
that increasing units of a resource yields diminishing returns. Diminishing returns means that each additional unit of the resource is less
productive. Explain how this "production function" is consistent with diminishing returns.
Second Derivatives, Convex, and Concave Functions
INTRODUCTION
In business, it's desirable to maximize some functions (such as profit) and to minimize others (such as inventory-related costs). A concave
function is easy to maximize. A convex function is easy to minimize.
To determine whether a function is concave or convex, look at the function's second derivative, which is the derivative of the function's first
derivative. The term y'' denotes the second derivative of a function y = f(x).
FINDING THE SECOND DERIVATIVE OF A FUNCTION

The second derivative of a function y = f(x) is denoted by f"(x), y'', or d2y/dx2. To find a function's second derivative, simply take the derivative of
the first derivative.
Consider y = x2. You already know that for this function, y' = f'(x) = 2x. Therefore, y" = f"(x) = 2. The second derivative is a constant because the
first derivative, y = 2x, is linear (it always has a slope of 2).
Consider another example: f(x) = x3 - x2. Then f'(x) = 3x2 - 2x, and f''(x) = 6x - 2.
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When a function's second derivative is positive, the function's first derivative is increasing; when a function's second derivative is negative, the
function's first derivative is decreasing. Thus, for y = x2, the first derivative is always increasing because y" = 2, which is greater than zero. For y
= x3 - x2, f"(x) = 6x - 2 is positive when x > 1/3 and negative when x < 1/3. Therefore, f'(x) is increasing for x > 1/3 and f'(x) is decreasing for x <
1/3.
CONVEX FUNCTIONS
A function f(x) is convex if for all values of x, f"(x) ≥ 0. In effect, a function f(x) is convex if and only if for all values of x, the slope of the function
is not decreasing.
The function y = x2 is a convex function. The following graph shows that for all values of x the slope is increasing. When x = -3, the slope of y = x2
is negative. As x increases toward zero, the slope of the graph also increases toward zero. As x increases from a value of zero, the slope of the
graph also increases from zero. Stated more rigorously, f'(x) = 2x and f"(x) = 2. Clearly, f"(x) is nonnegative (actually positive) for all x; therefore,
the function is convex.
CONCAVE FUNCTIONS
A function f(x) is concave if for all values of x, f"(x) ≤ 0. In effect, a function f(x) is concave if and only if for all values of x, the slope of the
function is not increasing.
The function y = -x2 is a concave function. The following graph shows that for all values of x, the slope is decreasing. When x = -5, the slope of y
= x2 is positive. As x increases toward zero, the slope of the graph decreases toward zero. As x increases from a value of zero, the slope of the
graph decreases from zero. Stated more rigorously, f'(x) = -2x and f"(x) = -2. Clearly f"(x) is nonpositive (actually negative) for all values of x;
therefore, the function is concave.
Maximizing and Minimizing Functions

FINDING THE MAXIMUM VALUE OF A FUNCTION
You just saw that the graph of y = -x 2

shows that the maximum value of the function occurs at x = 0. It is no accident that the slope of the
function at x = 0 is 0. A concave function attains its maximum value at any point where f'(x) = 0. Therefore, if you can verify that a function is
concave, you can find the value of x that maximizes the function simply by setting f'(x) equal to zero.
WHAT PRICE MAXIMIZES PROFIT FOR SMALLTOWN BAGELS?

For example, suppose that Smalltown Bagels's daily demand for bagels (in hundreds) is 5 - 2p and that it costs $0.80 to produce a bagel. What
price for bagels will maximize STB's daily profit, and what will the daily profit be at this price?
Let f(p) = (5 - 2p)(p - .8) be STB's daily profit. Using the FOIL method, you can simplify (5 - 2p)(p - .8) as follows:
FINDING THE MINIMUM VALUE OF A FUNCTION

The graph of y = x2 shows that the minimum value of the function occurs at x = 0. It is no accident that the slope of the function at x = 0 is 0. A
convex function attains its minimum value at any point where f'(x) = 0. Therefore, if you can verify that a function is convex, you can find the
value of x that minimizes the function simply by setting f'(x) equal to zero.
HOW MANY CARS MINIMIZES AVERAGE PRODUCTION COST?

An automobile manufacturer has opened a manufacturing plant in Smalltown to produce hybrid vehicles. The cost c(x) of producing x hybrids in
a day is expressed by x3 - 20x2 + 20,000x. What production level minimizes the average cost of producing a hybrid?
The average cost of producing x units is g(x) = c(x)/x = (x3 - 20x2 + 20,000x)/x = x2 - 20x + 20,000. Therefore, g'(x) = 2x - 20 and g''(x) = 2.
Given that g''(x) > 0 for any value of x, g(x) is a convex function. Thus, any value of x for which g'(x) = 0 will minimize the average production
cost.
To set g'(x) = 0, you must solve 2x - 20 = 0. Adding 20 to both sides of this equation yields 2x = 20. Then dividing both sides by 2 yields x = 10.
Therefore, producing 10 cars per day will minimize the average cost per hybrid.
The total cost of producing 10 cars, for example, is c(10) = 103 - 20(102) + 20,000(10) = 1,000 - 2000 + 200,000 = $199,000. The minimum
average cost of producing a hybrid is $199,000/10 = $19,900.
EXERCISES
(1) Is f(x) =1/x2 a convex or a concave function of x, for all values of x ≠ 0?
(2) Show that f(x) = x3 is neither a convex nor a concave function.
(3) Show that f(x) = -2x2 - 3x is a concave function of x.
20/48
(4) Suppose that it costs the automobile manufacturer $9000 to produce a hybrid and that the demand for hybrids (in thousands) for a price of p
thousand dollars is expressed by f(p) = 40 - 3p. What price for hybrids will maximize the company's profit? How would the answer change if f(p)
= 500p-2?
(5) Let K = the cost of placing an order for digital cameras, D = the annual demand for digital cameras, h = the cost of holding a digital camera in
inventory for a year, and c = the cost per camera ordered. Smalltown's electronics store knows that the annual cost for stocking cameras will be
(KD/q) + cD +.5hq. Show that an
order quantity (called the economic order quantity or EOQ) of 2

K
D
h
minimizes the total annual cost of stocking cameras.
(6) Suppose that you have 100 yards of fencing and want to build a rectangular fence that encloses the maximum possible area. What should the
dimensions of the fence be? Hint: If L = the length of the rectangle and W = its width, 2L + 2W = 100. First solve for L in terms of W; then
choose L to maximize the area of the fence.
(7) Suppose that you want build a rectangular fence that encloses 2500 square yards. What is the minimum amount of fencing needed?
Inflection Points
INTRODUCTION
A point where a curve changes from being convex to concave or concave to convex is an inflection point. For example, shown below is a
function that has been used to predict future world population. When the value for Years since 1900 = 95 (that is, in 1995), the graph changes
from convex to concave. This means that after 1995 the slope (or first derivative) of the graph starts decreasing. In effect, the model would
predict that after 1995, the growth in world population would begin to slow.
HOW TO FIND INFLECTION POINTS

Recall that a curve is convex if for all values of x, f"(x) ≥ 0 and concave if for all values of x, f"(x) ≤ 0. It is possible for a curve to be convex for
some values of x and concave for others — i.e., that it can change from being convex to being concave. If f"(x) > 0, the curve is convex for that
value of x. If f"(x) < 0, the curve is concave for that value of x. Therefore, an inflection point will occur when f"(x) = 0. As an example of how to
find an inflection point, suppose that the cost in dollars of baking x hundreds of bagels per day at Smalltown Bagels is given by c(x) = 100 + 2x3 -
20x2 + 50x. The graph of this function is shown below.
What is the inflection point for the bagel cost curve? We find that c'(x) = 6x2 - 40x + 50 and c"(x) = 12x - 40.
Therefore, c"(x) = 0 if 12x - 40 = 0 or x = 3.333. So, the inflection point of the bagel cost curve occurs at a level of 333.33 bagels. The graph shows
that if fewer than 333.33 bagels are produced, the cost function is concave and increasing; if more than 333.33 bagels are produced, the cost
function is convex and increasing. So, up to a production level of 333.33, bagel costs increase but at a decreasing rate. When more than 333.33
bagels are produced in a day, costs increase at an increasing rate. This behavior of the cost function may occur because a high level of production
can come with technological bottlenecks and overtime costs.
EXERCISE
(1) Suppose that the cost of producing x hundreds of bagels is c(x) = 150 + 5x3 - 12x2 + 50x. At what level of production does the bagel cost curve
have an inflection point? Does the cost function change from convex to concave or from concave to convex?
Statistics
INTRODUCTION
The analysis of data is crucial to business. In finance class, you will analyze returns on stocks and other investments. In your operations and
marketing classes, you will analyze monthly demand for products that are being sold. This section of the course begins by introducing you to the
basics of data analysis.
Summation Notation
INTRODUCTION
Suppose you want to add up the first 100 even positive integers. You could write a lengthy addition operation that specifies all 100 digits — i.e.,
2 + 4 + 6 + ... + 198 + 200. A less cumbersome, more elegant way to represent the operation is with the symbol ∑, which means summation.
∑
i
=
1
100
2
i
The notation dictates that for each of the first 100 positive integers i, find 2i; then add the results together. The only values of i for which you
determine 2i are those from 1 through 100 — they are, respectively, the lower and upper limits of the summation. The summation itself, or
sigma, of all the 2i calculations (2 + 4 + 6 + ... + 198 + 200) is your answer: 10,100.
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USING SUMMATION NOTATION TO EXPRESS AN AVERAGE

When you analyze data, you often need to find the average of n numbers. The list of numbers is written as x1, x2, ..., xn, and the average of them is
written with the x-bar symbol. In summation notation, you write:
x
¯
=
1
n
∑
i
=
1
n
x
i
It means that to find the average of n numbers, add up the n numbers and divide the sum by n. For example, if x1 = 3, x2 = 5, and x3 = 4, then
x
¯
=
1
3
∑
i
=
1
3
x
i
=
1
3
3
+
5
+
4
=
4
EXERCISES
(1) Evaluate ∑
i
=
1
4
3
i
-
1
(2) Smalltown Bagels bakes n types of bagels. Today the shop is planning to bake xi type i bagels, which each cost ci dollars to produce.
a. In summation notation, write an expression for the total cost of baking today's bagels.
b. Given the following assumptions
n=3
c1 = $1.20, x1 = 100
c2 = $1.50, x2 = 50
c3 = $2.00, x3 = 50
compute the total cost of baking today's bagels.
Using Bar Graphs and Histograms to Summarize Data
INTRODUCTION
Summarizing data often yields important managerial insights. There are two main ways to summarize data:
1. using a bar graph, or histogram, that gives a graphical summary of the data
2. using descriptive statistics such as mean, median, mode, and standard deviation
Let's start with bar graphs and histograms.
SETTING THE BIN RANGES FOR THE BAR GRAPH

The following table gives the height (in inches) of all of the girls in Tina's seventh-grade homeroom.
You can easily summarize these data in a bar graph.
First, divide the data into 5 to 10 categories, or bin ranges, of equal size. In this case, you might create seven bins: one for girls up to and
including 58 inches tall, another for girls over 58 inches up to and including 60 inches tall, a third for girls over 60 inches up to and including 62
inches tall, and so on. For example, 13 girls fall in the range of heights over 60 inches up to and including 62 inches (see the pink shaded cells).
Note: There are other ways to treat bin ranges; we are using the convention used by the Histogram tool in Microsoft Excel.
Next, create a frequency table that identifies how many data points, or observations, fall into each bin range.
CONSTRUCTING THE FREQUENCY TABLE

INSTALLING THE ANALYSIS TOOLPAK FOR A HISTOGRAM
If your data include thousands of observations, manual construction of a frequency table is impractical. Excel makes it easy to construct a
histogram for a data set of any size.
Before using Excel to create a histogram, install the Analysis Toolpak.
CONSTRUCTING A HISTOGRAM WITH EXCEL

Let's construct a histogram for the heights of the girls in Tina's homeroom. Please download the file histogram.xlsx.
EXERCISES
Please download the file histogramdata.xlsx.
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(1) The Salaries worksheet contains the annual salaries (in thousands of dollars) for the employees of the Smalltown tourist bureau. With bin
ceilings of 40, 50, 60, 70, 80, and 90, construct a bar graph of employee salaries.
(2) The Microsoft worksheet gives a sample of daily percentage returns on Microsoft stock. Use Excel to summarize these data with a histogram.
For your bin ranges, use upper boundaries of -20%, -15%, -10%, -5%, 0%, 5%, 10%, and 15%.
Measures of Central Tendency

INTRODUCTION
It's often practical to summarize data with a single number that typifies the data set. For example,
What is the typical number of ounces in a can of Coca-Cola?
What is a typical family income in Smalltown?
What is the typical number of points that a team scores in a game?
This section focuses on three measures of central tendency for a data set: mean, median, and mode.
DEFINING THE MEAN, MEDIAN, AND MODE

Suppose that you have a set of n numbers x1, x2, ..., xn.
The mean is simply the average of the n numbers. It is usually written as x-bar and expressed as
x
¯
=
1
n
∑
i
=
1
n
x
i
.

To compute the mean, simply add up all of your observations and divide by the number of observations.

The median is the halfway mark between the lower and upper extremes of the list of numbers in a data set. To find the median, first order
the numbers from smallest to largest. If n is odd, the median is the (n + 1)/2 smallest number. For example, if the data set includes 9
numbers, calculate (9 + 1)/2 = 5 to find that the median is the fifth-smallest number (the one in the middle). Of the eight other numbers,
four are smaller than the median and four are larger. If n is even, the median is the average of the n/2 smallest number and (n + 2)/2
smallest numbers. For example, if the data set includes 10 numbers, calculate 10/2 = 5 and (10 + 2)/2 = 6. The median is, therefore, the
average of the fifth- and sixth-smallest numbers. Five of the numbers are smaller than the median and five are larger; the median sits in
between these two groups.

The mode is the most frequently occurring number in a data set. A data set can have more than one mode (for the numbers that occur
most frequently may be identical in their frequency). If no number occurs more than once in a data set, the data set has no mode.
EXAMPLE OF COMPUTING THE MEAN

Suppose that the six employees of the Happytail Vet Clinic earn the following salaries (in thousands of dollars): 80, 30, 40, 50, 70, and 30. The
mean salary is simply 80
+
30
+
40
+
50
+
70
+
30
6
=
300
6
=
$50,000.
EXAMPLE OF COMPUTING THE MEDIAN

Let's compute the median salary of the six Happytail employees.
EXAMPLE OF COMPUTING THE MODE

Given that the employee salaries are 80, 30, 40, 50, 70, and 30, what is the mode? Two employees make exactly $30,000, and no other salary
occurs more than once. Therefore, the mode is $30,000.
If another employee were hired at a salary of $80,000, there would be two modes: $30,000 and $80,000.
If, instead, one of the two employees making $30,000 were to leave, there would be no mode.
USING EXCEL TO COMPUTE MEASURES OF CENTRAL TENDENCY

For large data sets, calculating the mean, median, and mode is difficult to do manually. Excel's AVERAGE, MEDIAN, and MODE functions make
it simple.
Please download the file Colts.xlsx. The file contains the number of yards gained on all passing plays attempted by the 2006 Super Bowl
Champion Indianapolis Colts. You can use Excel to compute the mean, median, and mode of the number of yards gained on a passing play.
EXERCISES
(1) Ten geography majors at the University of North Carolina had the following starting salaries (in thousands of dollars): 20, 25, 30, 28, 35, 20,
20, 25, 40, and 757. Find the mean, median, and mode of these salaries. Which seems to be the best measure of a typical geography major's
starting salary?
(2) Find the mean, median, and mode for both data sets in the file Histogramdata.xlsx.
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Skewness and Measures of Central Tendency
INTRODUCTION
The mode is rarely used as a measure of central location. If a shoe store could only stock one size, it would probably stock the modal shoe size.
In most situations, however, we use the mean or median as a measure of central location for a data set. In general, we use the mean as a measure
of central location unless extreme values greatly distort the mean. The U.S. government reports family income for the country as a whole as a
median, not a mean. A football team's offense is assessed in terms of the average, not the median, points scored per game. Why use the median
in the first situation and the mean in the second? The answer is that people with large incomes distort, or skew, the mean family income; the
median is not subject to that distortion. Before identifying precisely when to use the mean or median as a measure of central tendency, let's
return to the topic of histograms and define the concept of skewness.
SYMMETRIC DATA
A data set is symmetric if the data set's histogram has a single peak at the center and "looks the same" to the left and right of the most likely
value of the data. The following histogram displays IQs of students at Smalltown High School.
A symmetric data set's mean, median, and mode are approximately equal because the peak is at the center and the declines to the left and to the
right of the peak occur at the same rate. For example, nearly as many people have IQs around 95 as have IQs around 115.
POSITIVELY SKEWED DATA

A data set exhibits positive skewness (or is "skewed right") if its histogram has a single peak and the values of the data extend much farther to
the right than to the left of the peak. The following histogram describes the family income (in thousands of dollars) of Smalltown's residents.
The histogram shows that the most common income range is $30,000 to $50,000. Some people earn more than $300,000, whereas some earn
$10,000 or less. Because the data extend farther to the right of the peak than to the left, family incomes in Smalltown are positively skewed.
NEGATIVELY SKEWED DATA

A data set exhibits negative skewness (or is "skewed left") if its histogram has a single peak and the values of the data extend much farther to the
left than to the right of the peak. The following histogram shows the number days from conception to birth for babies born at Smalltown
Hospital.
The most common category is "more than 280 days." Because the data extend much farther to the left of the highest bar than to the right, days
from conception to birth is negatively skewed.
THE EXCEL SKEW FUNCTION

If the data you are analyzing are not skewed, use the mean as the measure of central tendency. In cases of great skewness, use the median as the
measure of central tendency to avoid distortion by extreme values.
You can usually assess skewness by simply eyeballing a histogram. To be precise about measuring skewness, apply the Excel SKEW function to a
data set.
If SKEW > +1, the data are positively skewed and the median is the better measure of central tendency.
If SKEW < -1, the data are negatively skewed and the median is again the better measure of central tendency.
If SKEW is between -1 and +1, the data are relatively symmetric and the mean is the better measure of central tendency.
MEAN OR MEDIAN?
Please download file Skewness.xlsx. Let's compare the mean and the median as measures of central tendency for the IQ, income, and
conception-to-birth data sets. In the cell range D3:F3, the skewness for each data set has been computed — e.g., using the formula
=SKEW(D8:D657) for IQs in cell D3. The median, mode, and mean for each data set have been computed using the MEDIAN, MODE, and
AVERAGE functions, respectively.
Click the column titles below to choose the appropriate skew behavior.
The data reveals the measure of central tendency that is best for each data set.
RELATION BETWEEN MEAN, MEDIAN, AND SKEWNESS

For positively skewed data sets, the mean is greater than the median. For negatively skewed data sets, the mean is less than the median. For
relatively symmetric data sets, the mean and median are usually very close in value. The three example data sets are consistent with these rules.
IQs are symmetric, and the mean (100.04) and the median (100) are virtually identical.
Income is positively skewed, and the mean (67.745) is larger than the median (48).
Days from conception to birth is negatively skewed, and the mean (259.9) is smaller than the median (269.5).
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EXERCISES
(1) Please download file Income.xlsx. The file contains data that are representative of the income of U.S. families (adjusted for inflation) during
the years 1975, 1985, 1995, and 2005. Does it appear that Americans were becoming better off as the decades passed?
(2) For the Colts' passing data, what measure of central location would you use?
Measures of Variability
INTRODUCTION
Sarah Lopez Clooney is trying to determine in which of two stocks to invest a client's money. For each of the last six years, the annual
percentage returns (expressed as a decimal) for the stocks were as follows:
Stock 1: .18, .22, .20, .20, .19, .21
Stock 2: -.4, .8, -.4, .8, -.4, .8
For each stock, the mean and median return for the last six years is .2. Therefore, the stocks are identical with respect to "typical" value. If you
assume (naively) that the past is a good predictor of the future, these two stocks seem to be equally good investments. Most investors, however,
would choose Stock 1, because its annual returns are more consistent than those on Stock 2. In this segment, you will learn how to use variance
and standard deviation to measure the dispersion, or spread, of the data set about its mean.
DEFINITION OF SAMPLE VARIANCE

Suppose that you have a data set of the n observations x1, x2, ..., xn . The sample variance of the data set (written as S2) is expressed as S
2
=
1
n
-
1
∑
i
=
1
n
x
i
-
x
¯
2
.
If you divide by n instead of n - 1, the sample variance is the average squared deviation of each data point from the average of the data. The
reasons why you should divide by n - 1 instead of n are complex enough to defer them to your statistics class.
The kind of data set that has the least spread about its mean is, not surprisingly, one in which all points have the same value and, thus, all equal
the mean. Such a data set has a sample variance of zero.
DEFINITION OF SAMPLE STANDARD DEVIATION

The sample standard deviation S is simply the square root of the sample variance. Sample deviation is often used as a measure of spread or
dispersion in a data set because the sample standard deviation has the same units as the data. For example, if your data are in dollars, the
sample variance is given in dollars squared. But what exactly is a dollar squared? Taking the square root of the variance to obtain the standard
deviation has the effect of returning the units to dollars.
COMPUTING THE SAMPLE VARIANCE

How can Sarah determine which of the two stocks is a better investment? Since both stocks have around the same average return,
Sarah will want to recommend the less risky investment. Risk is often measured by the standard deviation of a stock's annual return. Therefore,
you need to calculate the standard deviation of each stock's annual return. You do this by computing the variance of each stock's annual return
and then determine the standard deviation of each stock's annual return as the square root of the variance. After completing your calculation,
click on your stock choice below.
COMPUTING THE SAMPLE STANDARD DEVIATION

For each stock, the sample standard deviation is simply the square root of the sample variance. Therefore, for Stock 1, the sample standard
deviation =
.0002
=
.0141
. The sample standard deviation for Stock 2 =
.432
=
.657
. Since Stocks 1 and 2 have the same mean and Stock 2 has a
much larger standard deviation than Stock 1, most investors would prefer the less risky Stock 1 to Stock 2.
USING EXCEL
For any data set, Excel makes it easy to find the sample variance and standard deviation. Use the VAR function to find the sample variance and
the STDEV function to compute the sample standard deviation.
Please download the file Samplevariance.xlsx. In the file, the VAR and STDEV functions have been used to determine the sample variance and
standard deviation for each stock. For example, for Stock 1 in cell C13, the sample variance has been computed with the formula =VAR(C7:C12),
and in cell C14 the sample standard deviation has been computed with the formula =STDEV(C7:C12).
EXERCISE
(1) The heights (in inches) of the members of Smalltown High School girls' basketball team are 68, 70, 64, 62, and 68. Compute the sample
variance and sample standard deviation of these heights. Use Excel to verify your computations.
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The Rule of Thumb and Outliers

INTRODUCTION
William Edwards Deming (1900-1993) was an American quality-control guru who stressed the importance of understanding "normal
variation" in a business process. When a data set has a symmetric histogram (skewness between -1 and +1), you can usually gain insight into the
"normal range of variation for a data set" by relying on the following rule of thumb involving the sample mean x-bar and sample standard
deviation S:
68% of the data points are within S of the mean (between x-bar − S and x-bar + S).
95% of the data points are within 2S of the mean (between x-bar − 2S and x-bar + 2S).
99.7% of the data points are within 3S of the mean (between x-bar − 3S and x-bar + 3S).
Any data point that is more than 2S from the mean is designated an unusual observation or outlier. Deming showed how identifying the cause of
"unfavorable" outliers can help you prevent them from occurring again. Let's now apply these ideas to the distribution of IQs. The graph would
look like this:
COMPUTING RULE OF THUMB LIMITS MONTHLY STOCK RETURNS

Please download the file Cisco.xlsx. The file contains monthly stock returns for Cisco Systems during the 1990s. Use the rule of thumb to
decipher the "normal variation" in monthly returns of Cisco. In cells E7:E12, the bounds for the rule of thumb have been computed. The results
and formulas used are shown here:
Cells E3:E5 reflect computations of the mean (0.055), standard deviation (0.122), and skewness for the monthly returns. The skewness of .104
indicates that the Cisco returns are symmetric, so you would expect the rule of thumb to be approximately valid for this data set.
Computing the limits for the rule of thumb in cells E7:E12 reveals that
99.7% of the monthly returns should be between .055 ± 3 (.122) — i.e., between -31% and 42%.
95% of the monthly returns should be between .055 ± 2 (.122) — i.e., between -19% and 30%.
68% of the monthly returns should be between .055 ± .122 — i.e., between -7% and 18%.
HOW WELL DOES THE RULE OF THUMB DESCRIBE MONTHLY STOCK

RETURNS?
According to the example, "normal variation" for monthly Cisco returns is between -19% and 30%. Therefore, a month in which Cisco returned,
say, 28% or -15% would not be surprising. Any month during which Cisco returned less than -19% or more than 30% would be an outlier.
Highlighted in gray are Cisco monthly returns that fell within one standard deviation of the mean. In light and dark orange are returns that fell
within two standard deviations in either direction of the mean. Finally, the dark orange bars represent returns that fell more than 2S from the
mean. No returns fell more than 3S from the mean. Of the 130 monthly returns that constitute our data set, 9, or 6.9%, deviated from the mean
by more than 2S. Thus, 6.9% (close to the rule of thumb prediction of 5%) of returns were more than 2S from the mean. Of the 130 returns, 43,
or 33% (close to the rule of thumb prediction of 32%), were more than S from the mean.
EXERCISES
The file Cisco.xlsx also contains monthly stock returns for GM and Microsoft. Use these data to answer the following questions.
(1) You would expect 95% of the Microsoft monthly returns to be between __________ and ________.
(2) You would expect 68% of the GM monthly returns to be between __________ and __________.
Covariance and Correlation
INTRODUCTION
So far in our study of statistics we have discussed how to use measures of central tendency and variability to summarize a data set. We now turn
our attention to studying how to measure the strength of the relationship between two data sets. For example, how is the price of a house related
to the size of the house? How are the returns on two stocks related? How is a high school senior's SAT score related to his college GPA? The
relationship between two data sets is usually measured by the covariance and correlation between the two data sets.
COVARIANCE DEFINITION
Given n points (x1, y1), (x2, y2), ...(xn, yn), the covariance between data sets X and Y is given by
Covariance(X,Y) = ∑
i
=
1
n
x
i
-
x
¯
y
i
-
y
¯
n
-
1
Suppose that X and Y tend to go up and down together. That is, when X is larger than average, then Y is usually larger than average and when X
is smaller than average, then Y is usually smaller than average. Then most of the terms in the numerator of our covariance formula will be
positive and the covariance will be positive. Conversely, suppose that when X is larger than average, then Y is usually smaller than average and
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when X is smaller than average, then Y is usually larger than average. Then most of the terms in the numerator or our covariance formula will be
negative and the covariance will be negative. Therefore, if X and Y "covary" in the same direction, their covariance will be positive, whereas if X
and Y covary in opposite directions, their covariance will be negative.
In summary, a positive covariance indicates that X and Y tend to go up or down together whereas a negative covariance indicates that X and Y
tend to move in opposite directions (relative to their averages). Note that covariance only measures the strength of a linear
relationship and is not useful for detecting nonlinear relationships between variables. Therefore, covariance is a measure of
linear association between two variables.
SAMPLE DATA FOR COMPUTING COVARIANCE

Please download the file Correlcov.xlsx. The file gives the size in square feet and price (in dollars) of five houses in Smalltown.
When you graph these five points in the x-y plane it becomes clear that bigger houses tend to sell for a higher price.
SAMPLE DATA FOR COMPUTING COVARIANCE

Here X = size of house in square feet and Y = price of house. For example, x1 = 1500 and y1 = $140,000.
Note that for houses 1 and 2, both size and price are below average, whereas for houses 4 and 5, size and price are above average. For house 3,
size is average and price is slightly above average. Therefore, you expect that the covariance between home size and price will be positive.
COMPUTING THE COVARIANCE

We find that
x
¯
=
1,500
+
2,000
+
2,500
+
3,000
+
3,500
5
= 2500 square feet and
y
¯
=
140,000
+
260,000
+
330,000
+
345,000
+
420,000
5
= $299,000
Applying the formula for covariance, you find that
Covariance(X,Y) =
Or Covariance (X,Y) = 80,625,000 sq. ft. dollars.
The positive covariance indicates that home size and home price tend to go up and down together. As you will now see, however, it is difficult to
interpret the magnitude of the covariance.
COVARIANCE DEPENDS ON UNITS!

As we will now show, the covariance between two variables depends on the units in which the variables are measured. This makes it very difficult
to interpret the magnitude of a covariance. Continuing with our home example, suppose that we measure the size of a home in thousands of
square feet and measure the price in $100,000s of dollars. Then our data looks like
For example, 1500 square feet is 1.5 thousand square feet, whereas the $140,000 home price is 1.4 (in units of $100,000). You can see that in the
numerator of each term of the covariance, our home size will be divided by 1000 and each home price will be divided by 100,000. This means
that each term in the numerator or the covariance is divided by (1000)(100,000), or 100 million. Therefore, the covariance will now be the
original covariance of 80,625,000 divided by 100,000,000. That yields a covariance of .80625, measured in units of (thousands of square feet) ×
(hundreds of thousands of dollars). Since covariance depends on the units in which the data are measured, interpreting the magnitude of a
covariance is difficult. We now turn our attention to developing the correlation coefficient (called r), which is a unit-free measure of the strength
of a linear relationship between two variables.
CORRELATION DEFINITION
The Pearson correlation (usually denoted by r) is a unit-free measure of the degree of linear association between two data sets X and Y. Given n
points (x1, y1), (x2, y2), ...(xn, yn), the covariance between data sets X and Y is given by
r = Correlation(X,Y) = Covariance
X
,
Y
S
x
S
y
Here SX = sample standard deviation of X and SY = sample standard deviation of Y.
It can be shown that for any set of n points, -1 ≤ r ≤ 1. The correlation r is a unit-free measure of the degree of linear association between the data
sets X and Y. Values of r may be interpreted as follows:
Values of r near -1 indicate a strong negative linear relationship between X and Y. When X is larger than average, Y is almost always
smaller than average; when X is smaller than average, Y is almost always larger than average.
Values of r near -.5 indicate a moderate negative linear relationship between X and Y. When X is larger than average, Y tends to be
smaller than average; when X is smaller than average, Y tends to be larger than average.
Values of r near 0 indicate a weak linear relationship between X and Y. When X is larger than average, Y has little or no tendency to be
larger or smaller than average. Similarly, when X is smaller than average there Y has little or no tendency to be larger or smaller than
average.
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Values of r near +.5 indicate a moderate positive linear relationship between X and Y. When X is larger than average, Y tends to be larger
than average; when X is smaller than average, Y tends to be smaller than average.
Values of r near +1 indicate a strong positive linear relationship between X and Y. When X is larger than average, Y is almost always
larger than average; when X is smaller than average, Y is almost always smaller than average.
EXAMPLE OF A STRONG POSITIVE LINEAR RELATIONSHIP

Plotted below are the size in square feet and the price in dollars for a sample of Smalltown homes.
The correlation between home size and home price is r = .90, which indicates a strong positive linear relationship between home size and home
price. This high positive correlation is consistent with the fact that the data points are tightly scattered about a straight line that has a positive
slope.
EXAMPLE OF A MODERATE NEGATIVE LINEAR RELATIONSHIP

Plotted below are the daily price for lasagna dinners and the number of lasagna dinners sold at Smalltown's Italian restaurant. The correlation
between price and demand is r = -.50, indicating a moderate negative relationship between price and demand. Note that the data points are
widely scattered about a line that has a negative slope.
EXAMPLE OF A WEAK LINEAR RELATIONSHIP

Plotted below are monthly returns on Microsoft and GM.
Note that the correlation of r = .06 is near 0. That result is reflected in the weak linear relationship shown in the graph.
EXAMPLE OF COMPUTING A CORRELATION

Recall that for the following five data points
Covariance(Home Size, Home Price) = 80,625,000 sq. ft. dollars.
Let's find Correlation(Home Size, Home Price). Simply compute SHome Size and SHome Price.
Since Mean Size = 2500 sq. ft. and Mean Price = $299,000, we find that
SHome Size = 1500

-
2500
2
+
2000
-
2500
2
+
2500
-
2500
2
+
3000
-
2500
2
+
3500
-
2500
2
4
= 790.57 sq. ft.
SPrice = 140,000
-
299,000
2
+
260,000
-
299,000
2
+
330,000
-
299,000
2
+
345,000
-
299,000
2
+
420,000
-
299,000
2
4
= $105,498.82.
Therefore, Correlation(Home Size, Home Price) = 80,625,000

790.57
105,498.82
= .967
Note that the units of the numerator are sq. ft. dollars. These are also the units of the denominator. Therefore, the
correlation is unit-free.
USING EXCEL TO COMPUTE COVARIANCE

Recall the definition of covariance:
Covariance(X,Y) = ∑
i
=
1
n
x
i
-
x
¯
y
i
-
y
¯
n
-
1
If the values of X are in range 1 of our spreadsheet and the values of Y are in range 2 of our spreadsheet, then the Excel function COVAR(range1,
range2) computes as ∑
i
=
1
n
x
i
-
x
¯
y
i
-
y
¯
n
.
This is called the population covariance. In most uses of covariance, you should to divide by n - 1, which yields the sample covariance. To
convert Excel's covariance to a sample covariance, multiply the result of the COVAR function by n/(n - 1). In the current
example, you can obtain the sample covariance by multiplying the result of the COVAR function by 5/4 = 1.25.
Please download the file Correlcov.xlsx.
In cell E23, compute the sample covariance (80,625,000 sq. ft. dollars) by entering the formula
=(5/4)*COVAR(D16:D20,E16:E20).
USING EXCEL TO COMPUTE CORRELATIONS

If the values of X are in range 1 of our spreadsheet and the values of Y are in range 2 of our spreadsheet, then the Excel function
CORREL(range1, range2) computes the correlation between X and Y. For example, entering in cell E22 the formula =
CORREL(D16:D20,E16:E20) returns the .967 correlation between home size and home price.
DOES A STRONG CORRELATION IMPLY CAUSATION?
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People often assume that if X and Y have a correlation near +1 or -1, then X causes Y or Y causes X. However, this need not be true. For example,
let Xi = restaurants in city i and Yi = swimming pools in city i. For the hundred largest cities in the U.S., you would surely find a correlation near
+1. Does that mean that the presence of restaurants in a city leads to the establishment of swimming pools? Or does the strong correlation imply
that the presence of swimming pools causes the opening of restaurants? Of course not! The reason for the strong correlation between the
number of restaurants and the number of swimming pools in a city is that large cities have many swimming pools and restaurants and that small
cities have few swimming pools and few restaurants. In effect, this spurious correlation between restaurants and swimming pools is caused by a
third variable: the size of a city. In general, very advanced statistical methods are needed to prove true causality.
EXERCISES
(1) Annual returns on Hot Cakes Amalgamated and Bridges Consolidated stocks for the last five years are given below.
Find the covariance and correlation between the Hot Cakes and Bridges annual returns.
(2) Please download the file Nfldata.xlsx. The file contains the points scored by each NFL team and punts attempted during the 2008 season.
Compute the covariance and correlation between punts and points scored.
(3) For the data in the file Nfldata.xlsx, each team played 16 games. Compute points scored per game and punts attempted per game. Now
compute the covariance and correlation between these two data sets.
(4) There is a moderate negative correlation between points scored and punts attempted. Therefore, the SportsCenter anchors will sometimes
say that the less you punt, the more points you score. Hence you should never punt! What is wrong with this argument?
Probability
INTRODUCTION
If one thing is certain, it's that the future is uncertain. Fortunately, you can make intelligent estimates about the future using the basic rules of
probability. The rules can help you address questions such as these:
What is the likelihood that the market will go up at least 10% next year?
What is the probability that a team favored by 10 points will win the Super Bowl?
What are the chances of winning the casino game of craps on the first roll of the dice?
In this chapter, you will learn the principles underlying probability questions like these.
Experiments, Sample Spaces, and Events
EXPERIMENT
When you do an experiment, the outcome is uncertain. Here are some examples of experiments you can construct:
Drawing 5 cards from a deck of 52.
Tossing a coin to see how many throws it takes to get heads.
Buying a new car and observing how long the engine lasts before it needs its first repair.
Tossing two dice in a game of craps at the Smalltown Casino to see whether you can roll a total of 7 or 11 on the first try.
SAMPLE SPACE
A sample space consists of all possible outcomes for an experiment. For the four examples just considered, the sample spaces are as follows:
When you draw a card from a deck, the sample space consists of any one of 52 cards.
If you toss a coin, the first appearance of heads may be on the first try, the second try, or a subsequent try. Therefore, the sample space
consists of H, TH, TTH, and so on (where H is heads and T is tails).
The days elapsed until the time of a car engine's first repair can be any nonnegative number of days. Therefore, the sample space is the
set of all nonnegative numbers.
When rolling two dice, let f = the result on one die and s = the result on the other die. The sample space is all points of the form (f, s),
where f and s are integers between 1 and 6, inclusive. Therefore, the sample space is (1,1), (1,2),...and so on up to (6,5), (6,6) — a total of
36 points.
EVENTS
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Any subset of points in a sample space is called an event. Here are some examples of events:
Rolling a total of 7 or 11 on a toss of two dice.

Drawing a face card (a jack, queen, or king) from a deck of 52 cards.
Taking three or fewer tosses to observe the first head.
Going at least three years before a car engine needs to be repaired.
EXERCISES
(1) If you toss three dice one time, what are the points in the sample space? How many points are there? Which points correspond to throwing
exactly a 7 with the three dice?
(2) In your sock drawer, you have only pairs of white socks and pairs of blue socks. You randomly select two pairs of socks. Identify the points in
the sample space.
(3) Vivian is in Reno, and Michael is in Smalltown. The two cities are 300 miles apart. Using the same highway, Vivian drives toward Smalltown
and Michael drives toward Reno. Describe a sample space that represents the number of miles each has driven when they eventually pass each
other.
Calculations Involving Sample Spaces

INTRODUCTION
If you set up a sample space so that each point in it has an equal chance of occurring, many probability problems become easy to solve. That's
because the total probability of all points in a sample space must add up to 1 — after all, there is a 100% chance that some point in the sample
space will occur. For example, if a sample space consists of 10 equally likely points, each point has a 10% chance of occurring.
WHAT IS THE CHANCE THAT TWO DICE TOTAL 7?

Michael is going to the Smalltown Casino to play craps. In craps, you roll two dice; you win on the first roll if your total is 7 or 11. What is the
probability that Michael will roll a 7 in his first game of craps? What is the probability that he will roll an 11?
Recall that when you toss two dice, the sample space has 36 points.
The following six points in the sample space yield a total of 7: (1,6), (2,5), (3,4), (4,3), (5,2), (6,1). Therefore, the probability of rolling a 7 is 6/36
or 1/6. The two points (5,6) and (6,5) are the only two in the sample space that can yield a total of 11. Therefore, the chance of rolling an 11 is
2/36 or 1/18.
WHAT IS THE PROBABILITY WE DRAW A JACK FROM A DECK OF CARDS?

Each of the 52 cards in a deck is a point in the sample space. Each card has an equal chance (1/52) of being chosen. Four points in the sample
space are jacks (the Jack of Hearts, Jack of Clubs, Jack of Spades, and Jack of Diamonds). Therefore, the chance of drawing a jack is 4/52 or
1/13.
EXERCISES
(1) If you roll two dice, what is the probability that the total is 9?
(2) Michael and Vivian went to Smalltown Bagels for a snack. They asked the store owners (Wendy and Wayne) how many children they have.
Wendy and Wayne said they have two children. What is the chance that they have one boy and one girl?
Mutually Exclusive Events
DEFINITION
A group of events is considered mutually exclusive if the occurrence of any one event in the group precludes the occurrence of any other event
in the group. For example, if you toss two dice, these two events — E 1 = dice totaling 7 and E 2 = dice totaling 11 — are mutually exclusive because
if the dice total 7, they cannot also total 11.
FINDING PROBABILITIES INVOLVING MUTUALLY EXCLUSIVE EVENTS

Suppose the events E1, E2, ... En are mutually exclusive. The probability of E1, E2 ... or En occurring (that is, the probability that at least one of
these events occurs) is simply the sum of their individual probabilities: P(E1) + P(E2) + ... P(En). For example, you win a game of craps on the
first roll of the dice roll if you get a total of 7 or 11. What is the probability that you win a game of craps on the first roll?
Let E1 = the event of rolling a total of 7 on the first roll and E2 = the event of rolling a total of 11 on the first roll. Then determine the probability of
E1 or E2. The occurrence of a total of 7 precludes the occurrence of a total of 11, so these are mutually exclusive events. Given that P(E1) = 6/36
and P(E2) = 2/36, the probability of E1 or E2 is 6/36 + 2/36 = 8/36, or 2/9.
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PROBABLITY WHEN EVENTS ARE NOT MUTALLY EXCLUSIVE

Determine the probability of drawing either a jack or a diamond from a deck of 52 cards. Let E1 = the event of drawing a jack and E2 = the event
of drawing a diamond. The point "Jack of Diamonds" in the sample space is included in both events, so E1 and E2 are not mutually exclusive.
Therefore, you should not simply add the individual probabilities in this case. For any two events E1 and E2, the probability that E1 or E2 occurs
(i.e., the probability that at least one of E1 or E2 occurs) is expressed as
P(E1 or E2) = P(E1) + P(E2) - P(E1 and E2).
By subtracting the probability that both events occur, you avoid double-counting points that correspond to both E1 and E2.
EXERCISES
(1) What is the probability of drawing a spade or a club from a deck of 52 cards?
(2) What is the probability that if two dice are tossed, the total is 7 or 2?
(3) Of the students at Smalltown High School, 30% received an A in math this semester, 20% received an A in science, and 10% received an A in
both math and science. What is the chance that a single student at Smalltown High School received an A in either science or math this semester?
Complementary Events
DEFINITION
Let E be any event. The complement of the event E (written E¯) is the event that E does not occur. Note that E and E¯ are mutually exclusive
because the occurrence of either event precludes the occurrence of the other event. Together, E and E¯ make up the whole sample space, so P(E
or E¯) = 1 = P(E) + P(E¯). Rearranged, the equation is P(E) = 1 - P(E¯). Therefore, if you can find the probability of E¯, you can easily find the
probability of E as well.
COMPUTING PROBABILITIES USING THE COMPLEMENT

Find the probability that upon tossing two dice, you do not throw a total of 7. You could compute this probability by adding up the individual
probabilities of rolling 2, 3, 4, 5, 6, 8, 9, 10, 11, and 12, but that would be tedious. You already know the probability of a total of 7 is 6/36. If you
let E = the event that the total is 7 and E¯ = the event that the total is not 7, then E and E¯ are complements and
P(E¯) = 1 - P(E) = 1 - (1/6) = 5/6.
EXERCISES
(1) What is the probability of obtaining a total of 10 or less with a simultaneous toss of two dice?
(2) What is the probability of not drawing a face card from a deck of 52 cards?
Conditional Probability
DEFINITION
New information often changes your expectation about the probability that a particular event will occur. For example, you may initially think
that your college football team has an 80% chance of beating its archrival. But if you learn that your star quarterback is injured and will miss the
game, you would probably reduce your initial estimate.
Given two events, A and B, the conditional probability of A occurring, if B has already occurred, is expressed as P(A|B). In the college football
example, let A = the event of beating your archrival team and B = the event that your quarterback is injured. Your assumptions are expressed as
P(A) = .80 and P(A|B) < .80.
IMPORTANT CONDITIONAL PROBABLITY FORMULAS

Given two events A and B, P(A|B)
=
P
A and B
P
B
.
For example, imagine a sports team with a roster of nine players: four who play offensive positions, three who play defensive positions, one who
plays both offense and defense, and one who plays neither (for an example of this last, consider the kicker position in the NFL).
If we learn that one of our players has been implicated in a scandal, all other things being equal, the probability that it is a player who can play
offense — which we will call P(A) — is 5/9. The probability that it is a player who can play defense — which we'll call P(B) — is 4/9. The
probability that it is a player who can play both offense and defense — P(A and B) — is 1/9. The figure below represents our nine players and
their positional designations (A = offense; B = defense). Each square in the table has probability 1/9. Note that if the "middle" sample space
point in the grid occurs, then both A and B have occurred.
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Then, if we know that the player who was implicated in the scandal is a player who can play defense, the probability
that we will eventually learn that that player can also play offense is P(A|B)
=
1
9
4
9
=
1
4
.
A RED CARD IS DRAWN. WHAT IS THE PROBABLITY THAT CARD IS A

DIAMOND?
The defining formula for conditional probability is:
P(A|B)
=
P
A and B
P
B
Now let's solve some simple conditional probability problems.
Given that a card is red, what is the probability that the card is a diamond? Define A = the event that the card is a diamond and B = the event
that the card is red. We want to determine P(A|B). To use the equation for conditional probability, we need P(B) and P(A and B). P(B) is the
probability that a card is red. Since 26 out of 52 cards are red, P(B) = 26/52. P(A and B) is the probability that a card is red and is a diamond.
Since all diamonds are red, this is the same as the probability that a card is a diamond, which is 13/52.
Making use of our equation, we have P(A|B)

=
13
52
26
52
=
1
2
It is sometimes helpful to rearrange this equation by multiplying both sides by P(B). This yields P(A and B) = P(A|B)P(B).
A 5 IS DRAWN. WHAT IS THE CHANCE THAT CARD IS RED?

Let A = the event of drawing a red card and B = the event of drawing a 5. The deck contains four 5s, so P(B) = 4/52. There are two red 5s in the
deck, so P(A and B) = 2/52.
Therefore, P(A|B)
=
P
A and B
P
B
=
2
52
4
52
=
1
2
JOINT PROBABILTY OF TWO EVENTS

The probability that two events will occur together is called a joint probability. Joint probabilities, expressed as P(A and B), can often be easily
computed using the formula P(A and B) = P(A|B) × P(B). As an illustration, consider an urn that contains two white and two black balls. If you
draw two balls from the urn (without replacing the first ball), what is the probability of drawing two black balls?
Let B1 = the event that the first ball is black and B 2 = the event that the second ball is black.
Then, P(B1 and B2) = P(B1) × P(B2|B1).
EXERCISES
(1) If two dice are thrown and the total is 6, what is the probability that the first die shows a 3?
(2) If an urn contains two white and two black balls and you draw two balls (without replacing the first ball), what is the probability of drawing
one white ball and one black ball?
(3) About 5% of men and 0.25% of women are colorblind. If you are told a person is colorblind, what is the probability that the person is a man?
Hint: The probability that a person is colorblind is P(man and colorblind) + P(woman and colorblind).
(4) A Smalltown family has two children, of whom at least one is a boy. What is the chance that both children are boys?
Independent Events
INTRODUCTION
For n events, E , E , ... E , suppose that you want to know the chance that a subset of the n events will occur. If, for any subset of n events, you
1 2 n
can find the probability that all those events will occur by multiplying the probabilities of the individual events in the subset, then the events E1,
E2, ... En are independent.
For example, two events E1 and E2 are independent if and only if P(E1 and E2) = P(E1) × P(E2).
Three events E1, E2, E3 are independent if and only if all of the following are true:
P(E1 and E2) = P(E1) × P(E2),
P(E1 and E3) = P(E1) × P(E3),
P(E2 and E3) = P(E2) × P(E3),
P(E1 and E2 and E3) = P(E1) × P(E2) × P(E3).
To appreciate the underlying logic, assume that the events E1 and E2 are independent. Then, P(E1 and E2) = P(E1) × P(E2). Dividing both sides of
that equation by P(E2) yields P
E
1
and
E
2
P
E
2
=
P
E
1
.
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The left side of this equation is identical to the right side of the basic equation for conditional probability, and so it is equal to P(E1|E2).
Therefore, two events are independent if and only if P(E1|E2) = P(E1). Similarly, two events E1 and E2 are independent if and only if P(E2|E1) =
P(E2). In short, two events are independent if and only if the knowledge that one event has occurred does not change the estimate of the
probability that the other event will occur.
Knowing that the events in a set are independent of one another allows you to determine the probability that any subset of the events will
occur simply by multiplying the probabilities of the individual events.
A DRAWN CARD IS RED. THAT CARD IS A 5.

ARE THESE INDEPENDENT EVENTS?
Let R = the event that a drawn card is red and Five = the event that a drawn card is a 5. If P(R and Five) = P(R) × P(Five), then the two events are
independent. Given that there are 26 red cards in a deck of 52 cards, P(R) = 26/52. Given that there are four 5s in the deck, P(Five) = 4/52. Also,
P(R and Five) = 2/52. Because P(R and Five) = P(R) x P(Five), the two events are independent. In other words, the knowledge that the card
drawn is red does not change your estimate of the probability that a five was drawn.
Are the events that a red card is drawn and that a diamond is drawn independent events? Let R = the event that the card drawn is red and D =
the event that the card drawn is a diamond. Then, P(R) = 26/52 and P(D) = 13/52. Also, P(R and D) = 13/52. Therefore, P(R) × P(D) = (1/2)(1/4)
= 1/8 ≠ P(R and D), so R and D are not independent. Simple logic confirms this: If the card is red, it obviously cannot be a club or a spade, which
increases the probability that it is a diamond.
MACHINE RELIABILITY
Michael loves watching football games on his satellite TV. Suppose that there are ten parts of the TV whose failure can cause the TV to
malfunction during the game and that each part has only a 1% chance of failing during a game. What is the chance that Michael can watch an
entire football game without interruption?
Assume that failure of each TV part is an independent event. By the Law of Complements, the probability that a given part does not fail = 1 - (the
probability that a part fails) = 1 - 0.01 = 0.99. You can find the probability that no parts fail by simply multiplying the ten individual probabilities
that each part does not fail. Therefore, the probability that all ten parts do not fail = (0.99)10 = 0.904. So, 90.4% of the time Michael can watch a
whole game without being interrupted.
THE EFFICIENT MARKET HYPOTHESIS

In corporate finance class, you will study the efficient market hypothesis, which essentially states that future movements in a stock's price are
independent of past movements in the stock's price. For example, let U = the event that a stock price increases tomorrow and Down2 = the event
that the stock price dropped during both of the last two days. Suppose that the stock has an equal chance of going up or down tomorrow. Then,
P(U) = 0.50. The efficient market hypothesis implies that a stock price going down for two straight days does not increase (or change in any way)
the chance that the stock will be up the next day. Therefore, P(U) = P(U|Down2).
EXERCISES
(1) Are these two events independent: the total on two dice is 7, and one of them shows a 3?
(2) Are these two events independent: the total on two dice is 5, and one of them shows a 3?
(3) What is the probability that when you toss a coin ten times, it lands on heads all ten times?
(4) Let A = the event that the stock price of Company A increases during the next 12 months and B = the event that the stock price of Company B
increases during the next 12 months. Are A and B independent events?
(5) Let C = the event that the Celtics win next year's NBA championship and R = the event that the Red Sox win next year's World Series. Are C
and R independent events?
(6) Can two mutually exclusive events be independent?
Random Variables
DEFINITION
A random variable is simply a function that associates a numerical value with every point in an experiment's sample space. Here are some
examples:
If you toss three coins, you might define a random variable X as the number of heads tossed (random variables are usually written in
bold).
Consider an experiment in which you toss three coins and define the random variable X as the number of heads tossed. Let's now toss the three
coins. Two heads come up, so the random variable X = 2. On a second try, no heads come up, so the random variable X = zero.
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DISCRETE RANDOM VARIABLES

A random variable can be classified as either discrete or continuous. It is considered discrete if it can take on a finite number of values such as 0,
1, 2, 3, and so on. Here are some examples of discrete random variables:
If you are told that at most ten new casinos will open in Nevada during the next year, this discrete random variable can assume the values
0, 1, 2, ...10.
Let X be the random variable representing the number of new casinos to open in Nevada during the next year. When you toss two dice,
their total is a discrete random variable that can assume the values 2, 3, 4, ...12.
EXPECTED VALUE
If you perform an experiment a great many times, the expected value of a random variable is the "average value" of the random variable that you
can expect. The expected value of a discrete random variable is found simply by multiplying each value of the random variable by its probability
and then adding up the products. Let E(X) be the expected value of X. Assume that the random variable assumes n values x1, x2, ... xn. (Note that
the actual values assumed by a random variable are written in lowercase.) Let the value xi occur with probability pi. Then,
E
X
=
∑
i
=
1
n
p
i
x
i
For example, toss a die and define a random variable X as the toss result. This random variable is equally likely to be 1, 2, 3, 4, 5, or 6, so P(X =
1) = P(X = 2) = P(X = 3) = P(X = 4) = P(X = 5) = P(X = 6) = 1/6. Then, E(X) = (1/6)(1) + 1/6(2) + (1/6)(3) + (1/6)(4) + (1/6)(5) + (1/6)(6) =
21/6 = 3.5.
Thus, if you repeatedly toss a die, on average you will get 3.5 dots. Note that the expected value of a random variable need not be a possible value
of a random variable.
EXPECTED PROFIT ON A ROULETTE BET

A spin of a roulette wheel is equally likely to result in 0, 00, 1, 2, ... 36. Thus, each number has a 1/38 chance of occurring. Suppose that Vivian
bets on a single roulette number at a casino. If her number comes up, she earns $35 in profit; if her number does not come up, she loses $1.
What is the expected profit on such a $1 bet? Let X = the profit on a $1 bet. Whatever number is bet on has a 1/38 chance of coming up.
Therefore, P(X = 35) = 1/38 and P(X = -1) = 37/38. The expected profit is simply
(1/38)(35) + (37/38)(-1) = -2/38 = -.053, or -5.3 cents.
In other words, on average, Vivian can expect to lose 5.3 cents of every dollar bet, or 5.3% of her total stake.
DISCRETE RANDOM VARIABLES

The expected value of a discrete random variable tells you, on average, what value that variable has. You also need to measure how "spread out"
a random variable is. The variance of a random variable is defined as the average squared deviation of the random variable from its expected
value. Consider a discrete random variable that assumes n values x1, x2, ... xn . Let the value xi occur with probability pi. Then, the variance of X,
written as σ2(X), is defined as
σ
2
X
=
∑
i
=
1
n
p
i
x
i
-
E
X
2
The standard deviation of a random variable X, written as σ(X), is simply the square root of the variance. (The symbol σ is the lowercase Greek
letter "sigma.")
Find the variance and standard deviation of X, where X = the result when a single die is tossed. Recall that E(X) = 3.5. Given that each result has
a 1/6 chance of occurring,
σ2(X) = (1/6)(1 - 3.5)2 + (1/6)(2 - 3.5)2 + (1/6)(3 - 3.5)2 + (1/6)(4 - 3.5)2 + (1/6)(5 - 3.5)2 + (1/6)(6 - 3.5)2 = 2.917.
Then, σ
X
=
2.917
=
1.71
EXERCISES
(1) Is the number of aces dealt in a five-card poker hand a discrete random variable?
(2) Is a randomly selected person's height a discrete random variable?
(3) Is the number of gas stations that a Smalltown resident will have to choose from in 2013 a discrete random variable?
(4) For a toss of two fair coins, determine the expected value, variance, and standard deviation of the number of heads tossed.
(5) Suppose that the U.S. economy next year has a 60% chance of a boom, a 30% chance of a recession, and a 10% chance of a depression. The
following table gives the return on Vivian's investment portfolio under each scenario.
Determine the expected value, variance, and standard deviation of the annual return on Vivian's portfolio.
Continuous Random Variables
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DEFINITION
A continuous random variable can assume an infinite number of values and is defined over an interval or intervals of values. Here are some
examples of continuous random variables:
The height of a randomly selected Smalltown adult man is a continuous random variable that can theoretically assume any value between
0 inches and, say, 96 inches.
The time it takes Tina to swim 100 yards in Nevada's statewide high school swimming championship is a continuous random variable
that can assume any value in the range 45 seconds to, say, 75 seconds.
The return on a share of Company A's stock is a continuous random variable that can assume any value between -100% and, say, 300%.
WHAT IS THE PROBABILTY THAT A PERSON IS EXACTLY 6 FEET TALL?

When a die is tossed, there is a 1/6 probability that a three comes up. If you measure the height of a randomly selected Smalltown adult man,
what is the chance that he is exactly 6 feet tall? This probability must be zero, because to be exactly 6 feet tall, someone's height must be precisely
72.000000000000000000000000000 (infinite number of 0s!) inches. The chance of being exactly that height is, for all intents and purposes,
zero. Therefore, for most continuous random variables, each possible value has a zero probability. You can ask, however, what the probability is
that a person stands between 71.99 and 72.01 inches tall. It is not zero. Let's now discuss how to calculate probabilities for continuous random
variables.
PROBABILITY DENSITY FUNCTIONS (PDFs)

Any continuous random variable has associated with it a probability density function (PDF). The left-hand graph shows the PDF for the height of
a randomly selected Smalltown adult man.
Suppose that Smalltown Bagels, on a given day, is equally likely to use any amount of flour between 150 and 200 pounds, inclusive. The PDF for
daily flour use at Smalltown Bagels is shown in the right-hand graph.
PROPERTIES OF PROBABILITY DENSITY FUNCTIONS (PDFs)

A PDF has the following properties:
It is always nonnegative.
The height of a PDF for a value x of a continuous random variable represents the relative likelihood that the random variable assumes a
value near x.
In the above example on men's heights, the PDF is largest at 69 inches, so the most likely height of a Smalltown adult man is 69". It's also
clear that the PDF value at 64" is approximately half that at 69". Therefore, roughly half as many Smalltown adult men are about 64" tall
as are about 69" tall.
In the example on flour use, the fact that all PDF values between 150 and 200 pounds are the same means that any value in that range is
equally likely to occur.
The total area under the PDF must equal 1. For example, the PDF for flour use corresponds to a rectangle with a base of 50 and a height
of 0.02. Its area, therefore, is (0.02)(50) = 1.
The probability of an event involving a continuous random variable corresponds to the area under the PDF. The total probability of all
possible outcomes must equal 1, in line with the total area of 1 under the PDF.
AREA UNDER PDF = PROBABILITY

Consider how the area under a PDF corresponds to probabilities of interest by answering the following questions:
1. What is the probability that a randomly selected Smalltown adult man is at most 66" tall?
2. What is the probability that a randomly selected Smalltown adult man is at least 79" tall?
3. What is the probability that a randomly selected Smalltown adult man is between 67" and 75" tall?
4. What is the probability that on a given day Smalltown Bagels uses between 160 and 190 lbs. of flour?
EXERCISES
(1) Gregory shoots 50 free throws. Is the number of free throws he makes a continuous random variable?
(2) Is the percentage change in the price of an ounce of gold during the next year a continuous random variable?
(3) Is the time you wait in line to place an order at a sandwich shop a continuous random variable?
(4) What area corresponds to the probability that a Smalltown adult man is between 65 and 75 inches tall?
(5) According to the PDF given in this section, are more Smalltown adult men about 60" tall or about 80" tall?
(6) According to the PDF given in this section, what is the probability that on a given day Smalltown Bagels will use at least 180 pounds of flour?
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(7) According to the PDF given in this section, what is the probability that on a given day Smalltown Bagels will use at most 190 pounds of flour?
Normal Random Variable
INTRODUCTION
More real-world quantities can be described by the normal random variable than by any other continuous random variable. Some examples of
quantities known to follow a normal distribution are IQs, GMAT scores, height, weight, half gallons of milk sold by a supermarket in a week,
diameter of an elevator rail, and changes in a stock price in a short length of time. The normal random variable, often called the bell curve, has
the following PDF:
f
x
=
1
σ
2
π
e
-
x
-
μ
2
2
σ
2
Here e = 2.7182.
PROPERTIES OF THE NORMAL RANDOM VARIABLE

The normal random variable has several important properties:
A normal random variable assumes a mean value μ.

A normal random variable has a variance of σ2 and a standard deviation of σ.
There is a 68% chance that a normal random variable assumes a value within σ of the mean, a 95% chance that it assumes a value within
2σ of the mean, and a 99.7% chance that it assumes a value within 3σ of the mean. For example, IQs are normally distributed with a
mean of μ = 100 and standard deviation of σ = 15. Thus,
68% of people have IQs between 100 - 15 and 100 + 15 (i.e., 85 to 115).
95% of people have IQs between 100 - 2(15) and 100 + 2(15) (i.e., 70 to 130).
99.7% of people have IQs between 100 - 3(15) and 100 + 3(15) (i.e., 55 to 145).
The normal PDF is symmetric about the mean: It looks the same to the left of the mean as it does to the right. For example, recall that
IQs are normally distributed with a mean of μ = 100 and a standard deviation of σ = 15. The symmetry of the normal random variable
implies that for any x > 0, roughly as many people have IQs near 100 + x and 100 - x. For example, the chance that a person has an IQ
near 90 is equal to the chance that a person has an IQ near 110. The chances that a person has an IQ near 80 or near 120 are also equal to
each other.
WHAT DOES A NORMAL PDF LOOK LIKE?

A normal PDF looks like a bell curve. The left-hand graph shows PDFs for two normal random variables. Each has a mean of 100; one has a
standard deviation of σ = 20 and the other of σ = 5. Note that both PDFs are centered about the mean of 100, but the PDF with σ = 20 is much
more highly variable, or "spread out."
The right-hand graph shows the PDFs for two normal random variables, each with a standard deviation of σ = 5. The first normal random
variable has a mean of μ = 100, whereas the second has a mean of μ = 80.
Given that both random variables have the same standard deviation, their PDFs are equally spread out about their means. The normal random
variable PDF with μ = 100 is identical to the normal random variable with μ = 80, but shifted 20 units to the right.
FINDING NORMAL PROBABLITIES

Recall from the previous section that for any continuous random variable, a probability of interest is computed as the area under the random
variable's PDF. For example, the probability that a person has an IQ of at least 120 is simply the area to the right of 120 under the PDF for IQs.
How do you find areas under a normal PDF? In the past, most people used tables in statistics books. Nowadays, it is easy to use Excel's
NORMDIST function to compute normal probabilities. The function NORMDIST(x,MU,SIGMA,TRUE) — or NORMDIST(x, MU,SIGMA,1),
using 1 in place of the TRUE argument — computes the area to the left of x for a normal random variable with mean MU and standard deviation
SIGMA. For example, the probability that a person has an IQ of 90 or lower is computed from the formula =NORMDIST(90,100,15,TRUE).
Use the NORMDIST function to answer the following questions. Assume again that the height in inches of adult men in Smalltown follows a
normal distribution with μ = 69" and σ = 4". Please download the file Heights.xlsx.
1. What is the chance that a randomly selected Smalltown adult man stands 66" or shorter?
2. What is the chance that a randomly selected Smalltown adult man stands 79" or taller?
3. What is the chance that a randomly selected Smalltown adult man is between 67" and 75" tall?
EXERCISES
The daily demand for bagels at Smalltown Bagels must be a nonnegative integer, yet it can assume many values (say, 0, 1, 2, ... 1000). When a
discrete random variable can assume many values, it is often useful to approximate it as a continuous random variable. Therefore, assume that
the daily demand for bagels follows the pattern of a normal random variable with μ = 400 and σ = 80.
(1) What is the probability that Smalltown Bagels sells at most 350 bagels?
(2) What is the probability that STB sells at least 500 bagels?
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(3) What is the probability that STB sells between 380 and 450 bagels?
(4) The final margin of an NFL football game is approximately normally distributed, with a mean equal to the gambling point spread and a
standard deviation of 14 points. Recall the great 2008 Super Bowl in which the Giants upset the Patriots. The Patriots had been favored by 12
points. What does that fact imply about the Giants' initial (i.e., pre-game) chances of winning?
(5) Before the 2008 Super Bowl, chances were 95% that the Patriots would win by between _____ and _____ points.
Finance
INTRODUCTION
In finance class, you will have to assess and compare the attractiveness of streams of cash flows, such as these:
Placing a value on a sequence of cash flows is also vital in projecting future cash flows and accurately valuing companies according to those
projections. In this module, you will learn the main techniques needed to value and evaluate streams of cash flows.
Net Present Value (NPV)

DEFINITION OF PRESENT VALUE
The present value of a sequence of cash flows is the equivalent value of those cash flows in today's dollars. To compute that value, you need to
define a per-period interest rate, or discount rate, expressed as r. Given r, you can assume that $1 will grow in one period to $(1 + r). For
example, if r = 10%, then $1 today will grow in one period to $1.10. Dividing both sides of this equation by (1 + r) yields $1
1
+
r
today = $1 one
period from today.
It follows that you can convert $K received one period from now to an equivalent present value by dividing K by (1 + r). Similarly, you can
convert $K received two periods from now to an equivalent present value by dividing K by (1 + r)2. These observations are generalizable: In order
to convert $K received n periods from now to an equivalent present value, divide by (1 + r)n.
GENERAL FORMULA FOR PRESENT VALUE OF CASH FLOWS

Suppose that for time t = 0, 1, 2, ...n, at time t you receive a cash flow of ct. If the discount rate per period is r, then the present value of these
cash flows may be written as ∑
t
=
0
n
c
t
1
+
r
t
where NPV stands for net present value.
EXAMPLE OF COMPUTATION OF NPV

In Smalltown, Sarah Lopez Clooney's client Bernie Griffin runs a small lawn care business called Lawns Are Us. Bernie's company has two
investments under consideration. Investment 1 requires Bernie to invest $10,000 today and $14,000 two years from now. Investment 1 will pay
Bernie $24,000 one year from now. Investment 2 requires that Bernie invest $6000 today and $1000 two years from now. Investment 2 will pay
Bernie $8000 one year from now.
Bernie's naive answer is that Investment 2 is better because its total cash flow of $1000 exceeds Investment 1's total cash flow of $0. Sarah
points out to Bernie that he is ignoring the time value of money. That's why she gets paid the big bucks!
EXAMPLE OF COMPUTATION OF NPV

For each discount rate, find the NPV of each investment. An investment with an NPV > 0 increases the value of the company, whereas an
investment with an NPV < 0 decreases the value of the company. If the relevant discount rate is 20%, which is the better investment? What if the
discount rate is 5%?
DETERMINING NPV WITH EXCEL'S NPV FUNCTION

Excel's NPV function has the syntax =NPV(rate, range of cash flows), where rate is the interest rate per period. The NPV function requires that
cash flows be received at regularly spaced intervals. The Excel NPV function also assumes that the first cash flow occurs one period from today.
If the first cash flow occurs today, you should separate out that cash flow and apply the NPV function to the remaining cash flows. Please refer
to the file NPV.xlsx.
EXERCISES
(1) If you receive $100 today and $300 two years from now, what is the present value of each of these two cash flows? Assume that r = .10.
(2) If you pay out $300 today and receive $170 a year from now and $200 two years from now, what is the present value of each of three cash
flows? Assume that r = .10.
(3) Jennifer Clooney has a choice between receiving one of the following sequences of cash flows.
37/48
Jennifer knows (without any calculations) which sequence of cash flows she should choose. Explain her reasoning.
Internal Rate of Return (IRR)
INTRODUCTION
The problem with using NPV to compare investments is that it is difficult to come up with an appropriate discount rate. The advantage of
instead using Internal Rate of Return (IRR) is that you do not need to determine a discount rate. The IRR of a sequence of cash flows is simply
any discount rate that makes the NPV of the sequence of cash flows equal zero. Usually, a sequence of cash flows has a unique IRR. If a sequence
of cash flows has an IRR of, say, 12%, the sequence of cash flows is earning 12% per period on the money invested. Most of the time, ranking
projects by IRR gives you a good idea of the relative merits of different investments (exceptions are discussed later).
Let's suppose Bernie is trying to decide whether to invest in a new lawn mower or a fertilizer spreader for his business. Each of the two pieces of
equipment sells for $200, but they are associated with different future cash flows. In this section, we will explore the implications of this in terms
of IRR.
EXAMPLE OF COMPUTING IRR

So that Bernie can make a fair comparison, let's compute the IRR for each of the cash flow sequences given in the table below.
USING EXCEL TO COMPUTE IRR

Excel's IRR function can be used to compute the IRR of a sequence of regularly spaced cash flows. To ensure that the IRR function finds an
answer, use the syntax =IRR(range of cash flows, guess). "Guess" means a guess for the IRR of the cash flow sequence; you should let it range
between -90% and, say, 100%.
Use Excel to find the IRRs of the two sequences of cash flows shown previously. Please download the file IRR.xlsx.
PROBLEMS WITH IRR

If a sequence of cash flows begins with a negative cash flow and all later cash flows are nonnegative, then the sequence of cash flows has a unique
IRR. Unfortunately, some sequences of cash flows have multiple IRRs.
For example, the sequence of cash flows -20, 82, -60, 2 has two IRRs: -9.6% and 216.1%. The sequence of cash flows 10, -30, 35 has no IRR. See
the file Funkyirrs.xlsx.
RELATIONSHIP BETWEEN IRR AND NPV

A sequence of cash flows will have an NPV > 0 if the IRR exceeds the discount rate r. A sequence of cash flows will have an NPV < 0 if the IRR is
less than the discount rate r. Again consider the sequences of cash flows associated with Bernie's purchase of a new lawn mower versus a
fertilizer spreader. For Sequence 1, NPV > 0 if r < .10 and NPV < 0 if r > .10. For Sequence 2, NPV > 0 if r < .20 and NPV < 0 if r > .20.
EXERCISES
(1) Suppose that you can invest $1000 today and obtain $2000 in 2 years. What is the IRR of this investment?
(2) A bank has lent you $1,000,000 today. You have agreed to pay back $100,000 at the end of each year for 20 years. If you pay back the money
as promised, what is the IRR on the bank's loan?
Payback Criteria
PAYBACK DEFINITION
Sometimes firms feel that IRR and NPV are too complex and instead use what's known as payback criteria. To use payback criteria, you begin
by finding an investment's payback period, which is the time needed to pay back the investment. The investment should be accepted if the
payback period is less than a length of time that the investor finds acceptable — say, 5 years.
Vivian is thinking of buying a Magnetic Resonance Imaging (MRI) machine for her Happytail Vet Clinic. The machine costs $200,000 today and
is estimated to generate the following cash flows: Year 1, $72,000; Year 2, $88,000; Year 3, $100,000; Year 4, $120,000. Vivian wants to choose
investments that have a three-year payback or better. Should she invest in the MRI machine?
38/48
DRAWBACK OF PACKBACK CRITERIA

The problem with the payback criteria approach is that it ignores the time value of money. Payback treats $1 received five years from now the
same as $1 received a year from now. NPV and IRR properly account for the time value of money and are much better measures of the quality of
an investment than the payback period is.
EXERCISE
(1) Suppose that a new X-ray machine costs $100,000 and is estimated to generate the following cash flows: Year 1, $80,000; Year 2, $60,000;
Year 3, $60,000. Estimate the project's payback period. If a two-year payback period is required, should the X-ray machine be purchased?
Future Value
INTRODUCTION
When computing NPV, you try to determine the value of a sequence of cash flows in today's dollars. Often you also want to assess the value of
dollars received today in terms of future dollars. For example, if you invest $10,000 in your retirement account today and earn 10% annually on
that investment, how much money will you have in Year 10? The value of a cash flow moved forward in time is the cash flow's future value. In
this section, you will learn that the future value of a single cash flow is easy to determine.
EXAMPLE OF COMPUTATION OF FUTURE VALUE

Today Vivian deposits $10,000 in her retirement account. If she can earn 10% interest per year on her savings, what will she have when she
retires in 20 years? In one year, Vivian will have 10,000(1 + .1). In two years, she grows her one-year nest egg by 10% and has 10,000 x (1 + .1) x
(1 + .1) = 10,000 × (1.1)2. Generalizing from these examples, after n years Vivian will have (10,000) × (1.1)n. The future value of an amount K, at
n periods in the future when the per-period interest rate is r, is expressed as FV = K(1 + r)n. In this example, K = 10,000, n = 20, and r = .10.
Therefore, the future value in 20 years of Vivian's nest egg is 10,000(1 + .1)20 = $67,275.
EXERCISES
(1) If the interest rate is 12%, what is the future value of $10,000 in 5 years?
(2) Suppose that you receive $2 today, $1 a year from now, $2 two years from now, and $3 three years from now. If the interest rate is 10%, what
is the future value of this income three years from today?
(3) Legend has it that Native Americans sold Manhattan to Peter Minuit in 1626 for $24. If the Native Americans could instead have earned 5%
interest per year all that time, did they get a good deal from Minuit? (Assume that the 2010 value of all real estate in Manhattan is about $8
trillion.)
Annuities
DEFINITION OF AN ANNUITY
MATHEMATICAL FORMULA FOR THE VALUE OF AN ANNUITY

If the interest rate is r, and you receive $C at times 1, 2,... N, the present value of the annuity is equal to
C
1
r
-
1
r
1
+
r
N
For example, suppose that Vivian has inherited an annuity that pays her $10,000 per year for 5 years (at times 1, 2, 3, 4, and 5) and that the
interest rate is r = .10. What is the present value of the cash flows from this inheritance? In this example, N = 5, C = $10,000, and r = .10. So, the
present value of this annuity is
10,000
1
·
1
-
1
·
1
1
+
·
1
5
=
10,000
10
-
6.2092
=
$37,907.87
Therefore, receiving this sequence of cash flows is equivalent to receiving $37,907.87 today.
USING EXCEL TO VALUE AN ANNUITY

Excel's PV function makes it easy to value an annuity. The syntax =PV(r,N,-C,0,0) yields the present value of receiving $C at times 1,2,... N when
the per-period interest rate is r.
Please download the file PV.xlsx.
Entering the formula =PV(0.1,5,-10000,0,0) in any cell, such as E11 in this example, yields the present value ($37,907.87) of a five-year annuity
of $10,000 per year when r = .10. Of course, the Excel result matches the earlier calculation.
EXERCISES
39/48
(1) What is the present value of receiving $5000 at times 1, 2, and 3 if the interest rate is 10% per period?
(2) What is the present value of receiving $5000 at times 1, 2, 3, 4, 5, and 6 if the interest rate is 10% per period?
(3) What is the present value of receiving $5000 at times 4, 5, and 6 if the interest rate is 10% per period? Hint: Use the answers to problems 1
and 2.
Perpetuities
DEFINITION OF A PERPETUITY
FORMULA FOR VALUING A PERPETUITY

Recall that the value of an annuity is expressed as C
1
r
-
1
r
1
+
r
N
.
EXAMPLE OF VALUING A PERPETUITY

Suppose that Vivian's annual payment of $10,000 is guaranteed to go on forever. That is, at times 1, 2,... Vivian receives $10,000. Assume that r
= .10. What is the present value of this perpetuity? In this example, C = 10,000 and r = .10. Therefore, the present value of this annuity is simply
10,000/.1 = $100,000. By the way, no single function in Excel can value a perpetuity. Of course, you could let the number of periods in the PV
function grow large to approximate the value of a perpetuity, but it is much easier just to use the formula C/r.
EXERCISES
(1) Suppose that you will receive $5000 per year at times 1, 2, 3,.... If r = .20, what is the present value of these cash flows?
(2) As the interest rate increases, what happens to the present value of the perpetuity? Why?
Growing Perpetuity
INTRODUCTION
Recall that our definition of a perpetuity required that the cash flows be the same during each period. If we assume that the Smalltown
economy is growing, however, it seems reasonable to assume that cash flows generated by a company will grow over time. The growing
perpetuity model (often called the Gordon growth model) assumes an initial cash flow of $C one period from now, with cash flows growing at a
rate g per period thereafter. We assume that cash flows are discounted at a rate r per period. We require that r > g, or else the present
value of the growing perpetuity would be infinite. The growing perpetuity model is often used in finance to aid in valuation of a
business or a share of stock.
FORMULA FOR VALUING A GROWING PERPETUITY

The value of a growing perpetuity is simply C/(r − g). Note that when g is 0, the expression simplifies to the familiar formula for a perpetuity,
C/r. For example, let's assume that the Happytail Vet Clinic generated $150,000 in profit last year. If you assume that its profits will grow 8%
per year and you discount future profits at 10%, what is the value of all future profits?
Since Happytail generated $150,000 last year, C = $150,000(1.08) = $162,000. Given that g = .08 and r = .10, the stream of cash flows
generated by Happytail beginning one year from now would have a total value of $162,000/(.10 − .08) = $8,100,000. Therefore, the estimated
value of all future profits generated by Happytail is $8.1 million. Note that if Happytails's profits were not growing at all, you would have
obtained a much smaller value for future profits of $1.62 million.
EXERCISE
(1) The local Fourbucks coffee shop generated $130,000 in profits last year. If we assume that the shop's profits will grow at 10% per year and
we discount future profits at 15%, what would be the value of all future profits?
Compound Interest
DEFINITION OF COMPOUND INTEREST
Assume that a period equals one year. So far, cash flows have been calculated with simple interest. That is, for an interest rate of, say, 10%, $1
invested pays 10 cents in interest at the end of a year. However, financial institutions often pay interest compounded at more frequent intervals,
such as semiannually (twice per year) or quarterly (four times per year). Interest might even be continuously compounded, which means that at
every instant you earn interest on your interest.
For example, consider what would become of a $100 investment at the end of five years with annual, quarterly, and monthly compounding.
In this section, you will learn how to calculate compound interest. You will also learn about the effective interest rate, which ties together simple
and compound interest.
40/48
SEMIANNUAL AND QUARTERLY COMPOUNDING

Suppose that you invest $1 at a simple interest rate of r =.10. You know that in a year your money will grow from $1 to ($1)(1 + .10) = $1.10. If
interest is compounded semiannually, it is paid twice per year and a rate of .10/2 = .05 is used for each six-month period. Six months from now,
you will have $1(1 + .05) = $1.05. Then, in the subsequent six months, your $1.05 will grow by 5% to 1.05(1 + .05) = 1.052 = $1.1025, which is
greater than the $1.10 that annual compounding would yield.
Suppose that the interest is compounded quarterly. During each three-month period, you would earn .10/4 = 2.5% interest. Therefore, your
money would grow as follows:
in three months, $1(1 + .025) = 1.025

in six months, 1.025(1 + .025) = 1.0252
in nine months, 1.0252(1 + .025) = 1.0253
in one year, 1.0253(1 + .025) = 1.0254
To generalize, if the interest rate per year is r and the interest is compounded m times per year, $1 will grow by the end of the year to $1
1
+
r
m
m
.
For example, with quarterly compounding at r =.10 and an m of 4, in a year $1 grows to $1(1 + .025)4 = $1.104.
With semiannual compounding at r = .10 and an m of 2, in a year $1 grows to $1(1 + .05)2 = $1.1025.
Finally, in the example on the previous tab, where we explored $100 invested for five years, we would figure the total value of our investment at
the end of five years as follows, where t is the number of years
100
1
+
r
m
m
t
CONTINUOUS COMPOUNDING
Continuous compounding means that at every instant you earn interest on your interest. To approximate the growth of $1 invested for a year
with continuously compounded interest, you could let m grow large in $1
1
+
r
m
m
.
Suppose that the annual interest rate is r = .10. As m increases, the value of $1 in a year changes as follows:
For example, for m = 100, the computation is $1

1
+
.1
100
100
.
This table shows that if interest is compounded a large number of times, you end the year with $1.1052. In general, if interest is continuously
compounded at a rate of r, by time t $1 will grow to ert. The constant e is the base of natural logarithms and has an approximate value of 2.7182.
Thus, if r = .10, $1 would grow to e.1 = 1.1052. In Excel, you can compute ex with the formula =EXP(x). Thus, e.1 is computed with =EXP(.1).
Within three years, $1 would grow with continuous compounding to e3(.10) = e.3 = $1.35. With simple interest, $1 would grow, of course, to only (1
+ .10)3 = $1.331.
EFFECTIVE INTEREST RATE

For any situation in which interest is compounded, the effective interest rate is defined as the simple interest rate that would yield the same
ending cash position as compounded interest would. The concept of effective interest rate enables you to easily compare various interest
alternatives. For example, suppose that Vivian needs a loan to cover her credit card expenses. Smalltown Bank offers her two alternatives: 12%
continuously compounded annually or 13% compounded semiannually. Which alternative should Vivian choose?
Vivian wants to pay the least amount of interest, so she should choose the alternative with the smaller effective rate.
You know that $1 continuously compounded at 12% will grow to e.12(1) = $1.1275 and that $1 compounded at 13% semiannually will grow to (1 +
.065)2 = $1.134. Therefore, the effective interest rate with continuous compounding is 12.75% per year, and the effective interest rate with
semiannual compounding is 13.4% per year. Vivian should choose the continuously compounded loan.
EXERCISES
(1) Recall the legend that Native Americans sold Manhattan to Peter Minuit in 1626 for $24. If the Native Americans could have earned 5%
interest per year continuously compounded, did they get a good deal from Minuit? (Again, assume the 2010 value of all real estate in Manhattan
is about $8 trillion.)
(2) You have $100 in the bank. If you earn 8% interest compounded semiannually, what will you have in three years?
(3) You have $100 in the bank. If you earn 8% interest compounded quarterly, what will you have in three years?
(4) If you earn 8% interest compounded semiannually, what is the effective annual interest rate?
(5) If you earn 8% interest compounded six times per year, what is the effective annual interest rate?
Basic Bond Math

ZERO COUPON AND COUPON BONDS
41/48
Companies and governments often raise money by selling bonds to investors. Investors pay corporations money today, and in return the
investors receive cash flows in the future. A zero coupon bond pays cash at one point in the future. For example, suppose that Sarah buys each of
her children a $100 thirty-year savings bond. Each bond pays $100 to the holder 30 years from the time of purchase. The $100 is called the face
value of the bond.
ZERO COUPON AND COUPON BONDS

To raise money, the Smalltown city government might sell a $1000 ten-year bond at 8%. Ten years is the maturity of the bond. Such a bond
will pay its $1000 face value at maturity. Also, each year (including the year of maturity) the bond pays 8% of the face value ($80) as a coupon.
Ten years from now, the bond pays the coupon and the $1000 face value for a total of $1080.
In this section, you will learn how to determine a price for a bond, given an assumed current interest rate. Then you will learn how to determine,
given the current price of a bond, the interest rate or yield implied by the bond's cash flows.
PRICING A ZERO COUPON BOND

To determine a price for a bond, you usually assume a required interest rate r for bonds of similar risk. How would you determine the price of a
zero coupon bond paying a face value F at a time N years from now? It's simply the present value of $F received N years from now, or:
F
1
+
r
N
Assuming a required rate of return of r = 8% per year on the thirty-year $100 savings bond, what should the bond price be? In this example, F =
$100, N = 30, and r = .08, so the price should be:
100
1
+
·
.08
30
=
$9.94
Note that if the $100 bond were a ten-year bond, the price would be much higher:
100
1
+
·
.08
10
=
$46.32
PRICING A BOND WITH ANNUAL COUPONS

Consider a bond that pays an annual coupon of $C at the end of each year until maturity and also pays a face value of $F at maturity N years
from now. Assume a required annual rate of return r. How can you price such a bond? It is simply an N-year annuity paying $C each year + a
zero coupon bond paying $F in N years. From the formula for the value of an annuity, you know that the coupon portion of the bond has a
present value of:
C
1
r
-
1
r
1
+
r
N
On the previous screen, you saw that the $F payment has a present value of:
F
1
+
r
N
Therefore, assuming a required annual rate of return of r, a fair price for the bond with
annual coupons is:
C
1
r
-
1
r
1
+
r
N
+
F
1
+
r
N
Now come up with a fair price for the Smalltown $1000 ten-year bond at 8%, assuming an annual interest rate of 10%. ("At 8%" means that
during each year the bond pays out 8% of its face value in coupons.) In this example, r = .10, N = 10, F = $1000, and C = $80. Therefore, given
the formula above, a fair price for the bond is:
80
1
.1
-
1
.1
1
+
.1
10
+
$1,000
1
+
.1
10
=
80
10
-
3.8554
+
385.54
=
491.57
+
385.54
=
$877.11
PRICING A BOND WITH SEMIANNUAL COUPONS

Now consider a scenario in which the $1000 ten-year bond at 10% assuming semiannual payments.
You can value the coupons as a 20-period annuity with a rate per period of 5%, or half of the annual 10% rate. Now you can use C
1
r
-
1
r
1
+
r
N
+
F
1
+
r
N
to value the bond with semiannual coupons,
assuming that F = $1000, C = $40, N = 20, and r = .05. The value of the bond is: 40
1
.05
-
1
.05
1
+
.05
20
+
1000
1
+
.05
20
=
$498.49
+
$376.89
=
$875.38
YIELD OF A BOND
You often do not know the required rate of interest for a bond, but you usually know the bond's price. You can use the price of a bond to
determine the rate of interest implied by that price. The yield of a bond is simply the interest rate r that makes the present value of the bond's
payments equal to the price of the bond.
Suppose that the $100 thirty-year bond sold for $40. What is the yield r of the bond? Using the formula for the present value of cash flows, for
the price of the bond to equal $0, you need:
100
1
+
r
30
=
$40
To solve the equation, begin by multiplying both sides by (1 + r)30 to get 100 = 40 x (1 + r)30. Then divide both sides by 40 to get 100/40 = (1 +
r)30 or 2.5 = (1 + r)30. Raising each side of this equation to the 1/30 power, you get 2.51/30 = 1 + r. So, r = (2.5)1/30 - 1 = .031 or 3.1%. Thus, the
$40 price of this bond implies a 3.1% yield. In short, if the appropriate interest rate is 3.1% per year, this bond would sell for its actual price of
$40.
42/48
YIELD OF A BOND WITH COUPONS

For a bond with coupons, the yield is still defined as the interest rate that makes the present value of the cash flows equal to the bond's price. For
example, suppose that the Smalltown ten-year bond with annual coupons of $80 and a face value of $1000 sells for $900. How would you find
the bond's yield? You know that the value of the bond is expressed as:
80
1
r
-
1
1
r
1
+
r
10
+
$1,000
1
+
r
10
The yield of the bond is simply the value of r that makes this equation equal to the price of the bond, or $900. By trial and error, you can
determine that the yield of the bond is 9.6%, because plugging r = .096 into the equation yields $900.
Suppose that the $1000 ten-year 8% bond, making semiannual payments, sells for $900. You can solve for r, the annual yield on the bond, by
finding the value of r that makes the following quantity equal to the bond's $900 price.
40
1
r
2
-
1
r
2
1
+
r
2
20
+
$1,000
1
+
r
2
20
By trial and error, you find that r/2 = .0479, or r = .0958. Therefore, 9.58% is the yield of the bond.
FINDING A ZERO COUPON BOND PRICE WITH EXCEL

Please download the file Bondvalue.xlsx.
Using the Excel PV function, you can easily find the price of a bond.
For a zero coupon bond, entering the syntax =PV(Annual rate,Maturity,0,-Facevalue,0) computes the value of the bond.
Recall that the value of a thirty-year $100 bond requiring 8% interest per year is $9.94. In this Excel example, Annual rate = .08, Facevalue =
$100, and Maturity = 30. Entering into Excel the formula =PV(I10,E10,0,-F10,0) computes the value of the bond. (See cell J10.) We will soon see
an example that makes use of the "Times per year" cell.
USING EXCEL TO PRICE A BOND WITH ANNUAL COUPONS

For a bond paying annual coupons, entering the following formula computes the value of the bond:
=PV(Annual rate, Maturity,-Coupon,-Facevalue,0)
Recall that the value of the ten-year bond with a $1000 face value, paying 8% annual coupons and requiring 10% annual interest, was $877.11.
Entering into cell J11 the formula =PV(I11,10,-G11,-F11,0) computes the value of the bond. In this Excel example, Annual rate = .10, Maturity =
10 years, Coupon = $80, and Facevalue = $1000.
USING EXCEL TO PRICE A BOND WITH M COUPONS PER YEAR

For a bond paying annual coupons, entering the following formula computes the value of the bond:
=PV(Annual rate, Maturity,-Coupon,-Facevalue,0)
Recall that the value of a $1000 ten-year bond paying an 8% rate with semiannual coupons at a 10% annual interest rate was $875.38. In this
Excel example, Annual rate = .10, M = 2, Couponamount = .08(1000)/2 = $40, and Facevalue = $1000. Entering into cell J12 the formula
=PV(I12/2,E12*H12,-G12,-F12,0) computes the $875.38 value of the bond.
FINDING BOND YIELDS WITH EXCEL: ANNUAL PAYMENTS

A bond is simply a stream of cash flows. The yield of the bond is the interest rate that makes the NPV of the bond's cash flows (counting the price
of the bond as a negative cash flow) equal to zero. Therefore, you can find the yield of a bond simply by applying the IRR function to the bond's
cash flows. Please download the file Bondyields.xlsx.
Recall from the previous discussion that a $1000 ten-year bond paying 8% annual coupons has a yield of 9.6%. Use the IRR function to verify
this result.
FINDING BOND YIELDS WITH EXCEL: SEMIANNUAL PAYMENTS

Recall that the bond yield on a $1000 ten-year 8% coupon bond making semiannual payments is 9.6%. Use the IRR function to verify this result.
EXERCISES
(1) Assuming a required interest rate of 5%, value a 20-year bond with a $500 face value.
(2) Assuming an annual interest rate of 5%, value a 20-year bond with a $500 face value that makes annual payments at a coupon rate of 6%.
(3) Show that, for a bond making annual payments having a coupon rate equal to the required annual interest rate, the value of the bond equals
the bond's face value.
43/48
(4) Assuming an annual interest rate of 5%, value a 20-year bond with a $500 face value that makes semiannual payments at a coupon rate of
6%.
(5) Find the yields of the bonds in problems 1, 2, and 4 above.
CAGR: Compound Annual Growth Rate
MOTIVATION FOR CAGR
Investors often have historical data on the annual stock returns or revenue growth of a company and want to distill these data down to a single
number. For example, suppose that famous actress Betty Spears is one of Sarah's high-profit investment clients. Sarah is considering investing
Betty's money in the national coffee chain Fourbucks. The annual returns on Fourbucks stock during the last four years are -50%, + 60%, -50%,
and +60%. To summarize these data, you might use the average return over the last four years, which is -
50
+
60
-
50
+
60
4
=
5%
. This
calculation
illustrates that if Sarah invests Betty's money in Fourbucks, assuming that the past is representative of the future, Betty might expect to earn a
return of 5% per year. You will soon see that Fourbucks is not that good an investment!
WHAT'S WRONG WITH THE AVERAGE?

If the next four years were just like the previous four, what return would be generated by $1 invested in Fourbucks?
The problem with the simple average is that it ignores the large amount of variability or volatility in the annual returns on Fourbucks. The CAGR
(compound annual growth rate) provides a better measure of the quality of this investment.
DEFINITION OF CAGR
Suppose that you are given annual returns R1, R2 ,... Rn on an investment. The compound annual growth rate of this stock is expressed as n
1
+
R
1
1
+
R
2
...
1
+
R
n
-
1
.
For the Fourbucks data, the CAGR is 4

1
-
0.5
1
+
0.6
1
-
0.5
1
+
0.6
-
1
=
·
.8944
-
1
=
-
.1056
or
-
10.56%
.
The fact that Fourbucks' CAGR is -.1056 means that investing in Fourbucks would result in a loss of an average of 10.56% per year. If you assume
that during each of the next four years Fourbucks would lose 10.56%, then in four years $1 invested in Fourbucks would become (1 - .1056)4 =
.89444 = $0.64. Thus, Fourbucks' CAGR gives a better summary of the four years of returns than the simple average does.
CAGR AND THE GEOMETRIC MEAN

The geometric mean of n numbers is simply the nth root of their product. For example, the geometric mean of 5 and 20 is 5
20
= 10, and the
geometric mean of 2, 8, and 4 is 3
2
8
4
= 4. Therefore, to find the CAGR of an investment, begin by calculating for each year (1 + annual return).
Then, find the geometric mean of the (1 + annual return) sequence and subtract 1. The Excel function =GEOMEAN(range) finds the geometric
mean of the numbers in any cell range.
Please download the file CAGR.xlsx.
To find the CAGR for the Fourbucks data, compute for each year 1 + annual return in cells F6:F9. Then compute the geometric mean of these
numbers in cell F11 with the formula =GEOMEAN(F6:F9). Finally, compute the CAGR in cell F12 with the formula =F11-1.
EXERCISES
(1) The revenue growth figures for the PastaQuick restaurant during the last five years are 40%, 30%, 10%, -10%, and 20%. What is the five-year
CAGR for PastaQuick's revenue growth?
(2) Consider a stock that grew by 20% one year and then declined in value by 20% the next year. What is the two-year CAGR for the stock?
Option Pricing
INTRODUCTION
A stock option permits — but does not require — the holder to buy (in the case of a call option) or sell (in the case of a put option) a share of
stock. The price at which a share of stock can be bought or sold is called the strike or exercise price. The expiration date specifies the last
date an option can be exercised. In this section, you will learn about the widely used Black-Scholes model of pricing put and call options.
CALL OPTIONS - DEFINITIONS

A call option allows the holder to buy a share of, say, Cisco for a given amount x, called the strike or exercise price, within a period of T years.
T represents the duration of the option, and the last day on which the option can be exercised is the expiration date.
A European call option can only be exercised on the expiration date, whereas an American call option can be exercised on or before the
expiration date. In this course, only European options are discussed. See John Hull's Options, Futures and Other Derivatives (7th edition) for a
44/48
complete discussion of option pricing.
Many websites, such as ivolatility.com, give up-to-date information on option prices. On June 5, 2009, ivolatility reported that a share of Cisco
stock was selling for $19.87. On June 5, 2009, these were the prices of the most heavily traded call options:
The expiration date of an option is the Saturday following the third Friday of the expiration month. The June 2009 call options expired on
Saturday, June 20 (15 days from June 5, 2009), and the July call options expired on Saturday, July 18 (43 days from June 5, 2009).
Note that the higher the strike price, the smaller the call price. As you will soon see, this will always be the case.
CASH FLOWS FROM A CALL OPTION

Let's consider a European call option on Cisco with a strike price of x = $20. How does the cash flow from the call option depend on the stock
price S at expiration? Note that if S ≤ $20 (e.g., S = $18), the call option is worthless, or "out of the money." In this case, you would be unlikely to
exercise your right to buy a share of Cisco stock for $20 because you could buy one for the cheaper price of $18. Suppose that S = $25. Then you
could buy a share of Cisco for the strike price of $20 and immediately sell it for $25. You would then earn a profit of S - x = $5. Similarly, if S =
$30, you could earn a profit of $10. Given this logic, Cash flow from European call option = Max(0, S - x).
The following graph shows the cash flows (as a function of Cisco price on expiration date) for call options that have strike prices of $20, $25, and
$30.
Note that if the final stock price is less than or equal to the exercise price (here designated x), the call cash flows are $0, whereas if the final stock
price is greater than x, the cash flows follow a line of slope 1. This graph clearly shows that for any value of S, the cash flows from the $30 call are
no larger than the cash flows from a $25 or $20 call. Therefore, the fair price for a $30 call should be smaller than the fair price for a $25 or $20
call.
PLOTTING CASH FLOWS

Below you can plot the cash flows for various strike prices. This will aid your understanding of the cash flow patterns generated by a call option.
CASH FLOWS FROM A PUT OPTION

Here are the prices of several European put options on June 5, 2009, according to ivolatility.com:
Note that although the price of a call decreased as the exercise price increased, the price of a put increased as the exercise price increased. You
will soon see that a put price increases with the strike or exercise price.
CASH FLOWS FOR STRIKE PRICES

Let's consider a European put option on Cisco that has a strike price of x = $20. How does the cash flow from the put option depend on the stock
price S at expiration? Note that if S ≥ $20 (e.g., S = $28), the put option is worthless (out of the money). In this case, you would be unlikely to
sell a share of Cisco stock for $20 because you would have to buy a share for the more costly price of $28. Suppose that S < $20 (e.g., $15). Then
you could buy a share of Cisco for the $15 and immediately sell it for $20, earning a profit of X − S = $5. Similarly, if S = $10, you could earn a
profit of $10. Given that logic, Cash flow from European put option = Max(0, X − S).
The following graph shows the cash flows (as a function of the Cisco price on the expiration date) for strike prices of $20, $25, and $30.
Note that if the final stock price is greater than or equal to the exercise price, the put cash flows are $0, whereas if the final stock price is less
than x, the cash flows follow a line of slope −1. This graph clearly shows that for any value of S, the cash flows from the $30 put are no smaller
than the cash flows from a $25 or $20 put. Therefore, the fair price for a $30 put should be larger than the fair price for a $25 or $20 put.
HEDGING WITH OPTIONS

Now that you know how cash flows from put and call options are related to the price of a stock, you can understand how puts and calls are used
in Smalltown. Put options are often used to hedge investment risk. Here is an example.
Suppose that Sarah Lopez Clooney has purchased 100 shares of Cisco on June 5, 2009, at $19.87 per share for her client Britney Swift. The risk
to Britney is that the price of Cisco may drop and her investment will lose money. To hedge Britney's risk, Sarah has purchased fifty July $20 put
options at $0.94 per put. If, for example, the price of Cisco drops to $15 on the put's expiration date, Britney loses 100($4.87) = $487 on her
stock. Each of her puts will pay off $5, so she will make 50($5) = $250 on her puts. The gain on the puts offsets approximately half her loss on
the stock. Of course, if the price of Cisco increases, Britney loses her total investment in the puts.
EMPLOYEE STOCK OPTIONS

High-tech start-ups often use options to motivate their employees. Suppose that a new Internet service provider, Speedmail, has opened in
Smalltown. How can Speedmail give its employees an incentive to work hard? Many start-ups complement fairly low salaries with call options on
the company's share price. For example, suppose that Speedmail is currently selling for $4 per share. The company's management could issue
call options that expire in, say, 3 years with an exercise price of $8 to employees. If the stock price more than doubles in 3 years, the employees
could redeem their call options and make money. The issuance of employee stock options encourages the employees to work hard and increase
the value of the company stock. Of course, during the 1980s and early 1990s, many Microsoft employees became multimillionaires through their
stock options.
45/48
USING OPTIONS TO SPECULATE

If you feel sure that a stock will go up, you might buy shares of that stock, hoping to cash in when the stock price increases. Buying call options
provides a much riskier way to speculate on a stock's increase in price. For example, on June 5, 2009, Cisco sold for $19.87. If Sarah Lopez
Clooney believes Cisco's price will increase, she might buy 5 shares of Cisco. Alternatively, she could buy for $85 one hundred July calls with an
exercise price of $20.
If the price of Cisco increased to $40, the 5 shares of stock would earn $100.65 (5*(40 − 19.87)) in profit, whereas the 100 call options would
have earned $1915(100*(20) − 85). Thus, if Cisco does very well, you are better off buying the calls. Of course, if Cisco stock decreases to say $15,
you lose 100% of your investment in call options while your stock investment is still worth $75.
WHY ARE OPTIONS SO HARD TO VALUE

Recall that if Cisco sold for $19.87 on June 5, 2009 a July 2009 call option with a strike price of $21 would have sold for $0.45. Why is it hard to
come up with a fair price for such a call option? The reason is that on June 9 you did not know what Cisco's price would be on the option's
expiration date. If Cisco sold for less than or equal to $21 on the expiration date, the call would be worthless. If Cisco sold for $25 on the
expiration date, the call would be worth $4. If the call sold for $30 on the expiration date, it would be worth $9. To fairly value the option, you
need to define a random variable that realistically models the price of Cisco on the expiration date.
In the early 1970s, Fischer Black, Robert Merton, and Myron Scholes came up with the famous Black–Scholes option pricing formula, which is
used by many traders to approximate fair price for put and call options. Let's now turn our attention to using the Black–Scholes option pricing
formula to value European puts and calls.
INPUTS TO THE BLACK-SCHOLES FORMULA

To compute the Black–Scholes price for a European put or call option, the following inputs are required.
S = today's stock price.

T = duration of option in years. Consider 252 trading days (weekdays excluding holidays) to equal one year. Thus, if an option expires in
126 trading days, T = .5 years.
X = exercise or strike price for option.
R = risk-free rate (expressed as a continuously compounded rate per year). Thus, if money invested during the duration of the option
could be invested for a guaranteed continuously compounded rate of 4% per year, R = .04.
V = annual volatility of stock. A stock's volatility is similar, but not identical, to the standard deviation (expressed on an annual basis) of
the stock's daily percentage returns. The two methods used to compute a stock's volatility (historical and implied volatility) are beyond
the scope of this course. Estimates of the volatility of any stock may be found on ivolatility.com and elsewhere. For example, on June 8,
2009, the estimated annual volatility of 3M was 29%, and the estimated annual volatility for Eli Lilly was 32%.
Y = percentage of stock value paid annually in dividends. For example, if a stock pays out annually on average 5% of its share value in
dividends, Y = .05.
BLACK-SCHOLES FORMULA
Before examining the Black–Scholes formula for pricing a European put or call, let's define
d
1
=
L
n
S
x
+
R
-
Y
+
V
2
2
t
V
T
and
T
d2 = d1 - V * T
Recall that Ln(x) is the logarithm of x to base e, where e = 2.7182.
Then the call price C is expressed as C = Se-Yt N(d1) − xe-Rt N(d2).
N(x) is the cumulative normal probability for a normal random variable that has a mean of 0 and a σ of 1. That is, N(x) = the probability that a
standard normal random variable (one with a mean of 0 and a standard deviation of 1) is less than or equal to x. For example, N(-1) = .16; N(0) =
.5; N(1) = .84; N(1.96) = .975. The cumulative normal probability for a standard normal random variable may be computed in Excel with the
=NORMSDIST( ) function.
The price of a European put P may be written as P = Se-Yt (N(d1) − 1) − xe-Rt (N(d2) - 1).
These formulas are clearly difficult to compute by hand or even with a financial calculator. Therefore, this course includes an Excel template,
Bstemp.xlsx, to facilitate your computation of European put and call option prices.
Please download file BStemp.xlsx.
AN EXAMPLE - USING THE BLACK-SCHOLES OPTION PRICING FORMULA

Recall that on June 5, 2009, Cisco sold for $19.87 and that a June European call option (expiring on Saturday, June 20) sold for $1.10. Assuming
that Cisco pays no dividends and that the annual volatility is 34%, what is the estimated Black–Scholes price for this option? The option expires
in 10 trading days, so the option's duration is 10/252 = .0397 years.
The risk-free rate (based on simple interest) on June 5 was 0.20%. This means that $1 invested for a year would become $1.002. From the earlier
discussion of compound interest, you know that the continuously compounded rate r corresponding to this simple rate of interest satisfies er =
1.002.
46/48
Taking natural logarithms of both sides yields r = Ln(1.002) = .001998. You now have the inputs needed for the template that computes the
Black–Scholes call price.
S = today's stock price = $19.87

x = exercise price = $19
T = option duration = .0397 years
R = .001998
Q = dividend rate = 0
V = volatility = .34
Plugging these values into the template generates a Black–Scholes call price of $1.07, which is quite close to the actual price of $1.10. For a put of
the same duration with an exercise price of $19, the estimated Black–Scholes price is $0.20, whereas the actual price of the put was $0.18.
COMPARATIVE STATICS FOR BLACK-SCHOLES PRICES

Recall that inputs to the Black–Scholes option price formulas are
S = today's stock price

T = duration of option in years
X = exercise or strike price for option
R = risk-free rate (expressed as a compound rate per year)
V = annual volatility of stock
Y = percentage of stock value paid annually in dividends
Let's now discuss how the Black–Scholes call and put prices change as these parameters are changed. Comparative statics describes how a
formula changes when inputs to the formula are changed. The following table summarizes how European call and put prices change as the
inputs to the Black-Scholes formula increase. A plus sign indicates that an increase in the input parameter will increase the call or put price. A
minus sign indicates that an increase in the input will decrease the call or put price. A question mark indicates that an increase in the input
parameter might increase or decrease the call or put price.
For example, an increase in an option's exercise price will decrease the value of a European call and increase the value of a European put, as
discussed previously. Subsequent tabs explain the other entries in the table.
CHANGING TODAY'S STOCK PRICE

If we increase today's stock price, larger stock prices become more likely and smaller stock prices become less likely. Because call options pay off
more as the stock price on the expiration date increases, the value of a European call increases as today's stock price increases. Conversely,
because a put option pays off more as the stock price on the expiration date decreases, the value of a European put decreases and today's stock
price increases.
CHANGING THE OPTION DURATION

If the stock pays no dividends, then the longer the duration of the option, the higher the European put or call price. That is because in the
absence of dividends the stock price is likely to move more over a longer period of time than over a shorter period of time. Because options pay
off more on large movements (up for calls and down for puts), European options increase in value as their duration increases. If a stock pays
dividends in, say, ten weeks, then a three-month call might be worth less than a two-month call because the payment of the dividend in ten
weeks will depress the stock price, thereby lessening the value of the call option.
CHANGING VOLATILITY
More volatility increases the chance of a very high or very low stock price on the expiration date. Because a put or call option pays off on extreme
stock price values, an increase in volatility will increase both the European call and put price.
CHANGING THE RISK-FREE INTEREST RATE

As interest rates increase, investors will demand higher returns on stocks, which typically drives up the stock price at the expiration date. This is
good for a call option and bad for a put option. Therefore, an increase in the risk-free rate will increase the value of a European call and decrease
the value of a European put.
CHANGING THE DIVIDEND RATE

In general, the value of a stock is thought to reflect the NPV of the future cash flows generated by the stock. If a stock pays out more in dividends,
it has less to invest to generate future profits, so the NPV of future cash flows will drop. That will, in turn, cause a drop in future stock prices,
resulting in a decrease in the price of a European call option and an increase in the price of a European put option.
EXERCISES
(1) Today, Bridges Consolidated sells for $20 per share. Value a six-month European put or call option with an exercise price of $25 if the risk-
free rate is 5%, the stock's annual volatility is 40%, and the stock pays out 5% of its value annually in dividends.
(2) True or False: If the risk-free rate increases to 10%, the put and call price will both increase.
47/48
(3) True or False: If the exercise price drops to $22, the call price will increase and the put price will decrease.
(4) True or False: If the volatility drops to 25%, the call price and put prices will both decrease.
(5) Suppose that oil has been found on the Smalltown High School athletic fields. BigRigs Oil Company has offered $10 million for the rights to
the oil. Sarah Lopez Clooney has been called in to determine whether the high school should accept the offer. The high school cannot begin
drilling for five years. Sarah estimates that at current oil prices, the oil's value in today's dollars is $50 million. In five years, it will cost $70
million to extract the oil. Should the high school sell the oil rights? Assume that the risk-free rate is 5% and that the annual volatility of the oil's
value is 30%.
Appendices
Appendix A: Mathematics Concept Summary
MATHEMATICS CONCEPT SUMMARY
You may find it useful to refer to the Mathematics for Management Concept Summary while taking the course. This .pdf document is available
in the Briefcase as well.
Appendix B: Exercise Solutions

EXERCISE SOLUTIONS
As you work through the exercises at the end of each section, you may find it helpful to check your answers for accuracy. Below are links to
spreadsheets that contain the answers to each exercise presented in the tutorial. The answer sheets are organized by chapter for your
convenience. You can also download these items from the Briefcase at any time.
Algebra - algebraanswers.xlsx
Calculus - calculusanswers.xlsx
Statistics - statisticsanswers.xlsx
Probability - probabilityanswers.xlsx
Finance - financeanswers.xlsx
Final Exam Introduction
Welcome to the final exam for the Mathematics for Management tutorial. This test will allow you to assess your knowledge of Mathematics for
Management.
All questions must be answered for your exam to be scored.
Navigation:

one question to the next, select one of the answer choices or, if applicable, complete with your own choice and click the “Submit”
To advance from
button. After submitting your answer, you will not be able to change it, so make sure you are satisfied with your selection before you submit each
answer. You may also skip a question by pressing the forward advance arrow. Please note that you can return to “skipped” questions using the
“Jump to unanswered question” selection menu or the navigational arrows at any time. Although you can skip a question, you must navigate back
to it and answer it - all questions must be answered for the exam to be scored.
Your results will be displayed immediately upon completion of the exam.
After completion, you can review your answers at any time by returning to the exam.
Good luck!
Copyright Harvard Business School Publishing. Copying or posting is an infringement of copyright. Permissions@hbsp.harvard.edu or 617-783-7860.
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Functions of One Variable

ESTIMATING OPERATING COST

ESTIMATING DEMAND FOR LASAGNA DINNERS

WHAT IS A LINEAR FUNCTION?

Functions of More Than One Variable

ESTIMATING TOURIST VISITS

t = f(14,7) = 10,000 + 1000(14) - 2000(7) = 10,000.

ESTIMATING AVERAGE TIME SPENT

S, or the average number of patients Vivian can see in an hour

This dependence can be expressed by the following multivariate function:

LINEAR MULTIVARIATE FUNCTIONS

h = the cost of holding one digital camera in inventory for a year;

Linear Equations: One Variable

SOLVING LINEAR EQUATIONS

FINDING THE BREAKEVEN POINT

75(500) = 20,000 + 35(500) = 37,500

FINDING THE EQUILIBRIUM PRICE

The Cartesian Plane

(2) Graph the point (2, -4).

(3) Graph the point (1, 2).

(4) Graph the point (-3, 2).

How does monthly operating cost depend on units produced?

SLOPE INTERCEPT FORM

SLOPE INTERCEPT FORM OF A LINE

SLOPE INTERCEPT FORM OF A LINE: LINE GOES THROUGH (0,0)

USING TWO POINTS TO FIND A LINE

ESTIMATING A LINEAR DEMAND CURVE

(10 - 20)/(75 - 50) = -0.40.

HORIZONTAL AND VERTICAL LINES

GENERAL FORM OF A LINE EQUATION: ax+ by = c

Finding Solutions: Two Equations

THE GRAPHICAL APPROACH

HOW MANY SOLUTIONS?

Linear Inequalities: One Variable

EXAMPLES OF SOLVING LINEAR INEQUALITIES

(2) Find all values of x that satisfy -3x + 4 < 4x - 24.

Linear Inequalities: Two Variables

GRAPHING A LINEAR INEQUALITY: TWO VARIABLES

We begin by graphing the set of points where x ≥ 0.

Polynomials and Quadratic Functions

A polynomial is a function in the form f(x) = a 2 n

GRAPHING QUADRATIC FUNCTIONS

This yields x = 3 and x = 2.

(2) Graph the curve f(x) = x2 - 6x + 2.

(3) Find all roots of the equation 2x2 - 5x + 2 = 0.

Powers and Exponents

a positive fraction — say, a/b — then xa/b = b

RULES FOR DEALING WITH EXPONENTS

POWER FUNCTION AND COST CURVES

THE POWER CURVE AND DIMINISHING RETURNS

THE POWER CURVE AS A DEMAND CURVE

THE COBB-DOUGLAS PRODUCTION FUNCTION

(2) Evaluate 93/2.

(3) Simplify (x3)2 × (x4).

(5) Simplify x4 × (x3).

Please Excuse My Dear Aunt Sally.

EXAMPLES OF ORDER OF OPERATIONS

Entering Formulas and Graphing Functions in Excel

All formulas must begin with an equals sign (=).