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History of Probability Theory Started in the year of 1654 De Mere (a well-known gambler) asked a question to Blaise Pascal (a mathematician) Whether to bet on the following event? “To throw a pair of dice 24 times, if a ‘double six’ occurs at least once, then win.” correspond Blaise Pascal 4/30/2017 Pierre Fermat BUS304 – Probability Theory 1 Applications of Probability Theory Gambling: Poker games, lotteries, etc. Weather report: Likelihood to rain today Power of Katrina Many more in modern business world Risk Management and Investment • Value of stocks, options, corporate debt; • Insurance, credit assessment, loan default Industrial application • Estimation of the life of a bulb, the shipping date, the daily production 4/30/2017 BUS304 – Probability Theory 2 Concept: Experiment and event Experiment: A process that produces a single outcome whose result cannot be predicted with certainty. Example: Experiment Experimental Outcomes Toss a coin Head, tail Inspect a part Defective, nondefective Play a football game Win, lose, tie Roll a die Event: A certain outcome obtained in an experiment. Example of an event (description of outcome) Two heads in a row when you flip a coin three times; At least one “double six” when you throw a pair of dice 24 times. 4/30/2017 BUS304 – Probability Theory 3 Description of Events Elementary Events The most rudimentary outcomes resulting from a simple experiment Throwing one die, “obtaining a ” is an elementary event Denoted as “e1, e2, …, en” Note: the elementary events cannot be further divided into smaller events. e.g. flip a coin twice, how many elementary events you expect to observe? • “getting one head one tail” is NOT an elementary event. • Elementary events are {HH, HT, TH, TT} 4/30/2017 BUS304 – Probability Theory 4 Description of Events Sample Space: Collection of all elementary outcomes: In many experiments, identifying sample space is important. Write down the sample space of the following experiments: • throwing a pair of dice. • flipping a coin three times. • drawing two cards from a bridge deck. An event (denoted as E), can be represented as a combination of elementary events. E.g. E = A die shows number higher than 3 Elementary events: e1 = 4/30/2017 ; e2 = ; e3 = BUS304 – Probability Theory . 5 Rules of Assigning Probabilities Three rules are commonly used: Classical Probability Assessment Relative Frequency Assessment Subjective Probability Assessment 4/30/2017 BUS304 – Probability Theory 6 Basic Rules to assign probability (1) Classical probability Assessment: P(E) = Number of Elementary Events Total number of Elementary Events Exercise: Decide the probability of the following events 1. Get a card higher than 10 from a where: • E refers to a certain event. • P(E) represents the probability of the event E bridge deck 2. Get a sum higher than 11 from throwing a pair of dice. When to use this rule? 3. John and Mike both randomly pick When the chance of each elementary event is the same: e.g. cards, coins, dices, use random number generator to select a sample 4/30/2017 a number from 1-5, what is the chance that these two numbers are the same? BUS304 – Probability Theory 7 Basic Rules to assign probability (2) Relative Frequency of Occurrence Probability of Future Event = Relative Freq. of Past = Number of times E occurs N Examples: If a survey result says, among 1000 people, 600 prefer iphone to ipod touch, then you assign the probability that the next person you meet will like iphone is 60%. A basketball player’s percentage of made free throws. Why do you think Yao Ming has a better chance to win the free throw competition than Shaq O’Neal? The probability that a TV is sent back for repair? Based on past experience. The most commonly used in the business world. 4/30/2017 BUS304 – Probability Theory 8 Exercise A clerk recorded the number of patients waiting for service at 9:00am on 20 successive days Number of waiting Number of Days Outcome Occurs 0 2 1 5 2 6 3 4 ≥4 3 Total 20 Assign the probability that there are at most 2 agents waiting at 9:00am. 4/30/2017 BUS304 – Probability Theory 9 Exercise 4.1 (Page 137) Male Female Under 20 168 208 20 to 40 340 290 Over 40 170 160 Elementary Events? Sample Space? a) Probability that “a customer is a male”? b) Probability that “a customer is 20 to 40 years old”? c) Probability that “a customer being 20 to 40 years old and a male”? 4/30/2017 BUS304 – Probability Theory 10 Basic Rules to assign probability (3) Subjective Probability Assessment Subjective probability assessment has to be used when there is not enough information for past experience. Example1: The probability a player will make the last minute shot (a complicated decision process, contingent on the decision by the component team’s coach, the player’s feeling, etc.) Example2: Deciding the probability that you can get the job after the interview. • • • • • Smile of the interviewer Whether you answer the question smoothly Whether you show enough interest of the position How many people you know are competing with you Etc. Always try to use as much information as possible. As the world is changing dramatically, people are more and more rely upon subjective assessment. 4/30/2017 BUS304 – Probability Theory 11 Summary of Basic Approaches Classical Rule Elementary events have equal odds Relative Frequency Use relative frequency table. Probability assigned based on percentage of occurrence. Subjective Based on experience, combining different signals to make inference. No standard approach to have people agree on each other. No matter what method used, probability cannot be higher than 1 or lower than 0! 4/30/2017 BUS304 – Probability Theory 12 Rules for complement events what is the a complement event? E E The Rule: P( E ) 1 P(E) If Obama’s chance of winning the presidential campaign is assigned to be 60%, that means McCain’s chance is 1-60% = 40%. If the probability that at most two patients are waiting in the line is 0.65, what is the complement event? And what is the probability? 4/30/2017 BUS304 – Probability Theory 13 Composite Events E = E1 and E2 =(E1 is observed) AND (E2 is also observed) E1 E2 P(E1 and E2) ≤ P(E1) P(E1 and E2) ≤ P(E2) P(E1 and E2) E = E1 or E2 = Either (E1 is observed) Or (E2 is observed) E1 E1 or E2 E2 P(E1 or E2) ≥ P(E1) P(E1 or E2) ≥ P(E2) More specifically, P(E1 or E2) = P(E1) + P(E2) - P(E1 and E2) 4/30/2017 BUS304 – Probability Theory 14 Exercise Male Female Total Under 20 168 208 376 20 to 40 340 290 630 Over 40 170 160 330 Total 678 658 1336 1. What is the probability of selecting a person who is a male? 2. What is the probability of selecting a person who is under 20? 3. What is the probability of selecting a person who is a male and also under 20? 4. What is the probability of selecting a person who is either a male or under 20? 4/30/2017 BUS304 – Probability Theory 15 Mutually Exclusive Events If two events cannot happen simultaneously, then these two events are called mutually exclusive events. Ways to determine whether two events are mutually exclusive: If one happens, then the other cannot happen. Examples: Draw a card, E1 = A Red card, E2 = A card of club Throwing a pair of dice, E1 = one die shows E2 = a double six. All elementary events are E2 E1 mutually exclusive. Complement Events 4/30/2017 BUS304 – Probability Theory 16 Rules for mutually exclusive events If E1 and E2 are mutually exclusive, then P(E1 and E2) = ? P(E1 or E2) = ? E1 E2 Exercise: Throwing a pair of dice, what is the probability that I get a sum higher than 10? E1: getting 11 E2: getting 12 E1 and E2 are mutually exclusive. So P(E1 or E2) = P(E1) + P(E2) 4/30/2017 BUS304 – Probability Theory 17 Conditional Probabilities Information reveals gradually, your estimation changes as you know more. Draw a card from bridge deck (52 cards). Probability of a spade card? Now, I took a peek, the card is black, what is the probability of a spade card? If I know the card is red, what is the probability of a spade card? What is the probability of E1? What if I know E2 happens, would you E1 E2 change your estimation? 4/30/2017 BUS304 – Probability Theory 18 Bayes’ Theorem Conditional Probability Rule: PE1 and E2 PE1 | E2 P E2 Example: GPA3.0 GPA<3.0 Male 282 323 Female 305 318 P(“Male”)=? P(“Male” and “GPA<3.0”)=? P(“GPA<3.0” | “Male”) = ? 4/30/2017 Thomas Bayes (1702-1761) P(“GPA 3.0”)=? P(“Female” and “GPA 3.0”)=? P (“Female” | “GPA 3.0”)=? BUS304 – Probability Theory 19 Independent Events If PE1 | E2 PE1 then we say that “Events E1 and E2 are independent”. That is, the outcome of E1 is not affected by whether E2 occurs. Typical Example of independent Events: Throwing a pair of dice, “the number showed on one die” and “the number on the other die”. Toss a coin many times, the outcome of each time is independent to the other times. Independen t : PE1 and E2 PE1 PE2 How to prove? 20 Exercise 1. Calculate the following probabilities: a) Prob of getting 3 heads in a row? b) Prob of a “double-six”? c) Prob of getting a spade card which is also higher than 10? 2. Data shown from the following table. Decide whether the following events are independent? a) “Selecting a male” versus “selecting a female”? b) “Selecting a male” versus “selecting a person under 20”? Male Female Under 20 168 208 20 to 40 340 290 Over 40 170 160 4/30/2017 BUS304 – Probability Theory 21 Probability Distribution Random Variable: A variable with random (unknown) value. Examples 1. Roll a die twice: Let x be the number of times 4 comes up. x = 0, 1, or 2 2. Toss a coin 5 times: Let x be the number of heads x = 0, 1, 2, 3, 4, or 5 3. Same as experiment 2: Let’s say you pay your friend $1 every time head shows up, and he pays you $1 otherwise. Let x be amount of money you gain from the game. What are the possible values of x? 4/30/2017 BUS304 – Probability Theory 22 Discrete vs. Continuous Random variables Random Variables Discrete Examples: 4/30/2017 Continuous Examples: Number of students showed up next time The temperature tomorrow Number of late apt. rental payments in Oct. The total rental payment collected by Sep 30 Your score in this coming mid-term exam The expected lifetime of a new light bulb BUS304 – Probability Theory 23 Discrete Probability Distribution Table Two ways to represent discrete probability distributions X P(X) 0 0.25 1 0.5 2 0.25 Graph Probability All the possible values of x .50 .25 0 4/30/2017 1 BUS304 – Probability Theory 2 x 24 Exercise Describe the probability distribution of the random variables: Draw a pair of dice, x is the random variable representing the sum of the total points. Step 1: Write down all the possible values in left column Step 1.1: Write down the sample space Step 2: Write down the corresponding probabilities 4/30/2017 BUS304 – Probability Theory 25 Measures of Discrete Random Variables Expected value of a discrete distribution An weighted average, taking into account the probability The expected value of random variable x is denoted as E(x) E(x)= xi P(xi) E(x)= x1P(x1) +x2P(x2) + … + xnP(xn) Example: What is your expected gain when you play the flip-coin game twice? x -2 0 2 4/30/2017 P(x) .25 .50 .25 E(x) = (-2) * 0.25 + 0 * 0.5 + 2 * 0.25 =0 Your expected gain is 0! – a fair game. BUS304 – Probability Theory 26 Spreadsheet to compute the expected value Step1: develop the distribution table according to the description of the problem. Step2: add one (3rd) column to compute the product of the value and the probability Step3: compute the sum of the 3rd column The Expected Value 4/30/2017 x P(x) x*P(x) -2 0.25 -2*.25=-0.5 0 0.5 0*0.5=0 2 0.25 2*0.25=0.5 E(x) =-0.5+0+0.5=0 BUS304 – Probability Theory 27 Exercise You are working part time in a restaurant. The amount of tip you get each time varies. Your estimation of the probability is as follows: $ per night Probability 50 0.2 60 0.3 70 0.4 80 0.1 You bargain with the boss saying you want a more fixed income. He said he can give you $62 per night, instead of letting you keep the tips. Would you want to accept this offer? 4/30/2017 BUS304 – Probability Theory 28 More Exercise Buy lottery: price $10 With 0.0000001 chance, you can win $1million With 0.001 chance, you can win $1000 With 0.1 chance, you can win $50 What is the expected gain of buying this lottery ticket? Is buying lottery a fair game? Rule for expected value If there are two random variables, x and y. Then E(x+y) = E(x) + E(y) Example: “Head -$2”, “Tail +1” • x is your gain from playing the game the first time • y is your gain from playing the game the second time • x+y is your total gain from playing the two games. x P(x) y P(y) -2 0.5 -2 0.5 1 0.5 1 0.5 E(x)= -0.5 4/30/2017 E(y)= -0.5 Write down the probability distribution of x+y and calculate the expected value for x+y Is this game a fair game? BUS304 – Probability Theory 30 Exercise Assume that the expected payoff of playing the slot machine is -0.04 cents What is the expected payoff when playing 100 times? 10,000 times? Measure of risk-- variance Two games Flip a coin once, if head then you get $1, otherwise you pay $1; Flip a coin once, if head then you get $100, otherwise you pay $100; Which game will you choose? Three basic types of people Risk-lover Risk-neutral Risk-averse What is your type? Measures – variance Variance: a weighted average of the squared deviation from the expected value. x P(x) x – E(x) (x-E(x))2 (x-E(x))2P(x) 50 0.2 50-64=-$14 (-14)2=196 196*0.2=39.6 60 0.3 -$4 16 4.8 70 0.4 $6 36 14.4 80 0.1 $16 256 25.6 84.4 (sum of above) Step 1: develop the probability distribution table. Step 2: compute the mean E(x): 50x0.2+60x0.3+70x0.4+80x0.1=64 Step 3: compute the distance from the mean for each value (x-E(x)) Step 4: square each distance (x – E(x))2 Step 5: weight the squared distance: (x-E(x))2P(x) Step 6: sum up all the weighted square distance variance 4/30/2017 BUS304 – Probability Theory 33 Variance and Standard deviation Variance The variance of a random variable has the same meaning as the variance of population Calculation is the same as calculating population Standard deviation of a random variable: Same of the population standard deviation Calculate the variance Then take the square root of the variance. Written as sd(x) or variance using a relative e.g. for the example on page 10 frequency table. Written as var(x) or 2 4/30/2017 84.4 9.19 BUS304 – Probability Theory 34 More exercise: Page 4.66 4/30/2017 BUS304 – Probability Theory 35