Statistics for Economists (Econ2042) 2024/2025

CHAPTER ONE

1. OVERVIEW OF BASIC PROBABILITY THEORY

1.1 Random Experiment, Random variable, Sample Space, Sample Points, Events & Event
Space
1. Experiment: Any process of observation or measurement or any process which generates
well defined outcome.
2. Probability Experiment (Random Experiment): It is an experiment that can be repeated
any number of times under similar conditions and it is possible to enumerate the total number
of outcomes without predicting an individual outcome.
Example: If a fair coin is tossed three times, it is possible to enumerate all possible eight
sequences of head (H) and tail (T). But it is not possible to predict which sequence will occur
at any occasion.
3. Outcome: The result of a single trial of a random experiment
4. Sample Space(S): Set of all possible outcomes of a probability experiment.
Example: Sample space of a trial conducted by three tossing of a coin is
S= {HHH, HHT, HTH, HTT, THH, THT, TTH, TTT}
Sample space can be
 Countable (finite or infinite)
 Uncountable
5. Event (Sample Point): It is a subset of sample space. It is a statement about one or more
outcomes of a random experiment. It is denoted by capital letter A, B, C
Example 1, in the event, that there are exactly two heads in three tossing of a coin, it would
consist of three points HTH, HHT and THH.
Example 2: Consider the random experiment of throwing a die and the sample space will be,
S = {1, 2,3,4,5, 6}. Then, one can define events over S:
A = {getting odd number} = {1, 3, 5}.
B = {getting number 4} = {4}
C = {getting even number} = {2, 4, 6}
Remark: If S (sample space) has n members with two possible outcomes in each trial then there
are exactly 2n subsets or events.
6. Equally Likely Events: Events which have the same chance of occurring.
7. Complement of an Event: the complement of an event A means non- occurrence of A and is
denoted by A' or Ac or A , contains those points of the sample space which don’t belong to A.
8. Elementary (simple) Event: an event having only a single element or sample point.
9. Mutually Exclusive (Disjoint) Events: Two events which cannot happen at the same time.
10. Independent Events: Two events are said to be independent if the occurrence of one does
not affect the probability of the other occurring.
11. Dependent Events: Two events are dependent if the first event affects the outcome or
occurrence of the second event in a way the probability is changed.

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 Statistics for Economists (Econ2042) 2024/2025

1.2. Definitions of Probability

Probability is the chance of an outcome of an experiment. It is the measure of how likely an
outcome is to occur.
 In any random experiment there is always uncertainty as to whether a particular event will or
will not occur. As a measure of the chance, or probability, with which we can expect the
event to occur, it is convenient to assign a number between 0 and 1. If we are sure or certain
that the event will occur, we say that its probability is 100% or 1, but if we are sure that the
event will not occur, we say that its probability is zero.
1.3. Axioms of Probability
Probability theory is derived from a small set of axioms – a minimal set of essential assumptions
A deep understanding of axiomatic probability theory is not essential to financial econometrics
or to the use of probability and statistics in general, although understanding these core concepts
does provide additional insight.
Let “E” be a random experiment and S be a sample space associated with “E”. With each event
A, we associate a real number designated by P (A) and called the probability of A satisfies the
following properties:
1. 0  P A  1
2. P(S) =1
3. If A and B are mutually exclusive events, the probability that one or the other occur equals the
sum of the two probabilities. i. e. P (AuB) =P (A) +P (B)
4. If are mutually exclusive events, then

(⋃ ) ( ) ( ) ( ) ( )

For any finite n, (⋃ ) ∑ ( )

1.4. Counting Procedures
In order to calculate probabilities, we have to know
 The number of elements of an event
 The number of elements of the sample space.
That is in order to judge what is probable, we have to know what is possible.
 In order to determine the number of outcomes, one can use several rules of counting.
i) The addition rule
ii) The multiplication rule
iii) Permutation rule
iv) Combination rule

 To list the outcomes of the sequence of events, a useful device called tree diagram is
used.

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 Statistics for Economists (Econ2042) 2024/2025

Example: 1A student goes to the nearest snack to have a breakfast. He can take tea,
coffee, or milk with bread, cake and sandwich. How many possibilities does he have?

Solutions:

There are nine Possibilities

i) The addition rule:- Suppose that for an experiment the procedure is designated by
1 can be performed ways, the procedure is designated by 2 can be performed
ways, … the procedure is designated by K can be performed ways and each
procedure/steps cannot be performed together, then the total number of possibility of the
experiment can be performed ( )
Example:- Suppose we are planning a trip to some place. if there are 5 bus routes and 3 train
routs that can take, then there are 8 different routes possibility that we can take the trip place.
ii) The multiplication rule
If a choice consists of k steps of which the first can be made in n1 ways, the
Second can be made in n2 ways…, the kth can be made in nk ways, then the whole choice can be
made in (n1 * n2 *........* nk ) ways.
Example: The digits 0, 1, 2, 3, and 4 are to be used in 4 digit identification card. How many
different cards are possible if
a) Repetitions are permitted.
b) Repetitions are not permitted
Solutions
a)
1st digit 2nd digit 3rd digit 4th digit
5 5 5 5
There are four steps
1. Selecting the 1st digit, this can be made in 5 ways.

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 Statistics for Economists (Econ2042) 2024/2025

2. Selecting the 2nd digit, this can be made in 5 ways.

3. Selecting the 3rd digit, this can be made in 5 ways.
4. Selecting the 4th digit, this can be made in 5 ways.
⇒5*5*5*5 = 625 different cards are possible.
b)
1st digit 2nd digit 3rd digit 4th digit
5 4 3 2
There are four steps
1. Selecting the 1st digit, this can be made in 5 ways.
2. Selecting the 2nd digit, this can be made in 4 ways.
3. Selecting the 3rd digit, this can be made in 3 ways.
4. Selecting the 4th digit, this can be made in 2 ways.
⇒5*4*3*2 =120 different cards are possible.
Exercise
A student has two shoes, three trousers and three jackets. In how many can be dressed?
iii) Permutation
An arrangement of n objects in a specified order is called permutation of the objects.
Permutation Rules:
1. The number of permutations of n distinct objects taken all together is n!
Where n! =n*(n-1)*(n-2)*…*2*1.
2. The arrangement of n objects in a specified order using r objects at a time is called the
permutation of n objects taken r objects at a time. It is written as n Pr and the formula is
n!
n Pr =
n  r !
3. The number of permutations of n objects in which k1 are alike, k2 are alike ---- etc is
n!
nPr =
k1  k 2  ....k n

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 Statistics for Economists (Econ2042) 2024/2025

Example:
1. Suppose we have a letters A,B, C, D
a) How many permutations are there taking all the four?
b) How many permutations are there two letters at a time?
Solutions:
1.
a) Here n=4 , there are four distinct object
⇒There are 4!= 24 permutations
b)
Here n=4, r=2
⇒There are 4P2 = 4! / (4-2)! =12
1. How many different permutations can be made from the letters in the word
“MISSISSIPPI”?
Solution: n=11, out of them 1M, 4 I’s, 4 S’s, 2 P’s.

( ) ( )( )( )
= 34650

Exercises:
1. How many different permutations can be made from the letters in the word
“CORRECTION”?
2. In how many ways can a party of 7 people arrange themselves?
a) In a row of 7 chairs?
2. Six different statistics books, seven different physics books, and 3 different Economics
books are arranged on a shelf. How many different arrangements are possible if;
i. The books in each particular subject must all stand together
ii. Only the statistics books must stand together
iv) Combination:
A selection of objects without regard to order is called combination The number of combinations
of n distinct objects taken r at a time is the number of subsets of size r, taken from the n things
without replacement. We write this as( ).

Example: Given the letters A, B, C, and D list the permutation and combination for selecting two
letters

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 Statistics for Economists (Econ2042) 2024/2025

Solution

Permutation
Combination
AB BA CA DA
AB BC
AC BC CB DB
AC BD
AD BD CD DC AD DC
Note that in permutation AB is different from BA. But in combination AB is the same as BA.
Combination Rule: The number of combinations of r objects selected from n objects is denoted

by nC r or nr  and is given by the formula: nCr =

n!
n  r !r!
Example:
1. From a group of 5 women and 7 men, how many different committees consisting
i) Of 2 women and 3 men can be formed?
Solution:
i) As there are (5) possible groups of 2 women, and (7) possible groups of 3
(5)( ) (7)( )(5)
men, it follows from the basic principle that there are (5)(7) = ( )( ) ( )( )( )
=350 possible committees consisting of 2 women and 3 men.
1.5. Conditional Probability and Independence
 Conditional Events: If the occurrence of one event has an effect on the next occurrence of
the other event then the two events are conditional or dependent events. The conditional
probability of an event B is the probability that the event will occur given the knowledge
that an event A has already occurred. This probability is written P (B|A), notation for
the probability of B given A. In the case where events A and B are independent (where
event A has no effect on the probability of event B), the conditional probability of
event B given event A is simply the probability of event B, that is P(B).
If events A and B are not independent, then the probability of the intersection of A and B (the
probability that both events occur) is defined by P(A and B) = P(A)P(B|A).
From this definition, the conditional probability P(B|A) is easily obtained by dividing
p(A  B
by PA B  = , P (B)  0 or P (A  B) = P (A|B).P(B)
P B 

To calculate the probability of the intersection of more than two events, the conditional
probabilities of all of the preceding events must be considered. In the case of three
events, A, B, and C, the probability of the intersection
P(A∩B ∩ C) =P(A)P(B|A)P(C|A ∩B).

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 Statistics for Economists (Econ2042) 2024/2025

Conditional probability rule

 Addition rule: (A1 A2 … |B) =P(A1|B)+P(A2|B)+… for mutually disjoint events
A1,A2…
 Complement rule: P(Ac|B)=1-P(A|B)
 Multiplication rule: P(A B)=P(B) P(A|B). More generally, for any events A1, A2,…,An
then
…
P(A1 A2 )=P(A1)P(A1|A2)P(A3|A1 A2)…P(An|A1 A2 … An-1)
1.5.1. Conditional probability of an event
The conditional probability of an event A given that B has already occurred, denoted by P(A|B).
Since A is known to have occurred, it becomes the new sample pace replacing the original
sample space.
From this we are led to the definition
p(A  B
P A B  = , P (B)  0 or P (A  B) = P (A|B).P(B)
P B 

Remark:
1. PA  B = 1  PA B 

2. PB  A= 1  PB A

3. For three events then ( ) ( ) ( | ) ( | )

4. Generalization of multiplication theorem, for events we have
( ) ( ) ( | ) ( | ) ( | )
Example:
1. For a student enrolling at freshman at certain university the probability is 0.25 that he/she
will get scholarship and 0.75 that he/she will graduate. If the probability is 0.2 that he/she
will get scholarship and will also graduate. What is the probability that a student who get a
scholarship graduate?
Solution: Let A= the event that a student will get a scholarship
B= the event that a student will graduate
given p ( A)  0.25, p ( B )  0.75, p  A  B   0.20
Re quired p B A
p  A  B  0.20
p  B A    0.80
p  A 0.25

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 Statistics for Economists (Econ2042) 2024/2025

1.6. Bayes’ theorem

Bayes’ theorem (also known as Bayes’ rule or Bayes’ law) is a result in probability theory that
relates conditional probabilities. If A and B denote two events, P(A|B) denotes the conditional
probability of A occurring, given that B occurs. The two conditional probabilities P(A|B) and
P(B|A) are in general different. Bayes theorem gives a relation between P(A|B) and P(B|A).
An important application of Bayes’ theorem is that it gives a rule how to update or revise the
strengths of evidence-based beliefs in light of new evidence a posteriori.
Bayes’ theorem relates the conditional and marginal probabilities of stochastic events A and B:
( | ) ( )
( | ) Each term in Bayes’ theorem has a conventional name:
( )

 P(A) is the prior probability or marginal probability of A. It is”prior” in the sense that it
does not take into account any information about B.
 P(Ai|B) is the conditional probability of A, given B. It is also called the posterior
probability because it is derived from or depends upon the specified value of B.
 P(B|A) is the conditional probability of B given A.
 P(B) is the prior or marginal probability of B, and acts as a normalizing constant
 A prior probability is an initial probability value originally obtained before any additional
information is obtained.
 A posterior probability is a probability value that has been revised by using additional
information that is later obtained
Let be a partition of the sample space S and let B be the event associated with S.
Applying the definition of conditional probability, we have
( | ) ( )
( | )
∑ ( | ) ( )
( )
Proof:- ( | ) ( )
but P(A∩B)= P(B∩A)=P(A)P(B|A)
( | ) ( )
=∑ ( | ) ( )

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 Statistics for Economists (Econ2042) 2024/2025

Example 1: An aircraft emergency locator transmitter (ELT) is a device designed to

transmit a signal in the case of a crash. The Altigauge Manufacturing Company
makes 80% of the ELTs, the Bryant Company makes 15% of them, and the Chartair
Company makes the other 5%. The ELTs made by Altigauge have a 4% rate of
defects, the Bryant ELTs have a 6% rate of defects, and the Chartair ELTs have a 9%
rate of defects (which helps to explain why Chartair has the lowest market share).

A. If an ELT is randomly selected from the general population of all ELTs, find
the probability that it was made by the Altigauge Manufacturing Company.
B. If a randomly selected ELT is then tested and is found to be defective, find
the probability that it was made by the Altigauge Manufacturing Company.

Solution: We use the following notation: Let:-

A = ELT manufactured by Altigauge D= ELT is defective
B = ELT manufactured by Bryant = ELT is not defective (or it is good)
C = ELT manufactured by Chartai
A. If an ELT is randomly selected from the general population of all ELTs, the
probability that it was made by Altigauge is 0.8 (because Altigauge manufactures
80% of them).
B. If we now have the additional information that the ELT was tested and was
found to be defective, we want to revise the probability from part (a) so that the
new information can be used. We want to find the value of P(A|D), which is the
probability that the ELT was made by the Altigauge company given that it is
defective. Based on the given information, we know these probabilities:

P(A) = 0.80 because Altigauge makes 80% of the ELTs

P(B) = 0.15 because Bryant makes 15% of the ELTs
P(C) = 0.05 because Chartair makes 5% of the ELTs
P(D|A) = 0.04 because 4% of the Altigauge ELTs are defective
P(D|B) = 0.06 because 6% of the Bryant ELTs are defective
P(D|C) = 0.09 because 9% of the Chart air ELTs are defective
Here is Bayes’ theorem extended to include three events corresponding to the
selection of ELTs from the three manufacturers (A, B, C)
( | ) ( )
P(A|D)=
( | ) ( )
( )
= ( | ) ( ) ( | ) ( ) ( | ) ( )
= =0.703
55

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