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and Probability Distributions

Part 1: Probability and Probability

Distributions

Experiments and Outcomes

Experiment the observation of some activity

or the act of taking a measurement

Roll dice

Measure dimension of a manufactured good

Conduct market survey

Outcome a particular result of an

experiment

Sum of the dice

Length of the dimension

Proportion of respondents that favor a product

Events

Sample space - all possible outcomes of an

experiment

Dice rolls of 2, 3, , 12

All real numbers corresponding to a dimension

A proportion between 0 and 1

An event is a collection of one or more

outcomes from

Obtaining a 7 or 11 on a roll of dice

Having a manufactured dimension larger or

smaller than the required tolerance

The proportion of respondents that favor a

product is at least 0.60

Probability

Probability a measure (between 0 and 1) of

the likelihood that an event will occur

Three views:

Classical definition: based on theory

Relative frequency: based on empirical data

Subjective: based on judgment

Classical Definition

Probability = number of favorable outcomes

divided by the total number of possible

outcomes

Example: There are six ways of rolling a 7

with a pair of dice, and 36 possible rolls.

Therefore, the probability of rolling a 7 is

6/36 = .167.

Relative Frequency Definition

Probability = number of times an event has

occurred in the past divided by the total

number of observations

Example: Of the last 10 days when certain

weather conditions have been observed, it

has rained the next day 8 times. The

probability of rain the next day is 0.80

Subjective Definition

What is the probability that the New York

Yankees will win the World Series this year?

What is the probability your school will win its

conference championship this year?

What is the probability the NASDAQ will go

up 3% next week?

Probability Rules

1. Probability associated with any outcome must be

between 0 and 1

2. Sum of probabilities over all possible outcomes

must be 1.0

Example: Flip a coin three times

Outcomes: HHH, HHT, HTH, THH, HTT, THT, TTH,

TTT

Each has probability of (1/2)

3

= 1/8

Mutually Exclusive Events

Two events are mutually exclusive if the

occurrence of any one means that none

of the other can occur at the same time.

C

B

B & C

A

B

Probability Calculations

1. Probability of any event is the sum of

the outcomes that compose that event

2. If events A and B are mutually exclusive,

then

P(A or B) = P(A) + P(B)

3. If events A and B are not mutually

exclusive, then

P(A or B) = P(A) + P(B) P(A and B)

Example

What is the probability of obtaining exactly

two heads or exactly two tails in 3 flips of a

coin?

These events are mutually exclusive. Probability =

3/8 + 3/8 = 6/8

What is the probability of obtaining at least

two tails or at least one head?

A = {TTT, TTH, THT, HTT}, B = {TTH, THT, THH,

HTT, HTH, HHT, HHH} The events are not

mutually exclusive.

P(A) = 4/8; P(B) = 7/8; P(A&B) = 3/8. Therefore,

P(A or B) = 4/8 + 7/8 3/8 = 1

Conditional Probability

Conditional probability the probability

of the occurrence of one event, given

that the other event is known to have

occurred.

P(A|B) = P(A and B)/P(B)

Example

What is the probability of exactly 2 heads in

three flips, given that the first flip is a head?

HHH, HHT, HTH, THH, HTT, THT, TTH, TTT

A = exactly 2 heads in 3 flips

B = first flip is a head, P(B) = 4/8

A&B = {HHT, HTH} P(A&B) = 2/8

P(A|B) = P(A&B)/P(B) = (2/8)/(4/8) =

i.e.:

B = {HHH, HHT, HTH, HTT}; A shown in red

Joint Probability

Joint probability table probabilities of

outcomes of two different variables

Variable 1: Number of heads in three flips

of a coin

Variable 2: First flip (H or T)

Frequencies Joint Probabilities

Marginal Probability

P(A|B) = P(A&B) / P(B) = (1/4)/(1/2) =

Marginal

probabilities

Other Uses for Conditional

Probability

P(A and B) = P(B|A)*P(A)

P(A) = P(A|B

1

)*P(B

1

) + P(A|B

2

)*P(B

2

) +

+ P(A|B

k

)*P(B

k

)

where B

1

, B

2

, , B

k

are k mutually

exclusive and exhaustive outcomes.

Statistical Independence

Two events A and B are statistically

independent if the probability of A given

B equals the probability of A; in other

words P(A|B) = P(A) or P(B|A) = P(B).

Implications for marketing

Bayes Theorem

Suppose that A

1

, A

2

, , A

k

is a set of

mutually exclusive and collectively

exhaustive events, and seek the

probability that some event A

i

occurs

given that another event B has occurred.

P(B|A

i

)*P(A

i

)

P(A

i

|B) = --------------------------------------------------------------------

P(B|A

1

)*P(A

1

) + P(B|A

2

)*P(A

2

) + + P(B|A

k

)*P(A

k

)

Example

Suppose that a digital camera manufacturer is

developing a new model. Historically, 70 percent of

cameras that have been introduced have been

successful it terms of meeting a required return on

investment, while 30 percent have been unsuccessful.

Analysis of past market research studies, conducted

prior to worldwide market introduction, has found that

90 percent of all successful product introductions had

received favorable consumer response, while 60

percent of all unsuccessful products had also received

favorable consumer response. If the new model

receives a favorable response from a market research

study, what is the probability that it will actually be

successful?

Example (continued)

Events

A

1

= new camera successful, P(A

1

) = 0.7

A

2

= new camera unsuccessful, P(A

2

) = 0.3

B

1

= marketing response favorable,

B

2

= marketing response unfavorable

Other know information:

P(B

1

|A

1

) = 0.9

P(B

1

|A

2

) = 0.6

Applying Bayes Theorem

P(B

1

|A

1

)*P(A

1

)

P(A

1

|B

1

) = -------------------------------------------------------------------------

P(B

1

|A

1

)*P(A

1

) + P(B

1

|A

2

)*P(A

2

) + + P(B

1

|A

k

)*P(A

k

)

(0.9)(0.7)

P(A

1

|B

1

) = -------------------------------- = 0.778

(0.9)(0.7) + (0.6)(0.3)

Although 70 percent of all previous new models have been

successful, knowing that the marketing report is favorable

increases the likelihood to 77.8 percent.

Random Variables

Random variable a function that assigns a real

number to each element of a sample space (a

numerical description of the outcome of an

experiment). Random variables are denoted by capital

letters, X, Y, ; specific values by lower case letters,

x, y,

Random variables may be discrete, with a finite or

infinitely countable number of values (number of

inaccurate orders or number of imperfections on a

car) or continuous, having any real value possibly

within some limited range (tomorrows temperature)

Examples of Random Variables

Experiment: flip a coin 3 times.

Outcomes: TTT, TTH, THT, THH, HTT, HTH, HHT,

HHH

Random variable: X = number of heads.

X can be either 0, 1, 2, or 3.

Experiment: observe end-of-week closing

stock price.

Random variable: Y = closing stock price.

X can be any nonnegative real number.

Probability Distributions

Probability distribution a characterization of

the possible values a random variable may

assume along with the probability of

occurrence.

Probability distributions may be defined for

both discrete and continuous random

variables.

Discrete Random Variables

Probability mass function f(x): specifies the

probability of each discrete outcome

Two properties:

0 s f(x

i

) s 1

f(x

i

) = 1

Cumulative distribution function, F(x): specifies

the probability that the random variable will be

less than or equal to x.

Example: Census Data

Charts for f(x) and F(x)

Example: Roll Two Dice

Sum

of

dice, x

2 3 4 5 6 7 8 9 10 11 12

f(x)

1/36 2/36 3/36 4/36 5/36 6/36 5/36 4/36 3/36 2/36 1/36

F(x)

1/36 3/36 6/36 10/36 15/36 21/36 26/36 30/36 33/36 35/36 1.0

Joint Probability Distributions

Joint probability distribution of two random variables,

f(x,y): specifies that probability that X = x and Y = y

simultaneously.

Not a High

School Grad

High School

Graduate

Some College

No Degree

Associate's

Degree

Bachelor's

Degree

Advanced

Degree

Age

25-34 0.027 0.073 0.045 0.020 0.049 0.014 0.228

35-44 0.031 0.088 0.047 0.024 0.047 0.021 0.258

45-54 0.026 0.063 0.035 0.017 0.035 0.022 0.198

55-64 0.026 0.048 0.019 0.007 0.017 0.012 0.129

65-74 0.030 0.038 0.014 0.004 0.010 0.007 0.104

75 and older 0.031 0.027 0.011 0.003 0.007 0.004 0.082

0.172 0.338 0.172 0.075 0.164 0.080 1.000

Joint

Marginal

Continuous Random Variables

Probability density function, f(x), a continuous

function that describes the probability of

outcomes for the random variable X. A

histogram of sample data approximates the

shape of the underlying density function.

Properties of Probability

Density Functions

f(x) > 0 for all x

Total area under f(x) = 1

There are always infinitely many values for X

P(X = x) = 0

We can only define probabilities over

intervals: e.g.,

P( c < X < d), P(X < c), or P(X > d)

Cumulative Distribution

Function

F(x) specifies the probability that the random

variable X will be less than or equal to x; that

is, P(X s x).

F(x) is equal to the area under f(x) to the left

of x

The probability that X is between a and b is

the area under f(x) from a to b = F(b) F(a)

Example

f(x) = 4x 16 for 4 s x s 4.5

= -4x + 20 for 4.5 s x s 5

F(x) = 2x

2

16x + 32 for 4 s x s 4.5

= -2x

2

+ 20x 49 for 4.5 s x s 5

P(X > 4.7) = F(5) F(4.7) = 1 - 0.82 = 0.18

Cumulative Distribution Function

Expected Value and Variance

of Random Variables

Expected value of a random variable X is the theoretical

analogy of the mean, or weighted average of possible

values:

Variance and standard deviation of a random variable X:

1 = i

i i

) f(x x = E[X]

1 j =

j

2

j

) f(x E[X]) - (x = Var[X]

1 j =

j

2

j X

) f(x E[X]) - (x = o

Example

You play a lottery in which you buy a ticket

for $50 and are told you have a 1 in 1000

chance of winning $25,000. The random

variable X is your net winnings, and its

probability distribution is

x f(x)

-$50 0.999

$24,950 0.001

Calculations

E[X] = -$50(0.999) + $24,950(0.001) =

-$25.00

Var[X] = (-50 - [-25.00])2(0.999) +

(24,950 - [-25.00])2(0.001) = 624,375

Functions of Random

Variables

Two useful formulas:

E[aX] = aE[X]

Var[aX] = a

2

Var[X]

where a is any constant

Discrete Probability

Distributions

Bernoulli

Binomial

Poisson

Bernoulli Distribution

A random variable with two possible

outcomes (x = 0 and x = 1), each with

constant probabilities of occurrence:

f(x) = p if x = 1

f(x) = 1 p if x = 0

Binomial Distribution

n independent replications of a Bernoulli trial

with constant probability of success p on each

trial

Expected value = np

Variance = np(1-p)

( )

x

n

=

)! ( !

!

x n x

n

( )

otherwise

n x for p p

x

n

x f

x n x

0

,..., 2 , 1 , 0 ) 1 ( ) ( = =

Example

If the probability that any individual will react

positively to a new drug is 0.8, what is the probability

distribution that 4 individuals will react positively out

of a sample of 10

Excel Function

BINOMDIST(number_s, trials, probability_s,

cumulative)

Examples of the Binomial

Distribution

Poisson Distribution

Models the number of occurrences in some unit of

measure, e.g., events per unit time, number of items

per order

X = number of events that occur; x = 0, 1, 2,

Expected value = ; variance =

Poisson approximates binomial when n is large and p

small

otherwise

x for

x

e

x f

x

0

,... 2 , 1 , 0

!

) (

=

= =

Example

Suppose that the average number of customers

arriving at an ATM during lunch hour is l = 12

customers per hour. The probability that exactly x

customers will arrive during the hour is

Excel Function

POISSON (x, mean, cumulative)

Poisson Distribution ( = 12)

Properties of Continuous

Distributions

Continuous distributions have one or

more parameters that characterize the

density function:

Shape parameter controls the shape of

the distribution

Scale parameter controls the unit of

measurement

Location parameter specifies the location

relative to zero on the horizontal axis

Uniform Distribution

Density function

Distribution function

f x

b a

if a x b ( ) =

s s

1

0

1

if x a

F x

x a

b a

if a x b

if b x

<

=

s s

<

( )

a b

x

f(x)

= (a + b)/2

o

2

= (b a)

2

/12

a = location

b a = scale

Normal Distribution

Familiar bell-shaped curve.

Symmetric, median = mean = mode; half the area is on

either side of the mean

Range is unbounded: the curve never touches the x-axis

Parameters

Mean, (location)

Variance o

2

> 0 (scale)

Density function:

f(x) =

e

-(x- )

2

o

to

2

2

2

2

Standard Normal Distribution

Standard normal: mean = 0, variance = 1,

denoted as N(0,1)

See Appendix Table A.1

Standardized Normal Values

Transformation from N(,o) to N(0,1):

Standardized z-values are expressed in units

of standard deviations of X.

o

x

= z

Areas Under the Normal

Density

About 68.3% is within one sigma of the mean

About 95.4% is within two sigma of the mean

About 99.7% is within three sigma of the

mean

Normal Probability

Calculations

Customer demand averages 750

units/month with a standard deviation of

100 units/month.

Find P(X>900), P(X>700), P(700<X<900)

and the level of demand that will be

exceeded only 10% of the time.

P(X>900)

5 . 1

100

750 900

= z =

Area = 0.9332

Area = 0.0668

P(X>700)

5 . 0

100

750 700

= z =

From Table A.1, P(Z < -0.5) = 0.3085.

Thus, P(X > 700) = 1 - 0.3085 = 0.6915.

P(700<X<900)

First standardize the values of 700 and 900, obtaining

z = -0.5 and z = 1.5. Then using Table A.1, we have

P(700 < X < 900) = F(900) F(700)

= P(Z < 1.5) - P(Z < -0.5) = 0.9332 - 0.3085 = 0.6247

P(X>x)>.10

28 . 1

100

750

= z =

x

First, find the value

of z from Table A.1,

then solve for x

x = 878

Excel Support

NORMDIST(x, mean, standard_deviation,

cumulative)

NORMSDIST(z): same as Table A.1

STANDARDIZE(x, mean, standard_deviation)

computes z-values

Computing Normal Probabilities

Triangular Distribution

Three parameters:

Minimum, a

Maximum, b

Most likely, c

a is the location parameter;

(b a) the scale parameter,

c the shape parameter.

2

2

0

( )

( )( )

( )

( )

( )( )

x a

b a c a

if a x c

f x

b x

b a b c

if c x b

otherwise

s s

=

< s

Mean = (a + b + c)/3

Variance = (a

2

+ b

2

+ c

2

ab ac bc)/18

Exponential Distribution

Models events that occur randomly over time

Customer arrivals, machine failures

Properties of Exponential

Density function

Distribution function

Mean = 1/

Variance = 1/

2

Excel function EXPONDIST(x, lambda, cumulative).

f(x) = e

-x

, x > 0

F(x) = 1 - e

-x

, x > 0

Lognormal Distribution

X is lognormal if the distribution of lnX is

normal

Positively skewed, bounded below by 0

Models task times, stock and real estate

prices

Gamma Distribution

Family of distributions defined by shape o,

scale |, and location L

Defined for x > L

Models task times, time between events,

inventories

Weibull Distribution

Family of distributions defined by shape o,

scale |, and location L

When L = 0 and | = 1, same as exponential

with = 1/o.

Models results from life tests, equipment

failures, and task times.

Beta Distribution

Defined over the range (0, s)

Two shape parameters o and |; if equal, beta

is symmetric; o < |, positively skewed; if

either equals 1 and the other > 1, J

shaped.

Geometric Distribution

Sequence of Bernoulli trials that describes the

number of trials until the first success.

Negative Binomial

Distribution of number of trials until the r

th

success.

Logistic Distribution

Describes the growth of a population over

time.

Pareto Distribution

Distribution in which a small proportion of

items accounts for a large proportion of some

characteristic.

PHStat Tool: Probability &

Probability Distributions

PHStat menu > Probability & Probability

Distributions > choice of distribution:

Normal

Binomial

Exponential

Poisson

Hypergeometric

PHStat Output

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