2 4

Recap of Last Lecture Binomial Distribution

• Bayes’ Theorem • The binomial distribution is used to find the probability of a
▪ Update prior probability assessment based on new information specific number of successes out of 𝑛 independent trials of a
➢ General form Bernoulli process.
➢ Venn diagram
• Random variables and probability distributions • 𝑛 = the number of trials
▪ A mapping from all possible outcomes to real numbers. • 𝑝 = the probability of success on any single trial
▪ Discrete → histogram, cumulative probability graph • 𝑟 = the number of successes
▪ Continuous → cumulative distribution function (CDF), probability
density function (PDF) • ! means factorial (0! = 1)
𝑛!
➢ The probability value of each outcome of the continuous RV is 0. • 𝑃 𝑟; 𝑛, 𝑝 = ∙ 𝑝𝑟 ∙ 1 − 𝑝 𝑛−𝑟
➢ In the graph of PDF, the area underneath the curve represents probability. 𝑟! 𝑛−𝑟 ! 5!
▪ P (Getting 4 heads in 5 tosses) = ? ∙ 0.54 ∙ 1 − 0.5 5−4
= 0.15625
▪ Summary statistics → expected value and variance 4! 5−4 !
• Binomial distribution & Bernoulli process
• If 𝑋~𝐵 𝑛, 𝑝 , then 𝐸 𝑋 = 𝑛𝑝 and 𝑉 𝑋 = 𝑛𝑝 1 − 𝑝 .
3
Binomial Distribution
• The probability of obtaining specific outcomes in a Bernoulli
Chapter 01 Probability Concepts process is described by the binomial probability distribution.
and Applications • Characteristics of Bernoulli process
▪ Each trial in a Bernoulli process has only two possible outcomes (e.g.,
IIMT3636 success vs. failure, yes vs. no, head vs. tail, etc.).
Faculty of Business and Economics ▪ The probability stays the same from one trial to the next.
▪ The trials are statistically independent.
The University of Hong Kong
▪ The number of trials is a positive integer.
Instructor: Dr. Yipu DENG
• Example
▪ Tossing a coin for several times and counting the number of heads
 6 8
Poisson Distribution Poisson Distribution in Excel
• A Poisson RV describes the number of independent arrivals
during a unit period of time.
▪ Patients arriving at a health clinic
▪ Customers arriving at a bank window
▪ Passengers arriving at an airport
• 𝜆 = average number of arrivals per unit of time
• 𝑒 = 2.718, the base of the natural logarithm
• 𝑥 = the actual number of arrivals (0, 1, 2, …)
𝑒 −𝜆 ∙𝜆𝑥
• 𝑃 𝑥; 𝜆 = (Note: if x’ time length ≠ a unit period of time, adjust 𝜆)
𝑥!
▪ If the average number of arrivals per hour is 𝜆, the average number of
arrivals in every two hours should be 2𝜆.
• If 𝑋~𝑃𝑜𝑖𝑠𝑠𝑜𝑛 𝜆 , then 𝐸 𝑋 = 𝜆 and 𝑉 𝑋 = 𝜆.
5 7
Binomial Distribution in Excel Poisson Distribution 𝑃 𝑋≥1
𝑒 −𝜆 ∙ 𝜆𝑥
= 1−𝑃 𝑋 =0 𝑃 𝑥; 𝜆 =
• Example = 1 − 𝑒 −0.13 = 12.2% 𝑥!
▪ Assume the number of financial crisis in one year follows Poisson
distribution.
▪ How many crises are there in 100 years?
▪ What is the probability of seeing at least one crisis next year?
 10 12
Exponential Distribution Exponential Distribution in Excel
• The exponential distribution often describes the time
required to serve a customer or the interarrival time or the
lifespan of a product (e.g., a light bulb).
→ continuous
• If 𝑋~𝐸𝑋𝑃 𝜆 , then 𝑓 𝑥 = 𝜆𝑒 −𝜆𝑥 and 𝐹 𝑥 = 𝑃 𝑋 ≤ 𝑥 =
1 − 𝑒 −𝜆𝑥 , where 𝜆 = 1/𝐸 𝑋 .
▪ 𝜆 = average number of arrivals per unit of time
▪ E(X) = average service time or interarrival time or lifespan
➢ Example: a chef needs 0.5 hours on average to cook one meal.
X = the actual waiting time between completing two meals.
E(X) = 0.5, which means the average waiting time between completing
two meals. (Note: The unit used in describing 𝜆 determines the unit for the time X.)
𝜆 = 2, which means the average rate at which meals are cooked per hour.
• 𝐸 𝑋 = 1/𝜆 and 𝑉 𝑋 = 1/𝜆2 .
9 11
Binomial and Poisson Distributions Exponential Distribution
• It turns out the Poisson distribution is just a special case of the • Example 𝐹 𝑥 = 𝑃 𝑋 ≤ 𝑥 = 1 − 𝑒 −𝜆𝑥
binomial distribution — where the number of trials is very large,
▪ The service person can install new doors at a rate about 3 per
and the probability of success in any given one is small.
hour.
• We can use a Binomial distribution with parameters (𝑛, 𝑝) to
▪ The service time is exponentially distributed.
approximate a Poisson distribution with rate 𝜆 by setting 𝑛 to a large
number and 𝑝 = 𝜆/𝑛. ▪ What is the probability that the time to install a new door will be
30 minutes or less?
▪ If n≥100 and np≤10, the approximation can be very good.
Poisson, l = 5
0.2
𝑃 𝑋 ≤ 0.5
0.15 = 1 − 𝑒 −3∗0.5
= 1 − 𝑒 −1.5 = 77.7%
0.1
0.05
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
 14 16
Exponential and Poisson Distributions Uniform Distribution in Excel
• Example • The 𝑟𝑎𝑛𝑑() function generates a number from a uniformly
▪ Suppose customer arrivals at a retail store per hour follow distributed random variable on [0,1]
Poisson with mean 𝜆 = 3. Given that a customer arrived at
2:30pm, what is the probability that the next customer will arrive
• For a general uniform distribution on [a,b], we can use
before 3:00pm? (Hint: how to define the random variable?)
“= 𝑎 + 𝑟𝑎𝑛𝑑() ∗ 𝑏 − 𝑎 ”
▪ 𝑃𝑃 𝑋 ≥ 1; 𝜆 = 1.5 or 𝑃𝐸 𝑌 ≤ 0.5; 𝜆 = 3
13 15
Exponential and Poisson Distributions Uniform Distribution
• Exponential and Poisson are related: if the number of • A random variable 𝑋 is uniformly distributed if it takes
arrivals per time period follows Poisson(𝜆0 ), then the any value equally likely from a finite interval 𝑎, 𝑏 .
time between arrivals (1/ 𝜆1 ) follows exponential Probability density function Cumulative distribution function
distribution EXP(𝜆1 ) with an identical rate 𝜆1 = 𝜆0 .
𝑥−𝑎
= 𝑏−𝑎
▪ Example: if the number of phone calls arriving at a customer
service center follows a Poisson distribution with a mean of 10
calls per hour (𝜆 = 10), the time between each phone call would
be exponentially distributed, with the average time between calls
as 1/10 hours or 6 minutes.
1 1
• 𝐸 𝑋 = 𝑎+𝑏 ;𝑉 𝑋 = (𝑏 − 𝑎)2
2 12
 18 20
Normal Distribution (PDF) Normal Distribution
• Normal distribution with different 𝜇. (shape unchanged)
| | |
40 m = 50 60
Smaller m, same s
| | |
m = 40 50 60
Larger m, same s
| | |
40 50 m = 60
17 19
Normal Distribution Normal Distribution
• The normal distribution is the most popular and useful • Normal distribution with different 𝜎. (always symmetric)
continuous probability distribution.
▪ E.g., return of a stock portfolio, forecast errors, and test scores.
• The probability density function is
1 𝑥−𝜇 2 Same m, smaller s
−
𝑓 𝑥 = ∙ 𝑒 2𝜎2
𝜎 2𝜋
Same m, larger s
• The normal distribution is specified completely when we
know the mean 𝐸(𝑥), 𝜇, and the standard deviation, 𝜎.
We often use the notation 𝑁 𝜇, 𝜎 2 .
m
 22 24
Standard Normal Distribution: Example In-class Exercise
• If 𝑋 follows normal distribution with mean 𝜇 = 100, 𝜎 = • If 𝑋 follows normal distribution with mean 𝜇 = 100 and
15, and we are interested in finding the probability that X s.d. 𝜎 = 22, then 𝑃 𝑋 < 120 = ?
is less than 130, then z = ?
▪ Hint: P(X ≤ x) = P (Z ≤ z) 𝑋−𝜇 120−𝜇
• 𝑃 𝑋 < 120 = 𝑃 𝑋 − 𝜇 < 120 − 𝜇 = 𝑃 <
𝜎 𝜎
𝑋−𝜇
𝑥−𝜇
• Define 𝑍 = .
𝑧=
𝜎
𝜎
130−100 • 𝑃 𝑋 < 120 = 𝑃 𝑍 < 0.91 = 0.8186
= =2
15
21 23
P(Z<-z) = P(Z>z)
Standard Normal Distribution Standard Normal Distribution: Z Table
P(Z<0.57)? 0.7157
If P(Z<z) = 0.65, z? 0.385
z = 2.00, the area is 0.97725, P(X<130)? 0.97725
Areas under the normal curve
𝑋−𝜇
If 𝑿~𝑵 𝝁, 𝝈𝟐 , then 𝑍 = 𝜎 follows standard normal distribution.
Here, Z represents the number of standard deviations from X to the mean, 𝜇
 26 28
Haynes Construction Company Haynes Construction Company
• Builds three- and four-unit apartment buildings • Suppose Haynes can hire more workers to reduce the
• Total construction time follows a normal distribution mean construction time while keeping the standard
• For triplexes, μ = 100 days and σ = 20 days deviation constant (i.e., 20 days). Hence, to ensure a
penalty is avoided with probability 0.95, what should be
• Contract calls for completion in 125 days
the new mean?
• Late completion will incur a severe penalty fee
• Probability of completing in 125 days? 𝑋 ′ −𝜇
• Objective: find 𝜇 such that 𝑃 𝑋′ < 125 = 𝑃 ቀ <
20
125−𝜇
ቁ = 0.95
20
𝑃 𝑋 < 125 = 𝑃 𝑍 < 1.25 = 0.8944 • Step 1: 𝑧0.95 = 1.645
125−𝜇
m = 100 days • Step 2: find 𝜇 such that = 1.645; 𝜇 = 92.1
s = 20 days 20
x = 125 days
25 27
Finding the x value Haynes Construction Company
• If 𝑋 follows normal distribution with mean 𝜇 = 100 and s.d. • If finished in 75 days or less, bonus = $5,000. Probability of bonus?
𝜎 = 22 and we want 𝑋 to be less than a certain value with • 𝑃 𝑋 < 75 = 𝑃 𝑍 < −1.25
probability 0.8, then how to find this value? Or 𝑃 𝑋 < ? = • = 𝑃 𝑍 > 1.25 = 1 − 𝑃 𝑍 < 1.25 = 1 - 0.8944 = 0.1056
0.8.
• What is the probability of completing between 110 and 125 days?
• Step 1: Finding the z value corresponding to 𝑃 𝑋 < 𝑥 . • 𝑃 110 < 𝑋 < 125 = 𝑃 𝑋 < 125 − 𝑃 𝑋 < 110
▪ If we need 𝑥 for 𝑃 𝑋 < 𝑥 , find 𝑧 corresponding to 𝑃 𝑋 < 𝑥 .
𝑧0.8 = 0.84
= 0.8944 – P(Z<0.5)
If we need 𝑥 for 𝑃 𝑋 > 𝑥 , find 𝑧 corresponding to 1 − 𝑃 𝑋 > 𝑥 .
= 0.8944 – 0.6915
• Step 2: Setting 𝑥 to 𝑥𝑧 = 𝜇 + 𝑧 ∙ 𝜎. = 0.2029
𝑋−𝜇
▪ 𝑃 𝑋 < 𝑥𝑧 = 𝑃 𝑋 < 𝜇 + 𝑧 ∙ 𝜎 = 𝑃 𝜎 < 𝑧 = 𝑃 𝑍 < 𝑧 = 𝑃 𝑋 < 𝑥
𝑃 𝑋 < 100 + 𝑧0.8 × 22 = 𝑃 𝑋 < 118.48 = 0.8
110 days 125 days
 31 33
In-Class Exercise In-Class Exercise
• When a man passes the airport security check, they • A candidate for public office has claimed that 60% of
discover a bomb in his bag. He explains. “Statisticians voters will vote for her. If 5 registered voters were
show that the probability of one bomb being on an sampled, what is the probability that exactly 3 would say
airplane is 1/10,000. However, the chance that there are they favor this candidate? (hint: utilize BINOM.DIST in
two bombs on one plane is 1/10,000,000. So, I am much Excel)
safer …”
• Suppose the statisticians are right and it is impossible to Binomial distribution with n = 5, p = 0.6, r = 3, prob = 0.3456
have more than two bombs on an airplane. Do you agree
with the man?
No. The conditional probability of flying with another bomb is 1/1,000.
29 32
Normal Distribution in Excel In-Class Exercise
• A class contains 30 students. Ten are female (F) and U.S.
citizens (U); 12 are male (M) and U.S. citizens; 6 are
female and non-U.S. citizens (N); 2 are male and non-
U.S. citizens.
• A name is randomly selected from the class roster, and it
is female. What is the probability that the student is a
U.S. citizen?
P(U|F) = P(UF)/P(F) = (10/30)/[(10+6)/30] = 0.625
 2 4
Decision makers have
The Science of Decision Making Thompson Lumber Company no control over it.
• Making a decision is about choosing among alternatives. • List all possible alternatives (i.e., course of action or strategies)
▫ Whether to pursue a graduate study (BA or Marketing); whether to • Identify possible outcomes/states of nature (e.g., high vs. low demand)
seek a job
▫ Whether to buy a stock and how much money to invest (e.g., all, half, • List the payoff of the combination of alternatives and outcomes
1/3); other investment opportunities • Select and apply the decision theory model, make decisions
▫ Whether to expand the product line and how to expand (e.g., new or
existing technology)
STATE OF NATURE
• Six Steps in Decision Making FAVORABLE MARKET UNFAVORABLE MARKET
▫ Clearly define the problem (Goal to achieve) ALTERNATIVE (profit in $) (profit in $)
▫ List the possible alternatives
Construct a large plant 200,000 –180,000
▫ Identify the possible outcomes or states of nature
▫ List the payoff of each alternative in each state of nature Construct a small plant 100,000 –20,000
▫ Select one of the decision theory models Do nothing 0 0
▫ Apply the model and make your decision
Decision/payoff table
3
Thompson Lumber Company
• John Thompson, the founder and president, needs to make the
decision on whether to expand his product line by manufacturing
Chapter 02 and marketing a new product.
• Define the problem
Decision Analysis à whether to expand the product line
IIMT3636
Faculty of Business and Economics
The University of Hong Kong
Instructor: Dr. Yipu DENG
 6 8
Decision Making under Risk Decision Making under Risk
• EMV is the weighed sum of possible payoffs for each alternative.
• EVwPI = ∑ best payoff in state - . probability of state -
STATE OF NATURE Expected
Monetary Expected
FAVORABLE UNFAVORABLE Value STATE OF NATURE
Monetary
ALTERNATIVE MARKET (profit in $) MARKET (profit in $) (EMV, $) FAVORABLE UNFAVORABLE Value
ALTERNATIVE MARKET (profit in $) MARKET (profit in $) (EMV, $)
Construct a large plant 200,000 –180,000 –9,000
Construct a small plant 100,000 –20,000 34,000 Construct a large plant 200,000 –180,000 –9,000
Do nothing 0 0 0 Construct a small plant 100,000 –20,000 34,000
Probability 0.45 0.55 Do nothing 0 0 0
Best payoff 200,000 0 90,000
Probability 0.45 0.55 EVwPI
If John maximizes the EMV, then he should choose to construct a small plant.
EVPI = EVwPI – Best EMV
= $90,000 – $34,000 = $56,000 < $65,000. Don’t buy!
5 7
Types of Decision-Making Environments Decision Making under Risk
• Decision making under certainty • Scientific Marketing, Inc. offers analysis that will provide
▫ The decision maker knows with certainty the consequences of every
alternative or decision choice. certainty about market conditions. S.M. would charge
▫ Example: have $1,000 to invest for 1 year (open a savings account $65,000 for the information. Should John buy the
with 4% interest vs. invest in a government bond with 6% interest)
• Decision making under risk information?
▫ There are several possible outcomes for each alternative, and
decision maker knows the probabilities of each outcome.
▫ Example: get $10 if we roll a 5 on a standard dice à maximize • To make this decision, John has to evaluate the expected
expected monetary value or minimize opportunity loss value of perfect information (EVPI) by computing the
• Decision making under uncertainty expected value with perfect information (EVwPI) and
▫ There are several possible outcomes for each alternative, and
decision maker does not know the probabilities of the various the best EMV under risk.
outcomes.
▫ Example: the probability of success of a new product
 10 12
Decision Making under Risk In-class Exercise: Café du Donut
Favorable Market VwPI Unfavorable Market
• Monetary Payoff (Profit) Table
OL2
OL3
VwPI • Cost = $40, revenue = $60
MV1
OL2
MV2 MV3 OL1 MV3
MV2 D=4 D=5 D=6 D=7 D=8 D=9 D = 10 EMV
MV1 4x60 6x40 6x60 6 x40
Q=6 0 60Go 120 120 120 120 120 105
-
-
Option Option Option Option Option Option O 120 120 10 120 120 105
1 2 3 1 2 3 60 7 x 40
4-40 7x 60 7 x 40
Q=7 x
202 O 80 140 140 140 140 104
-
-
- 40 80 140 140 140 140 104
Prob. 0.05 0.15 0.15 0.20 0.25 0.10 0.10
EVwPI EMVLQ =
6) = 0x0 05 + 60 x 0 .
15 + 120 x (0 .
15 +0 . 20 +
0 .
25 +0 .
10 + 0 -
10) =
105
EOL2
.
EOL1 EOL3
• Should we reduce the order size from 6 to 5? What is the EMV of Q=5?
EMV1 EMV2 EMV3
Option 1 Option 2 Option 3 • If we can only choose between 6 and 7, what is the EVPI?
9 11
Decision Making under Risk In-class Exercise: Café du Donut
• To minimize expected opportunity loss (EOL) • The Café buys donuts each day for $40 per carton of 20 dozen
• Opportunity loss = optimal payoff – actual payoff (in a given state of nature)
donuts. Any cartons not sold are thrown away at the end of
STATE OF NATURE Expected the day. If a carton is sold, the total revenue is $60.
Monetary
FAVORABLE
FAVORABLE Mkt UNFAVORABLE
UNFAVORABLE Mkt EOL
Value DAILY DEMAND PROBABILITY CUMULATIVE
ALTERNATIVE (Opp. Loss
MARKET in $)
(profit in $) (Opp. Loss
MARKET in $)
(profit in $) (EMV,
(in $) (CARTONS) PROBABILITY
Construct a large plant 0
200,000 180,000
–180,000 99,000
–9,000 • The original plan 4 0.05 0.05
Construct a small plant 100,000 20,000
–20,000 56,000
34,000
is to order 6 5 0.15 0.2
Do nothing 200,000
0 0 90,000
0
cartons per day. 6 0.15 0.35
Probability 0.45 0.55 Should the Café 7 0.20 0.55
• Minimizing EOL always results in the same decision as maximizing increase the 8 0.25 0.8
9 0.10 0.9
EMV. order size to 7?
• The minimum EOL always equal the EVPI. 10 0.10 1.0
Total 1.00