11/11/2022

Probability Distributions
and Normal Distribution
Types of uncertainty

Quantitative Methods for Business- MSc Shipping Mgt Dr. P. Avramidis

Measurable vs non-
measurable uncertainty

Two individuals draw one ball from a bawl. Drawing a black ball wins.
• John is aware that the bawl has 3000 red and 1000 black balls and
therefore the chance to select a black ball is 25%.
• Peter is ignorant of the numbers of each color.

Is there any difference between the two individuals’ situation?

Uncertainty is a situation in which the outcome is not well-charted.

Risk is quantifiable uncertainty, in which all outcomes are well-charted.

1
 11/11/2022

Law of large numbers

Can Peter find out how many red/black balls are in the bawl?

• In the first 10 draws, Peter observes RRRBRRBBBR

• In the first 100 draws he observes 2.7:1,
• after 1000 draws we observe 2.85:1
• and after 3000 draws it is 2.99:1.

“As we increase the information observed (large sample), the sample average is
more likely to be closer to the actual average” (Jacob Bernoulli 1713)

Probabilities

• Because uncertainty is essentially lack of information, the move from non-

quantifiable to quantifiable risk can represent a significant reduction in the
amount of uncertainty surrounding a situation.
• We make the move from uncertainty to risk by assigning probabilities to the
possible outcomes of an uncertain situation

Two cases to assign probabilities

1. When you toss two dices and add the figures on the sides facing up, what is the probability that
the sum is more or equal to 10?

2. What is the probability that the Canadian/USA dollar exchange rate will fall more than 2.5%?

2
 11/11/2022

Frequentist view

• According to the frequency-based interpretation, probability simply

represents the relative frequency that an event will occur.

• The frequentist view of probability relies on being able to repeat an identical

experiment or use counting rules to calculate the ratio:

No. of oc curences
P(Z) =
No. of exp eriments

• A priori (classical) probability A fundamental set of “events” exists (like in

the case of games of chance, dice etc.). The probability of an event is then
the ratio of the number of cases it occurs to the number of all cases.

• Empirical (classical) probability Probability is essentially the convergence

limit of relative frequencies under repeated independent trials. This
pragmatic argument explains its popularity.

A priori (classical) probability

1. When you toss two dices and add the figures on the sides facing up, what is the probability that
the sum is more or equal to 10?

6
𝑝= = 0.167
36

3
 11/11/2022

Empirical classical probability

2. What is the probability that the Canadian/USA dollar exchange rate will fall more 2.5%?

𝑝 = 0.02

Definitions
Probability Distribution

A probability distribution is a table, formula, or graph that describes the values

of a random variable and the probability associated with these values.

Experiment: Toss 2 Coins. Let X = # heads.

Probability Distribution
X Value Probability
Probability

0 1/4 = .25 .50

1 2/4 = .50 .25

2 1/4 = .25
0 1 2 X

4
 11/11/2022

Distribution
Expected Value

Expected Value (or mean) of a discrete distribution is the

weighted average
N
E(X) =  =  xi P( X = xi )
i =1
X Value Probability
Example: Toss 2 coins, X = # of heads, 0 1/4 = .25
Compute expected value of X:
1 2/4 = .50
E(X) = (0)(.25) + (1)(.50) + (2)(.25) 2 1/4 = .25
= 1.0

Distribution
Dispersion
• Standard deviation of a discrete random variable
N
σ = σ2 = [x
i =1
i − E(X)]2 P(X = x i )

where: E(X) = Expected value of the discrete random variable X

Xi = the ith outcome of X
P(Xi) = Probability of the ith occurrence of X

– Example: Toss 2 coins, X = # heads, compute standard

deviation (recall that E(X) = 1)
N
σ = σ2 = [x
i =1
i − E(X)]2 P(X = x i )

σ = (0 − 1) (.25) + (1− 1)2 (.50) + (2 − 1)2 (.25) = .50 = .707

2

5
 11/11/2022

Decision making under

uncertainty using probabilities

1. List Alternative Courses of Action

– Choices or actions

2. List Uncertain Events

– Possible events or outcomes

3. Determine ‘Payoffs’
– Associate a Payoff with Each Event/Outcome combination

4. Decision Criteria
– Evaluate Criteria for Selecting the Best Course of Action

Actions and uncertain events

Step 1: Invest in Step 2: Economic Forecasts

Strong Economy

Large Vessel Stable Economy

Weak Economy

Strong Economy

Average Vessel Stable Economy

Weak Economy

Strong Economy

Small Vessel Stable Economy

Weak Economy

6
 11/11/2022

Payoff table

Step 3: A payoff table shows alternatives, states

of nature, and payoffs

Investment Choice
Profit in $1,000’s (Action)
(Events)
Large Vessel Average Vessel Small Vessel

Strong Economy (0.3) 200 90 40

Stable Economy (0.5) 50 120 30
Weak Economy (0.2) -120 -30 20

Expected value

Step 4: Maximize expected value

• The expected value is the weighted average payoff, given
specified probabilities for each event

N
E(X) =  =  xi P( X = xi )
i =1

Where E(X) = expected monetary value of action X

Xi = payoff for action X when event i occurs
Pi = probability of event i

7
 11/11/2022

Expected value

Investment Choice
Profit in $1,000’s (Action)
(Events) Large Average Small
Vessel Vessel Vessel

Strong Economy (0.3) 200 90 40

Stable Economy (0.5) 50 120 30
Weak Economy (0.2) -120 -30 20
Expected Values 61 81 31

E(Large Vessel) = 200(.3) + 50(.5) + (-120)(.2) = 61

E(Average Vessel) = 90(.3) + 120(.5) + (-30)(.2) = 81

E(Small Vessel) = 40(.3) + 30(.5) + (20)(.2) = 31

Accounting for variability

The st. deviation is the weighted
N average distance of each event’s payoff
σ = σ2 = [x
i =1
i − E(X)]2 P(X = x i ) from the expected (mean) value, given
specified probabilities for each event
Investment Choice
Profit in $1,000’s (Action)
(Events) Large Average Small Vessel
Vessel Vessel

Strong Economy (0.3) 200 90 40

Stable Economy (0.5) 50 120 30
Weak Economy (0.2) -120 -30 20
Expected value 61 81 31

St.Deviation (σ) 111.4 57 7

𝜎(𝐿𝑎𝑟𝑔𝑒 𝑉𝑒𝑠𝑠𝑒𝑙) = 0.3 × (200 − 61)2 + 0.5 × 50 − 61 2 + 0.2 × (−120 − 61)2

= 5796.3 + 60.5 + 6552 = 12409 = 111.4

8
 11/11/2022

Accounting for variability

𝐸(𝑋)
Return-to-Risk ratio (RTR): 𝑅𝑇𝑅 =
𝜎𝑋
Expresses the expected return (expected payoff) for every unit of
risk (standard deviation)
Investment Choice
Profit in $1,000’s (Action)
(Events) Large Average Small
Vessel Vessel Vessel

Expected Values 61 81 31

St.Deviation (σ) 111.4 57 7

Return-to-Risk ratio 0.548 1.421 4.428

Decision making
under uncertainty-
example
Q: The manager of a large shipping company is considering to buy one of the two
different vessels. Suppose that the estimated annual profits (in mil Euros),
under each economic condition are indicated in the following table. Which
vessel should the manager invest in?

Investment Choice (Action)

Probability
VLCC (mil Euros) Aframax (mil
Euros)

Strong economic growth 0.2 0.5 0.25

Moderate economy growth 0.35 0.2 0.15
Weak economic growth 0.3 0.1 0.1
Negative economy growth 0.15 -0.3 -0.1

9
 11/11/2022

Normal Distribution

Whether it is weight, income, IQ, fitness level, etc. data falls into a “normal”
distribution when it is plotted. It has a lot of datapoints around the middle (the
average) and outliers at both the high and low extremes.

https://galtonboard.com/probabilityexamplesinlife

Normal Distribution in business

• An example of how normal distribution is used in business comes from marketing. The
implication for marketers is understanding the segments of the bell curve, and using
these segments to your advantage: The quick message is that you can’t market to
everyone – as you move across the curve from one end to the other needs change
dramatically.

• An example will help illustrate this. Let’s explore the implications of the bell curve for
fitness level. On the far left side of the curve, these are the “least fit” people around.
They would have to improve their fitness level significantly in order to even be
considered “average”. On the far right, are the “extreme fitness enthusiasts”. Everyone
else is somewhere closer to the middle – the “mean” or average. Knowing this, let’s
assume we are challenged with marketing a specific service – fitness club membership.

• Marketing to the very far left end of the bell curve (the most unfit segment) will of
course require different messaging than other segments. For this group, appeals are
probably centered on “strive for change” and “you can fit in – members are not all hard
bodies”, etc. At the other extreme – the messaging is quite different. These people
have discipline established, and according to our data are already fit. Successful appeals
to this segment will likely be in messaging such as “Are your abs beach-worthy? We can
help.” “Your competition is already training for race season. Will you be ready?”. This is
of course if you decide to market to this group at all.

10
 11/11/2022

The Normal Distribution

Shape

Normal Probabilities

Probability is
measured by the
area under the
curve

11
 11/11/2022

The Normal Distribution:

Example
You are interested in the number of customers arriving at a sales
outlet. Assume that on an average day, 100 customers arrive and
the deviation is typically +/-50 customers. What is the probability
that less than 200 customers arrive on a single day?

1. If X is distributed normally with mean of 100 and

standard deviation of 50, the Z value for X = 200 is
3. Use the Standardized
X − μ 200 − 100 Normal Table
Z= = = 2.0
σ 50
2. This says that X = 200 is two standard deviations
(2 increments of 50 units) above the mean of 100.

Normal Probability Tables

You are interested in the number of customers arriving at a sales

outlet. Assume that on an average day, 100 customers arrive and
the deviation is typically +/-50 customers. What is the probability
that less than 200 customers arrive on a single day?

the probability that less than

200 customers arrive on a
single day is 97.7%

To find P(X < b) when X is distributed normally:

Draw the normal curve for the problem in terms of X.
Translate X-values to Z-values.
Use the Standardized Normal Table.
To find P(X > b)=1-P(X < b)

To find P(a<X < b) =P(X < b)-P(X<a)

12
 11/11/2022

The Normal Distribution:

Example
What is the probability that more than 200 customers arrive on a
single day?

P(X > 200)=1-P(X < 200) the probability that more than 200
P(X > 200)=1-0.977=0.023 customers arrive on a single day is 2.3%

What is the probability that more than 100 but less than 200
customers arrive on a single day?

P(100<X <200) =P(X < 200)-P(X<100) the probability that more than 100
P(100<X <200) =0.977-0.5=0.477 and less than 200 customers arrive
on a single day is 47.7%

Normal Probability
Example

Q: A world famous luxury products company wishes to launch a new product targeting middle
income households (ie. income from 15,000 to 24,000). Annual income is assumed to
follow a normal distribution with mean of 20,000 Euro and st. deviation is 4,000.
(a) What proportion of households has an annual income of less than 15,000?
(b) What proportion of households has an annual income of more than 24,000?
(c) What proportion of households has an annual income of more than 15,000 but less than
24,000 (the targeted group)?

13
 11/11/2022

Given the Probability,

Find the X Value

Let X represent the time it takes (in mins) to complete an online application for car
insurance. Suppose X is normal the mean time is 8 mins and standard deviation 5
mins. Find the time X such that 20% of applications take less than X mins.

Given Normal Probability,

Find the X Value

• First, find the Z value corresponds to the known probability using

the table.

• Second, convert the Z value to X units using the

following formula.
X = μ + Zσ
= 8.0 + (−0.84)5.0
= 3.80
So 20% of the applications from the distribution with mean 8.0
and standard deviation 5.0 take less than 3.80 mins.

14
 11/11/2022

Normal Probability,
Example

Q: (Continuing with the previous example) A world famous luxury products

company wishes to launch a new product. What should be the income
threshold, if the aim is to target the highest 60% of income households?
(Annual income is assumed to follow a normal distribution with mean of
20,000 Euro and st. deviation is 4,000.)

Distribution Functions in Excel

15