Block 5: Probability and probability distributions

There is an introduction video on the VLE, you can access it here:

https://emfssvideo.s3.amazonaws.com/MT%26ST/ST2187/ST2187_Block5_Intro.mp4
The key aspect of solving real business problems is dealing appropriately with uncertainty.
This involves recognising explicitly that uncertainty exists and using quantitative methods to
model uncertainty. There are many sources of uncertainty. In many situations, the uncertain
quantity - demand, time between arrivals, stock price return, change in interest rate - is a
numerical quantity. In the language of probability, such a numerical quantity is called a
random variable. Associated with each random variable is a probability distribution which
lists all of the possible values of the random variable and their corresponding probabilities.
After completing this block, you should be able to:
 explain the basic concepts and tools necessary to work with probability distributions
 calculate summary values of univariate and joint probability distributions.

Readings
Albright, S and Winston, W.L, Business Analytics Data Analysis & Decision Making,
(Cengage Learning, 2017) 6th edition [ISBN 9781305947542] Chapter 4.

Probability and probability distributions

Probability essentials
A probability is a number between 0 and 1 which measures the likelihood that some event
will occur. An event with probability 0 cannot occur, whereas an event with probability 1 is
certain to occur.
An event with probability greater than 0 and less than 1 involves uncertainty, and the closer
its probability is to 1, the more likely it is to occur.
The simplest probability rule involves the complement of an event. If A is any event, then the
complement of Ac, denoted by (or in some books by 𝐴̅), is the event that A does not occur. If
the probability of A is A(P) then the probability of its complement is given by the equation:
𝑃(𝐴𝑐 ) = 1 − 𝑃(𝐴).
We say that events are mutually exclusive if at most one of them can occur. That is, if one of
them occurs, then none of the others can occur. Events are exhaustive if they exhaust all
possibilities - one of the events must occur. The addition rule of probability involves the
probability that at least one of the events will occur:
𝑃(at least one of 𝐴1 through 𝐴𝑛 ) = 𝑃(𝐴1 ) + 𝑃(𝐴2 ) + ⋯ + 𝑃(𝐴𝑛 ).
Probabilities are always assessed relative to the information currently available. As new
information becomes available, probabilities often change. A formal way to revise
probabilities on the basis of new information is to use conditional probabilities.
Let A and B be any events with probabilities P(A) and P(B). Typically, the probability P(A) is
assessed without knowledge of whether B occurs. However, if you are told that B has
occurred, then the probability of A might change. The new probability of A is called
the conditional probability of A given B.
Conditional probability:
𝑃(𝐴 ∩ 𝐵)
𝑃(𝐴 | 𝐵) = .
𝑃(𝐵)
Multiplication rule:
𝑃(𝐴 ∩ 𝐵) = 𝑃(𝐴 | 𝐵) 𝑃(𝐵).
Probabilistic independence means that knowledge of one event is of no value when
assessing the probability of the other. The main advantage to knowing that two events are
independent is that in that case the multiplication rule simplifies to:
𝑃(𝐴 ∩ 𝐵) = 𝑃(𝐴) 𝑃(𝐵).
How can you tell whether events are probabilistically independent? Unfortunately, this issue
usually cannot be settled with mathematical arguments; typically, you need empirical data to
decide whether independence is reasonable.
In many situations, outcomes are equally likely (for example, flipping (fair) coins, throwing
(fair) dice, etc.). Many probabilities, particularly in games of chance, can be calculated by
using an equally likely argument. Probabilities calculated in this way satisfy all of the rules of
probability, including the rules we have already discussed. However, many probabilities,
especially those in business situations, cannot be calculated by equally likely
arguments, simply because the possible outcomes are not equally likely.

Objective vs. subjective probabilities

Objective probabilities are those that can be estimated from long-run proportions, whereas
subjective probabilities cannot be estimated from long-run proportions.
The relative frequency of an event is the proportion of times the event occurs out of the
number of times the random experiment is run. A relative frequency can be recorded as a
proportion or a percentage. A famous result called the law of large numbers states that this
relative frequency, in the long run, will get closer and closer to the ‘true’ probability of an
event.
Subjective probabilities are usually relevant for unique, one-time situations.

Distribution of a single random variable

There are two types of random variables: discrete and continuous. A discrete random variable
has only a finite number of possible values, whereas a continuous random variable has a
continuum of possible values.
Usually a discrete distribution results from a count, whereas a continuous distribution results
from a measurement. This distinction between counts and measurements is not always clear-
cut.
Mathematically, there is an important difference between discrete and continuous probability
distributions. Specifically, a proper treatment of continuous distributions requires calculus.
The essential properties of a discrete random variable and its associated probability
distribution are quite simple. To specify the probability distribution of X, we need to specify
its possible values and their probabilities. We assume that there are k possible values,
denoted x1, x2, … xk. The probability of a typical value xi is denoted in one of two ways,
either P(X = xi) or p(xi).
Probability distributions must satisfy two criteria:
 the probabilities must be non-negative
 they must sum to 1.
A cumulative probability is the probability that the random variable is less than or equal to
some particular value.
It is often convenient to summarise a probability distribution with two or three well-chosen
numbers. The first of these is the mean, often denoted 𝜇. It is also called the expected value
of X and denoted E(X). The mean is a weighted sum of the possible values, weighted by their
probabilities

The variance (or standard deviation) measures the variability in a distribution. The variance,
denoted by 𝜎 2 or Var(X), is a weighted sum of the squared deviations of the possible values
from the mean, where the weights are again the probabilities. The variance is expressed in the
square of the units of X, such as dollars squared.
Therefore, a more natural measure of variability is the standard deviation, denoted by 𝜎
or sd(X). It is the square root of the variance.
Variance of a probability distribution, 𝜎 2 is:

Standard deviation of a probability distribution, 𝜎 is:

Conditional mean and variance

There are many situations where the mean and variance of a random variable depend on some
external event. In this case, you can condition on the outcome of the external event to find the
overall mean and variance (or standard deviation) of the random variable.
Conditional mean:
Conditional variance:

All calculations can be done easily in Excel.

Distribution of two random variables

Covariance and correlation measure the relationship between the two random variables.
Conceptually, they are different from the (sample) covariance and (sample) correlation
introduced previously - they are calculated from a probability distribution.
Covariance between X and Y:

Correlation between X and Y:

An alternative method for specifying the probability distribution of two random variables X
and Y is as follows.
1. You first identify the possible values of X and the possible values of Y. Let x and y be
any two such values.
2. Next, you directly assess the joint probability of the pair (x, y) and denote it by 𝑃(𝑋 =
𝑥 ∩ 𝑌 = 𝑦) or p(x, y).
3. This is the probability of the joint event that X = x and Y = y both occur. As always,
the joint probabilities must be non-negative and sum to 1.
It indicates not only how X and Y are related, but also how each of X and Y is distributed. In
probability terms, the joint distribution of X and Y determines the marginal distributions of
both X and Y, where each marginal distribution is the probability distribution of a single
random variable.
In the joint probability approach, a whole table of joint probabilities must be assessed. One
approach is to proceed backward. Instead of specifying the joint probabilities and then
deriving the marginal and conditional distributions, you can specify either set of marginal
probabilities and either set of conditional probabilities, and then use these to calculate the
joint probabilities.
Joint probability formula
𝑃(𝑋 = 𝑥 ∩ 𝑌 = 𝑦) = 𝑃(𝑋 = 𝑥 | 𝑌 = 𝑦) 𝑃(𝑌 = 𝑦).

Alternative formula:

𝑃(𝑋 = 𝑥 ∩ 𝑌 = 𝑦) = 𝑃(𝑌 = 𝑦 |𝑋 = 𝑥) 𝑃(𝑋 = 𝑥).

A very important special case of joint distributions is when the random variables
are independent. The most intuitive way to express independence of X and Y is to say that
their conditional distributions are equal to their marginals. In words, knowledge of the value
of Y has no effect on probabilities involving X.

Joint probability formula for independent random variables:

𝑃(𝑋 = 𝑥 ∩ 𝑌 = 𝑦) = 𝑃(𝑋 = 𝑥) 𝑃(𝑌 = 𝑦).

Linear combinations of random variables

Let 𝑋1 , 𝑋2 , … , 𝑋𝑛 be any n random variables (which could be independent or dependent), and
let 𝑎1 , 𝑎2 , … , 𝑎𝑛 be any n constants. We form a new random variable Y which is the weighted
sum of the Xs:

𝑌 = 𝑎1 𝑋1 + 𝑎2 𝑋2 + ⋯ + 𝑎𝑛 𝑋.

In general, it is difficult to find the distribution of a weighted sum of random variables.

However, for some analyses, such as portfolio analysis, it suffices to find means and standard
deviations.

Expected value of a weighted sum of random variables:

The variance is not as straightforward. Its value depends on whether the Xs are independent
or dependent. If they are independent, then Var(Y) is a weighted sum of the variances of
the Xs, using the squares of the as as weights:

If the Xs are not independent, the variance of Y is more complex and requires covariances. In
particular, for every pair of Xi and Yi, there is an extra term:

For the sum of independent random variables, we assume the Xs are independent and the
weights are all 1, that is, 𝑌 = 𝑋1 + 𝑋2 + ⋯ + 𝑋𝑛 . Therefore, the mean of the sum is the sum
of the means, and the variance of the sum is the sum of the variances:

E(𝑌) = E(𝑋1 ) + E(𝑋2 ) + ⋯ + E(𝑋𝑛 ) and Var(𝑌) = Var(𝑋1 ) + Var(𝑋2 ) + ⋯ + Var(𝑋𝑛 ).

For the difference between two independent random variables, we assume 𝑋1 and 𝑋2 are
independent and the weights are 𝑎1 = 1 and 𝑎2 = −1, so that Y can be written as 𝑌 = 𝑋1 −
𝑋2. The mean of the difference is the difference between means, but the variance of the
difference is the sum of the variances:

E(𝑌) = E(𝑋1 ) − E(𝑋2 ) and Var(𝑌) = Var(𝑋1 ) + Var(𝑋2 ).

For the sum of two dependent random variables. In this case, we make no independence
assumption and set the weights equal to 1, so that 𝑌 = 𝑋1 + 𝑋2 . Therefore, the mean of the
sum is again the sum of the means, but the variance of the sum includes a covariance term:

E(𝑌) = E(𝑋1 ) + E(𝑋2 ) and Var(𝑌) = Var(𝑋1 ) + Var(𝑋2 ) + 2 Cov(𝑋1 , 𝑋2 ).

For difference between two dependent random variables, this is the same as the second case
except that the Xs are no longer independent.

E(𝑌) = E(𝑋1 ) − E(𝑋2 ) and Var(𝑌) = Var(𝑋1 ) + Var(𝑋2 ) − 2 Cov(𝑋1 , 𝑋2 ).

For linear functions of a random variable, suppose that Y can be written as 𝑌 = 𝑎 + 𝑏𝑋 for
some constants a and b. In this special case the random variable Y is called a linear function
of the random variable X. The mean, variance and standard deviation of Y can be calculated
from the similar quantities for X with the following formulae:
E(𝑌) = 𝑎 + 𝑏E(𝑋), Var(𝑌) = 𝑏 2 Var(𝑋) and sd(𝑌) = |𝑏|sd(𝑋).

Excel self-study examples

Market return
An investor is concerned with the market return for the coming year, where the market return
is defined as the percentage gain (or loss, if negative) over the year. The data
file Market_return.xlsxshows how to compute the mean, variance, and standard deviation of
the probability distribution of the market return for the coming year.
Note that the probabilities sum up to 1, as they should. Uncertainty is often a key factor, and
you cannot simply ignore it!

Portfolio investments
The data file GM_vs_Gold.xlsx considers the return of General Motors (GM) stock and gold
under different economic conditions. We can use this file to obtain the relevant joint
distribution and use it to calculate the covariance and correlation between returns on the two
given investments, and also to analyse a portfolio containing these two investments.
The scenario approach applies because a given state of the economy defines both GM and
gold returns.
This file also includes an introduction to simulation.
Simulation is an extremely useful tool which can be used to incorporate uncertainty explicitly
into spreadsheet models. A simulation model is the same as a regular spreadsheet model
except that some cells include random quantities. Each time the spreadsheet recalculates, new
values of the random quantities occur, and these typically lead to different bottom-line
results.
The key to simulating random variables is Excel’s RAND function, which generates a
random number between 0 and 1. It has no arguments: =RAND().
Substitute products
A company sells two products which are substitutes for each other. The data
file Substitute_products.xlsx shows the company’s assumed joint probability distribution of
demand for the two products during the coming month.
We can use the given joint probability distribution of demands to find the conditional
distribution of demand for each product, given the demand for the other product, and to
calculate the covariance and correlation between demands for these substitutes.
Let 𝐷1 and 𝐷2 denote the demands for products 1 and 2, respectively. You first find the
marginal distributions of 𝐷1 and 𝐷2 . The marginal distributions indicate that ‘in-between’
values of 𝐷1 or of 𝐷2 are most likely, whereas extreme values in either direction are less
likely.
The joint probabilities spell out this relationship, but they are rather difficult to interpret. A
better way is to calculate the conditional distributions of 𝐷1 given 𝐷2 , or of 𝐷2 given 𝐷1 . The
relationships between the demands are shown graphically.

Personal digital assistant sales

The data file PDA_sales.xlsx uses historical data to represent the joint distribution of daily
demands for two popular personal digital assistants.
Here we can use the assessed joint probability distribution to find the conditional distribution
of daily sales of each PDA, given the sales of the other PDA, and to determine whether the
daily sales of these two products are independent random variables.
We begin by applying the addition rule for probability to find the marginals for each of the
two personal digital assistants.

Portfolio analysis
Consider the data file Portfolio_analysis.xlsx . This can be used to determine the mean annual
return of the portfolio, and to quantify the risk associated with the total dollar return from the
given weighted sum of annual stock returns.
This is a typical weighted sum model. The random variables are annual returns from stocks;
the weights are the dollar amounts invested in stocks.

Block 5 learning activities

Conceptual questions on the block’s topics

Solutions can be viewed on the VLE through the link below:
https://emfss.elearning.london.ac.uk/mod/book/view.php
1. Suppose that you want to find the probability that event A or event B wil occur. If
these two events are not mutually exclusive, explain how you would proceed.
2. ‘If two events are mutually exclusive, they must not be independent events.’ Is this
statement true or false? Explain your choice.
 3. Is the number of passengers who show up for a particular commercial airline flight a
discrete or a continuous random variable? Is the time between flight arrivals at a
major airport a discrete or a continuous random variable? Explain your answers.
4. Suppose that officials in the government are trying to determine the likelihood of a
major epidemic within the next 12 months. Is this an example of an objective
probability or a subjective probability? How might the officials assess this
probability?
5. ‘When there are a finite number of outcomes, then all probability is just a matter of
counting. Specifically, if 𝑛n of the outcomes are favourable to some event 𝐸E, and
there are 𝑁N outcomes in total, then the probability of E is n/N.’ Is this statement
always true? Is it always false?
6. ‘If there is uncertainty about some monetary outcome and you are concerned about
return and risk, then all you need to see are the mean and standard deviation. The
entire distribution provides no extra useful information.’ Do you agree or disagree?
Provide an example to back up your argument.
7. Historically, the most popular measure of variability has been the standard deviation,
the square root of the weighted sum of squared deviations from the mean, weighted
by their probabilities. Suppose analysts had always used an alternative measure of
variability, the weighted sum of the absolute deviations from the mean, again
weighted by their probabilities. Do you think this would have made a big difference in
the theory and practice of probability and statistics?
8. Suppose a person flips a coin, but before you can see the result, the person puts her
hand over the coin. At this point, does it make sense to talk about the probability that
the result is heads? Is this any different from the probability of heads before the coin
was flipped?
9. Consider an event which will either occur or not. For example, the event might be that
there will be another global financial crisis in the next 10 years. You let 𝜋 be the
probability that the event will occur. Does it make sense to have a probability
distribution of 𝜋? Why or why not? If so, what might this distribution look like? How
would you interpret it?
10. Suppose a couple is planning to have two children. Let 𝐵1 be the event that the first
child is a boy, and let 𝐵2 be the event that the second child is a boy. You and your
friend get into an argument about whether 𝐵1 and 𝐵2 are independent events. You
think they are independent and your friend thinks they are not. Which of you is
correct? How could you settle the argument?

Spreadsheet solutions to the end-of-chapter case

Case 4.1 Simpson’s paradox - Excel file: Case 4.1 - solutions.xlsx

Practice problem – Probabilities

Solutions can be viewed on the VLE through the link below:
https://emfss.elearning.london.ac.uk/mod/book/view.php?id=28423&chapterid=7638
A sample of 1000 households was selected to determine information concerning consumer
behaviour. Among the questions asked was ‘Do you enjoy shopping for clothing?’. Overall,
720 answered yes. 480 males were interviewed, and 272 males answered yes.
a. What is the probability that a household answered no?
b. How many females were interviewed?
c. What is the probability that a respondent was female?
d. What is the probability that a respondent chosen at random is a male?
e. What is the probability that a respondent chosen at random enjoys shopping for
clothing?
f. What is the probability that a respondent chosen at random does not enjoy shopping
for clothing?
g. What is the probability that a respondent chosen at random is a female and enjoys
shopping for clothing?
h. What is the probability that a respondent chosen at random is a male and does not
enjoy shopping for clothing?
i. What is the probability that a respondent chosen at random is a female and does not
enjoy shopping for clothing?
j. What is the probability that a respondent chosen at random is a male who enjoys
shopping for clothing or a female who enjoys shopping for clothing?
k. What is the probability that a respondent chosen at random is a male or a female?
l. What is the probability that a respondent chosen at random enjoys or does not enjoy
shopping for clothing?
m. Does consumer behaviour depend on the gender of consumer? Explain using
probabilities.

Practice problem – Oil drilling

Solutions can be viewed on the VLE through the link below:
https://emfss.elearning.london.ac.uk/mod/book/view.php?id=28423&chapterid=7639
An oil company is planning to drill three exploratory wells in different areas. The company
estimates that each of these wells, independent of the others, has about a 30% chance of
being successful.
a. What is the probability that any well will not be successful?
b. What is the probability that none of the oil wells will be successful?
c. If a new pipeline will be constructed in the event that all three wells are successful,
what is the probability that the pipeline will be constructed?
d. If it costs $200,000 to drill each well and a successful well will produce $1,000,000
worth of oil over its lifetime, what is the expected net value of this three-well
programme if no wells are successful?
 e. If it costs $200,000 to drill each well and a successful well will produce $1,000,000
worth of oil over its lifetime, what is the expected net value of this three-well
programme if all three wells are successful?

Practice problem – Project completion

Solutions can be viewed on the VLE through the link below:
https://emfss.elearning.london.ac.uk/mod/book/view.php?id=28423&chapterid=7640
A manufacturing facility needs to open a new assembly line in four months or there will be
significant cost overruns. The manager of this project believes that there are four possible
values for the random variable X (the number of months from now it will take to complete
this project): 3, 3.5, 4 and 4.5. It is currently believed that the probabilities of these four
possibilities are in the ratio 1 to 2 to 3 to 2. That is, X = 3.5 is twice as likely as X = 3 and X =
4 is 1.5 times as likely as X = 3.5.
a. Determine the probability distribution of X.
b. What is the probability that this project will be completed in less than 4 months from
now?
c. What is the probability that this project will not be completed on time?
d. What is the expected completion time (in months) from now for this project?
e. How much variability (in months) exists around the expected value in part d?

Practice problem – Stock picking

Solutions can be viewed on the VLE through the link below:
https://emfss.elearning.london.ac.uk/mod/book/view.php?id=28423&chapterid=7641
The possible annual percentage return of the stocks of Gamma and Delta share a common
probability distribution, given below.

Return of Return of
Probability
Gamma Delta

0.05 36.2 -6.4

0.15 23.4 -1.8

0.30 15.2 6.9

0.20 6.2 12.4

0.15 -2.0 16.8

 Return of Return of
Probability
Gamma Delta

0.05 -4.2 30.2

a. What is the expected annual return of each stock?

b. What is the standard deviation of the annual return of each stock?
c. On the basis of your answers to parts a and b, which of these stocks would you prefer
to buy? Justify your choice.
d. Are the annual returns of these two stocks positively or negatively associated with
each other? How might the answer to this question influence your decision to
purchase shares?

Practice problem – Checkout queues

Solutions can be viewed on the VLE through the link below:
https://emfss.elearning.london.ac.uk/mod/book/view.php?id=28423&chapterid=7642
A small grocery store is considering installing an express checkout line. Let X be the number
of customers in the regular checkout line. Note that these numbers include the customers
being served, if any. The probability distribution of X is given in the table below.

X=x 0 1 2 3

P(X = x) 0.28 0.22 0.26 0.24

a. Find the probability that one customer is in the regular checkout line.
b. Find the probability that no more than one customer is in line.
c. Find the probability that at least two people are in line.
d. Find the probability that three or fewer customers are in line.
e. What is the probability that no one is waiting or being served in the regular checkout
line?
f. What is the probability that three customers are waiting in line?
g. On average, how many customers would you expect to see in line?

Practice problem – Product demand

Solutions can be viewed on the VLE through the link below:
https://emfss.elearning.london.ac.uk/mod/book/view.php?id=28423&chapterid=7643
Suppose that the manufacturer of a particular product assesses the distribution of the demand
for its product in the upcoming quarter as presented below. Use this information to answer
the following questions.

X=x 2000 2500 3000 3500

P(X = x) 0.28 0.26 0.20 0.26

a. Find the expected demand (in units) for the upcoming quarter.
b. What is the probability that the demand for this product will be above its mean in the
upcoming quarter?
c. What is the probability that the demand of this product will be below its mean in the
upcoming quarter?
d. What is the probability that the demand for this product exceeds 2500 units in the
upcoming quarter?
e. What is the probability that the demand for this product will be less than 3500 units in
the upcoming quarter?

Practice problem – Product demand

Solutions can be viewed on the VLE through the link below:
https://emfss.elearning.london.ac.uk/mod/book/view.php?id=28423&chapterid=7644
A sporting goods store sells softball bats. Let X be the numbers of bats sold on a typical day
at the store. Based on the store’s historical data, the probability distribution of X is provided
in the table below.

X=x 0 1 2 3

P(X = x) 0.190 0.374 0.335 0.101

a. What is the expected number of bats sold on a typical day?

b. Calculate the variance of the probability distribution.
c. What is the standard deviation of the probability distribution?
d. What is probability of observing the sale of no more than one bat at this sporting
goods store?
e. What is the probability of observing the sale of at least one bat on a given day at this
sporting goods store?
f. What is the probability of observing the sale of no more than two bats on a given day
at this sporting goods store?
 g. What is the probability of observing the sale of at least two bats on a given day at this
sporting goods store?

Textbook problem – Probability essentials

The publisher of a popular financial periodical has decided to undertake a campaign in an
effort to attract new subscribers. Market research analysts in this company believe that there
is a 1 in 4 chance that the increase in the number of new subscriptions resulting from this
campaign will be less than 3000, and there is a 1 in 3 chance that the increase in the number
of new subscriptions resulting from this campaign will be between 3000 and 5000. What is
the probability that the increase in the number of new subscriptions resulting from this
campaign will be less than 3000 or more than 5000?

A solution file is available here: Chapter_4_Problem_3_solutions.xlsx

Textbook problem – Probability essentials

In a study designed to gauge married women’s participation in the workplace today, the data
provided in the file P04_05.xlsx were obtained from a sample of 750 randomly selected
married women. Consider a woman selected at random from this sample in answering the
following questions.
a. What is the probability that this woman has a job outside the home?
b. What is the probability that this woman has at least one child?
c. What is the probability that this woman has a full-time job and no more than one
child?
d. What is the probability that this woman has a part-time job or at least one child, but
not both?
A solution file is available here: Chapter_4_Problem_5_solutions.xlsx

Textbook problem – Probability distribution of a single random variable

A construction company has to complete a project no later than three months from now or
there will be significant cost overruns. The manager of the construction company believes
that there are four possible values for the random variable X, the number of months from now
it will take to complete this project: 2, 2.5, 3 and 3.5. The manager currently thinks that the
probabilities of these four possibilities are in the ratio 1 to 2 to 4 to 2. That is, X = 2.5 is twice
as likely as X = 2, X = 3 is twice as likely as X = 2.5, and X = 3.5 is half as likely as X = 3.
a. Determine the probability distribution of X.
b. What is the probability that this project will be completed in less than three months
from now?
c. What is the probability that this project will not be completed on time?
d. What is the expected completion time (in months) of this project from now?
e. How much variability (in months) exists around the expected value you found in part
d?
A solution file is available here: Chapter_4_Problem_13_solutions.xlsx

Textbook problem – Probability distribution of a single random variable

The ‘house edge’ in any game of chance is defined as:
E(player ′ s loss on a bet)
.
Size of a player ′ s loss on a bet
For example, if a player wins $10 with probability 0.48 and loses $10 with probability 0.52
on any bet, the house edge is:
−[10(0.48) − 10(0.52)]
= 0.04.
10
Give an interpretation to the house edge that relates to how much money the house is likely to
win on average. Which do you think has a larger house edge: roulette or sports gambling?
Why?
A solution file is available here: Chapter_4_Problem_17_solutions.xlsx

Textbook problem – Introduction to simulation

A quality inspector picks a sample of 15 items at random from a manufacturing process
known to produce 10% defective items. Let X be the number of defective items found in the
random sample of 15 items. Assume that the condition of each item is independent of that of
each of the other items in the sample. The probability distribution of X is provided in the
file P04_18.xlsx .
a. Use simulation to generate 500 values of this random variable X.
b. Calculate the mean and standard deviation of the simulated values. How do they
compare to the mean and standard deviation of the given probability distribution?
A solution file is available here: Chapter_4_Problem_18_solutions.xlsx

Textbook problem – Consolidation exercise

A manufacturing company is trying to decide whether to sign a contract with the government
to deliver an instrument to the government no later than eight weeks from now. Due to
various uncertainties, the company is not sure when it will be able to deliver the instrument.
Also, when the instrument is delivered, there is a chance that the government will judge it as
being of inferior quality.
The company estimates that the probability distribution of the time it takes to deliver the
instrument is as given in the file P04_39.xlsx . Independently of this, it estimates that the
probability of rejection due to inferior quality is 0.15. If the instrument is delivered at least a
week ahead of time and the government judges the quality to be inferior, the company will
have time to fix the problem (with certainty) and still meet the deadline. However, if the
delivery is late, or if it is exactly on time but of inferior quality, the government will not pay
up.
The company expects its cost of manufacturing the instrument to be $45,000. This is a sunk
cost that will be incurred regardless of timing or the quality of the instrument. The company
also estimates that the cost to fix an inferior instrument depends on the number of weeks left
to fix it: $7,500 if there are three weeks left, $10,000 if there are two weeks left, and $15,000
if there is one week left. The government will pay $70,000 for an instrument of sufficient
quality delivered on time, but it will pay nothing otherwise.
Find the distribution of profit or loss to the company. Then find the mean and standard
deviation of this distribution. Do you think the company should sign the contract?
A solution file is available here: Chapter_4_Problem_39_solutions.xlsx

Block 5: Test your understanding

This activity is a multiple-choice quiz, please complete it on the VLE using the link below:
https://emfss.elearning.london.ac.uk/mod/quiz/view.php?id=28448&forceview=1

Learning Outcomes Checklist

Use this to assess your own understanding of the chapter. You can always go back and
amend the checklist when it comes to revision!
 Explain the basic concepts and tools necessary to work with probability distributions.
 Calculate summary values of univariate and joint probability distributions.