DAFM - Unit 6 - RM - Hypothesis Testing

Data Analysis for Managers
Unit 6
Hypothesis Testing
Unit 6 - Hypothesis Testing
Learning Objectives
At the completion of this unit, you will be able to:

• State null and alternative hypotheses for the problem.
• Define and distinguish between one and two-tailed tests.
• Explain how to minimise the occurrence of Type I and Type II errors.
• Recognise the significance level and calculate the p-value.
• Examine Type II errors and the power of a test.
• Comprehend practical significance and statistical significance.
© Copyright 2017, all rights reserved. Manipal Global Education Services Pvt. Ltd. 2
Table of contents
S.No Details Page No.
1. Introduction 4
2. Hypothesis 5
2.1 Hypothesis Testing 5
2.2 Null and Alternative Hypothesis 5
3. One-tailed and Two-tailed Tests 7
4. Type I and Type II Errors 8
5. Level of Significance 10
6. p-value 13
6.1 How small is a ‘small’ p-value? 14
7. Test Statistic 14
7.1 Power of a Test 14
8. Chi-Square Test 15
8.1 How it is Calculated? 15
8.2 Application of χ2 Test 19
9. Chapter Summary 22
1. Introduction
Decision-making involves identifying alternatives and assessing the pros and cons before arriving at a
decision. In order to arrive at a decision, we have certain assumptions that we need to test. These
assumptions are called hypotheses. To test our assumption statistically, we have to collect data.
This data is usually a sample obtained from a larger population. We have to test it to determine
whether there is a difference between the hypothesised value and the actual value obtained (usually a
test statistic).
We judge the significance using tools such as chi-square test. These tools can be used in identifying
associations between variables and they can be used in decision making. For instance, you may wish
to know the association between gender and the preference for mutual funds.
Running a chi-square test will help in determining the association.
2. Hypothesis
The assumption that the researcher holds about some characteristic of the population parameter is called a ‘hypothesis’.
2.1 Hypothesis Testing

The objective of testing a hypothesis is to assess whether there is sufficient statistical evidence to confirm the hypothesis.
2.2 Null and Alternative Hypothesis

We often need to make inferences about a population of interest based on sample data. The inferences often involve making a decision about a particular
theory or hypothesis that we would like to test.
The null hypothesis as the word refers to the hypothesis that the experimenter seeks to nullify. It is usually
Null hypothesis
represented as H0.
The alternate hypothesis is the hypothesis that the researcher’s stated assumption. In other words, it is the
Alternative hypothesis
assumption that the researcher wants to prove. It is usually represented by Ha or H1.
Example:
For instance, an XYZ bank manager might claim that the average default rate for outstanding credit card payment is less than 20% in his branch at M.G.
Road, XYZ bank. Based on the data collected for one month, it is possible to calculate the proportion of default from the sampling experiment. Depending
on the results obtained, the manager can then decide whether or not to reject the claim.
Before we can test the particular theory or hypothesis though, we need to understand the basic concepts involved in hypothesis testing. The manager’s
assumption of it being less than 20% is the hypothesis that we are testing and it is called the alternate hypothesis.
Ha = µ < 20%
The other two possibilities apart from the manager’s assumption are greater than or equal to 20 %, and this would be the null hypothesis, which is to be
rejected with sufficient statistical evidence to accept the claim of the Manager (i.e., the alternate hypothesis).
H0 = µ ≥ 20%
In this case, if there is sufficient evidence to reject the null (i.e., H0 = µ ≥ 20%), then the manager’s clain can be accepted.
Two important issues that should be kept in mind are:

1. Tests are only performed on population parameters.
2. The assumption researcher wants to prove should be an alternate hypothesis and the other possibilities should be an alternate hypothesis.
3. One-tailed and Two-tailed Tests

Hypothesis tests can be either one-tailed or two-tailed, and this indicates the direction of the test. When the researcher is looking to prove it in one direction,
then it is called the one-tailed test. If the researcher is not interested in the direction per se then it is a two-tailed test.
For example, assume that the researcher is experimenting to study the effect of inflation on deposits. Let us assume that he is testing whether an increase
in inflation leads to an increase in deposit, then it is a one-tailed test as the test is skewed in one direction. If he just tests whether inflation has an impact on
deposit in general and does not specify the direction such as increase or decrease, then we call it as a two-tailed test.
The reason it is called one-tailed is that it specifies the critical region. It is either on the left tail or the right tail of the distribution. In the case of a two-tail test,
it could be on either.
One-tailed Test: For example, if the manufacturer was interested in whether or not the average battery life of a laptop is more than 50,000 hours, then the
hypothesis might be set-up as:
H0 : μ ≤ 50,000 hours
H1 : μ > 50,000 hours
Two-tailed Test: For example, if the manufacturer of the batteries was only interested in whether the average life of their battery is 50,000 hours, then the
hypothesis might be set-up as a two-tailed test:
H0 : μ = 50,000 hours
H1 : μ ≠ 50,000 hours
One-tailed Test Two-tailed Test
𝛼 𝛼/2 𝛼/2
0 tcrit -tcrit 0 tcrit

t t
Fig 6.1 Fig 6.2
4. Type I and Type II Errors

A researcher can either reject or fail to reject the null hypothesis that he or she is making. If we reject a null that is false, then the decision is right, and the
same holds when we fail to reject a null that is true. This can lead to two situations:
a. The possibility of rejecting the null that is true – Type I error
b. The mistake of accepting a null that is false – Type II error
Type I and Type II Errors

Truth
H0 is true H1 is true
Reject H0 Type I error No error
Decision
Do not reject H0 No error Type II error
For example, suppose a bank manager is interested in whether or not the

mean waiting time for customers had increased from its previous value.
In this case, the null hypothesis might be that the mean waiting time has
not changed. If the manager sampled a group of customers and
performed a hypothesis test on the results, the possible errors that the
manager could make are:
1. Type I error: Concluding that the average waiting time had increased
when it had not.
2. Type II error: Concluding that the average waiting time was the
same, when in fact it had increased.
A compromise has to be made based on the relative costs of making

each type of error. Fig 6.3
5. Level of Significance
The level of significance signifies the strength of evidence should be present to reject the null hypothesis. It is the rejection region in the bell curve, the level
of significance should be specified by the researcher before conducting the study.
If the level of significance is 5% then the researcher should hold sufficient evidence against the null hypothesis so that the null hypothesis claim lies in the
rejection region (I.e level of significance) beyond the confidence interval of 95%.
When doing any assessment or experiment, we

obtain certain results. The results could have
happened by chance or due to the factor that the
experimenter assumes as the cause.
When a finding is considered statistically
significant, it means that the result occurred by
design and not by chance.
Statistical significance, therefore, is an important
concept in hypothesis testing. However, it stands
to reason that more often than not some parts of
the experiment may by chance turn away from our
assumptions.
For example, you could test the hypothesis that the customers who
complain are likely to close their accounts. It can happen that a large
number of customers who closed their accounts did indeed complain
before closing their account.
It can also be the case that they could have closed the account for other
reasons. It is safe to assume that a small margin of customers would
have closed their accounts for other reasons.
Frequency
Therefore, we cannot assume all customers who raised the complaint will
close their account, and at the same time we cannot even reject the
claim without testing it.
This level of significance signifies what percentage of evidence is
essential to accept the claim. Accept Null
The level of significance is the chance of rejecting a null hypothesis that

-4
is actually true. It is usually represented by the Greek alpha α. -2 0 2 4
Test Statistic
In practice, the 1, 5 or 10% levels are chosen as levels of significance. Reject Null Reject Null
For instance, when the test is seen to be p<0.10, it means that the
chance of the result being a result of chance is less than one in ten Fig 6.4
times.
Example: The bank manager claims that the average balance maintained by customers is more than Rs 190000. A study was conducted by collecting 100
account balances of customers and the average balance was Rs 210000. Assume that the standard deviation of the claim is Rs 30000. Check whether the
claim is acceptable at 95% confidence level.
Solution:
H0 – The average balances maintained by customers is less than or equal to Rs 190000.
H1 – The average balance maintained by the customers is more than Rs 190000.
210000−190000
𝑍𝑐𝑎𝑙 = 30000 =4
100
Table value at 95% confidence level for right tail test 1.645.
Z cal > Ztab hence null hypothesis stands rejected.
Therefore the alternate hypothesis will be accepted. The average
balance maintained by customers is more than 190000.
6. p-value
The p-value is used to determine the significance value of the output. A small p-value means that the evidence against the null hypothesis is very strong.
We will reject the null hypothesis if the p-value is very small.
It is the probability value inside the rejection region of the bell curve.
6.1 How small is a ‘small’ p-value?

We often need to make inferences about a population of interest based on sample data. The inferences often involve making a decision about a particular
theory or hypothesis that we The p-value depends on various factors, but is largely determined by the following considerations:
• The p-value is less than 0.01, it is clear proof that we can accept the alternate hypothesis.
• The p-value is between 0.01 and 0.05, shows that the evidence against the null is strong.
• The p-value is between 0.05 and 0.10, does not provide clear proof and is therefore in the grey area.
• The p-values are greater than 0.10 are interpreted as weak evidence against the null and therefore is not reliable evidence to support the alternate.
7. Test Statistic
To accept or reject a null hypothesis, we obtain a test statistic from the data which is then compared with the original hypothesis. If the test statistic is similar
to the original hypothesis it will be accepted.
7.1 Power of a Test

The probability of committing a Type II error is denoted by β. A Type II error is the probability that we will fail to reject the null hypothesis in the situation,
where the null hypothesis is actually false. Given that, the probability that we would correctly reject a null hypothesis that was actually false is given by 1 -
β.
This probability is known as the power of a test.
Example
As an example, suppose that you were the branch manager for an XYZ bank that you have introduced a new investment product, and your bank was
making claims that the product was successful. In the survey to test this claim, the null hypothesis would be that the investment product was successful.
If we were to commit a Type II error during these tests, we would be failing to reject a null hypothesis that was actually false. In other words, we would be
saying that the investment product was successful when in fact it was not successful. In this case, we would be committing a serious error.
In this case, we would like to minimise the probability of making a Type II error. To do that, we would like to increase the power of the test. One popular
method of increasing the power of the test is to increase the sample size.
8. Chi-Square Test
The chi-square test is used to explore the association between variables. We may, for example, wish to know whether there is an association between
gender and the likelihood of taking up mutual funds. This can be assessed using a chi-square test.
8.1 How it is calculated?

The test statistic in a chi-square test is computed using the formula:
(Observed value – Expected value)2

Chi-square= Expected value
Let us look at an example.
Consider the Employee Appraisal System of your bank. It has been taking place once a year. Now there is a proposal to have two appraisals each year.
Employees from each of the four zones were asked to state if they were in favour of the change. The responses are recorded in the table below.
East North West South

Number of employees
preferring present 68 75 57 79
system
Number of employees
preferring change 32 45 33 31
proposal
A table like this is called a contingency table. This table has a dimension of 2 rows by 4 columns. So, this is called a 2 x 4 contingency table.
The bank management wishes to know if the proportion of respondents who prefer the existing system is the same for all the regions.
We can use the χ2 test (pronounced kai square) to explore this question.
Degrees of Freedom
The degrees of freedom are calculated using the rows and columns of the contingency table.
Formula: (R-1)* (C-1) where R stands for the number of rows and C stands for the number of columns.
Conditions
1. The frequencies used in the chi-square test must be absolute and not in relative terms.
2. The total number of observations collected for this test must be large.
3. Each of the observations which make up the sample of this test must be independent of each other.
4. As χ2 test is based wholly on sample data, no assumption is made concerning the population distribution. In other words, it is a non-parametric-test.
5. χ2 test is entirely dependent on degrees of freedom.
6. The expected frequency of any item or cell must not be less than 5, the frequencies of adjacent items or cells should be polled together in order to
make it more than 5.
7. The data should be expressed in original units for the convenience of comparison and the given distribution should not be replaced by relative
frequencies or proportions.
This test is used only for drawing inferences through a test of the hypothesis, so it cannot be used for estimation of a parameter value.
Interpretation:
After ascertaining the χ2 value, look at the χ2 table to find the acceptance region value.
The table has columns headed with symbols like 0.05 for 5% level of significance. The
first row indicates the degrees of freedom. The cells define the value that separates the
acceptance and rejection regions.
If the calculated value of χ2 falls in the acceptance region, the null hypothesis H0 is
accepted and otherwise, H0 is not accepted.
8.2 Application of χ2 Test

Tests for Independence χ2 of Attributes
The number of degrees of freedom is given by
df = (Number of rows – 1) x (Number of columns – 1)
The expected value is given by
fe = (Row Total x Column Total) / (Grand Total)
Example – Salesman/Territory
The table gives the sales of a product by three salesmen in three territories.
Test at 5% level of significance whether salesman and territories are independent.
Salesmen
1 2 3 Total
I 5 15 20 40
Territories II 10 20 20 50
III 15 25 20 60
Total 30 60 60 150
Solution
Observed value (fo) Expected value (fe) (fo-fe)2 (fo-fe)2/fe
5 40x30/150 = 8 9 1.1250
10 50x30/150 = 10 0 0.0000
15 60x30/150 = 12 9 0.7500
15 40x60/150 = 16 1 0.0625
20 50x60/150 = 20 0 0.0000
25 60x60/150 = 24 1 0.0417
20 40x60/150 = 16 16 1.0000
20 50x60/150 = 20 0 0.0000
20 60x60/150 = 24 16 0.6667
3.6458
1. Ho: Performance of a Salesman is independent of his operational territory.
HA: Performance of a salesman is not independent of his operational territory.
2. Level of Significance 5%,
df (3 – 1) x (3 – 1) = 4
From the table, χ2 tab(0.05, 4) = 9.49
3. Test Statistics χ2 = ∑ (fo - fe)2 / fe.
4. Test:
fe = (Row Total x Column Total)/(Grand Total)
χ2cal = 3.6458
5. Conclusion: Since χ2cal (3.6458) < χ2tab (9.49), Ho is not rejected.
We conclude that the performance of a salesman is independent of his operational territory.
9. Chapter Summary
Here are the key points discussed in this unit.
• The assumption that the researcher holds about some characteristic of the population parameter is called a ‘hypothesis’.
• The objective of testing a hypothesis is to assess whether there is sufficient statistical evidence to confirm the hypothesis.
• The null hypothesis as the word refers to the hypothesis that the experimenter seeks to nullify. It is usually represented as H0.
• The alternate hypothesis is the hypothesis that the researcher’s stated assumption. In other words, it is the assumption that the
researcher wants to prove. It is usually represented by Ha or H1.
• When the researcher is looking to prove it in one direction then it is called the one-tailed test. If the researcher is not interested in
the direction per se then it is a two-tailed test.
• The possibility of rejecting the null that is true – Type I error.
• The mistake of accepting a null that is false – Type II error.
• The level of significance is the chance of rejecting a null hypothesis that is actually true. It is usually represented by the Greek
alpha α.
• The p-value is used to determine the significance value of the output. A small p-value means that the evidence against the null
hypothesis is very strong.
• The chi-square test is used to explore the association between variables.

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Data Analysis for Managers

At the completion of this unit, you will be able to:

2.1 Hypothesis Testing

2.2 Null and Alternative Hypothesis

Two important issues that should be kept in mind are:

3. One-tailed and Two-tailed Tests

One-tailed Test Two-tailed Test

0 tcrit -tcrit 0 tcrit

Fig 6.1 Fig 6.2

4. Type I and Type II Errors

Type I and Type II Errors

For example, suppose a bank manager is interested in whether or not the

A compromise has to be made based on the relative costs of making

When doing any assessment or experiment, we

The level of significance is the chance of rejecting a null hypothesis that

6.1 How small is a ‘small’ p-value?

7.1 Power of a Test

8.1 How it is calculated?

(Observed value – Expected value)2

Let us look at an example.

East North West South

5. χ2 test is entirely dependent on degrees of freedom.

8.2 Application of χ2 Test

Observed value (fo) Expected value (fe) (fo-fe)2 (fo-fe)2/fe

1. Ho: Performance of a Salesman is independent of his operational territory.

HA: Performance of a salesman is not independent of his operational territory.

2. Level of Significance 5%,

From the table, χ2 tab(0.05, 4) = 9.49

3. Test Statistics χ2 = ∑ (fo - fe)2 / fe.

fe = (Row Total x Column Total)/(Grand Total)

5. Conclusion: Since χ2cal (3.6458) < χ2tab (9.49), Ho is not rejected.

We conclude that the performance of a salesman is independent of his operational territory.

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