Chapter 4

Introduction to Probability

Experiments, Counting Rules, and

Assigning Probabilities
Events and Their Probability
Some Basic Relationships of Probability
Conditional Probability
Bayes’ Theorem
 Probability

Probability is a numerical measure of the likelihood

that an event will occur.
Probability values are always assigned on a scale from
0 to 1.
A probability near 0 indicates an event is very unlikely
to occur.
A probability near 1 indicates an event is almost
certain to occur.
A probability of 0.5 indicates the occurrence of the
event is just as likely as it is unlikely.
 Probability as a Numerical Measure
of the Likelihood of Occurrence

Increasing Likelihood of Occurrence

0 .5 1
Probability:

The occurrence of the event is

just as likely as it is unlikely.
 An Experiment and Its Sample Space

An experiment is any process that generates well-

defined outcomes.

The sample space for an experiment is the set of all

experimental outcomes.

A sample point is an element of the sample space, any

one particular experimental outcome.
 Example: Bradley Investments

Bradley has invested in two stocks, Markley Oil and

Collins Mining. Bradley has determined that the
possible outcomes of these investments three months
from now are as follows.
Investment Gain or Loss
in 3 Months (in $000)
Markley Oil Collins Mining
10 8
5 -2
0
-20
 A Counting Rule for
Multiple-Step Experiments
If an experiment consists of a sequence of k steps in
which there are n1 possible results for the first step, n2
possible results for the second step, and so on, then
the total number of experimental outcomes is given
by (n1)(n2) . . . (nk).
A helpful graphical representation of a multiple-step
experiment is a tree diagram.
 Example: Bradley Investments

A Counting Rule for Multiple-Step Experiments

Bradley Investments can be viewed as a two-step
experiment; it involves two stocks, each with a set of
experimental outcomes.
Markley Oil: n1 = 4
Collins Mining: n2 = 2
Total Number of
Experimental Outcomes: n1n2 = (4)(2) = 8
 Example: Bradley Investments

Tree Diagram
Markley Oil Collins Mining Experimental
(Stage 1) (Stage 2) Outcomes
Gain 8 (10, 8) Gain $18,000
(10, -2) Gain $8,000
Lose 2
Gain 10 Gain 8 (5, 8) Gain $13,000

Lose 2 (5, -2) Gain $3,000

Gain 5
Gain 8
(0, 8) Gain $8,000
Even
Lose 2 (0, -2) Lose $2,000
Lose 20 Gain 8
(-20, 8) Lose $12,000
Lose 2 (-20, -2) Lose $22,000
 Counting Rule for Combinations

Another useful counting rule enables us to count the

number of experimental outcomes when n objects are to
be selected from a set of N objects.
Number of combinations of N objects taken n at a
time
 N N!
CnN   
 n  n !(N  n )!

where N! = N(N - 1)(N - 2) . . . (2)(1)

n! = n(n - 1)( n - 2) . . . (2)(1)
0! = 1
 Counting Rule for Permutations

A third useful counting rule enables us to count the

number of experimental outcomes when n objects are to
be selected from a set of N objects where the order of
selection is important.
Number of permutations of N objects taken n at a time
 N N!
PnN  n !  
 n  (N  n )!
 Assigning Probabilities

Classical Method
Assigning probabilities based on the assumption
of equally likely outcomes.
Relative Frequency Method
Assigning probabilities based on experimentation
or historical data.
Subjective Method
Assigning probabilities based on the assignor’s
judgment.
 Classical Method

If an experiment has n possible outcomes, this method

would assign a probability of 1/n to each outcome.
Example
Experiment: Rolling a die
Sample Space: S = {1, 2, 3, 4, 5, 6}
Probabilities: Each sample point has a 1/6 chance
of occurring.
 Example: Lucas Tool Rental

Relative Frequency Method

Lucas would like to assign probabilities to the
number of floor polishers it rents per day. Office
records show the following frequencies of daily rentals
for the last 40 days.
Number of Number
Polishers Rented of Days
0 4
1 6
2 18
3 10
4 2
 Example: Lucas Tool Rental

Relative Frequency Method

The probability assignments are given by dividing
the number-of-days frequencies by the total frequency
(total number of days).

Number of Number
Polishers Rented of Days Probability
0 4 .10 = 4/40
1 6 .15 = 6/40
2 18 .45 etc.
3 10 .25
4 2 .05
40 1.00
 Subjective Method

When economic conditions and a company’s

circumstances change rapidly it might be
inappropriate to assign probabilities based solely on
historical data.
We can use any data available as well as our
experience and intuition, but ultimately a probability
value should express our degree of belief that the
experimental outcome will occur.
The best probability estimates often are obtained by
combining the estimates from the classical or relative
frequency approach with the subjective estimates.
 Example: Bradley Investments

Applying the subjective method, an analyst

made the following probability assignments.
Exper. Outcome Net Gain/Loss Probability
( 10, 8) $18,000 Gain .20
( 10, -2) $8,000 Gain .08
( 5, 8) $13,000 Gain .16
( 5, -2) $3,000 Gain .26
( 0, 8) $8,000 Gain .10
( 0, -2) $2,000 Loss .12
(-20, 8) $12,000 Loss .02
(-20, -2) $22,000 Loss .06
 Events and Their Probability

An event is a collection of sample points.

The probability of any event is equal to the sum of
the probabilities of the sample points in the event.
If we can identify all the sample points of an
experiment and assign a probability to each, we can
compute the probability of an event.
 Example: Bradley Investments

Events and Their Probabilities

Event M = Markley Oil Profitable

M = {(10, 8), (10, -2), (5, 8), (5, -2)}
P(M) = P(10, 8) + P(10, -2) + P(5, 8) + P(5, -2)
= .2 + .08 + .16 + .26
= .70
Event C = Collins Mining Profitable
P(C) = .48 (found using the same logic)
 Some Basic Relationships of Probability

There are some basic probability relationships that

can be used to compute the probability of an event
without knowledge of all the sample point
probabilities.
– Complement of an Event
– Union of Two Events
– Intersection of Two Events
– Mutually Exclusive Events
 Complement of an Event

The complement of event A is defined to be the event

consisting of all sample points that are not in A.
The complement of A is denoted by Ac.
The Venn diagram below illustrates the concept of a
complement. Sample Space S

Event A Ac
 Union of Two Events

The union of events A and B is the event containing all

sample points that are in A or B or both.
The union is denoted by A B
The union of A and B is illustrated below.
Sample Space S

Event A Event B
 Example: Bradley Investments

Union of Two Events

Event M = Markley Oil Profitable

Event C = Collins Mining Profitable
M C = Markley Oil Profitable
or Collins Mining Profitable
M C = {(10, 8), (10, -2), (5, 8), (5, -2), (0, 8), (-20, 8)}
P(M C) = P(10, 8) + P(10, -2) + P(5, 8) + P(5, -2)
+ P(0, 8) + P(-20, 8)
= .20 + .08 + .16 + .26 + .10 + .02
= .82
 Intersection of Two Events

The intersection of events A and B is the set of all

sample points that are in both A and B.
The intersection is denoted by A 
The intersection of A and B is the area of overlap in the
illustration below.
Sample Space S
Intersection

Event A Event B
 Example: Bradley Investments

Intersection of Two Events

Event M = Markley Oil Profitable

Event C = Collins Mining Profitable
M C = Markley Oil Profitable
and Collins Mining Profitable

M C = {(10, 8), (5, 8)}

P(M C) = P(10, 8) + P(5, 8)
= .20 + .16
= .36
 Addition Law

The addition law provides a way to compute the

probability of event A, or B, or both A and B
occurring.
The law is written as:

P(A B) = P(A) + P(B) - P(A  B

 Example: Bradley Investments

Addition Law

Markley Oil or Collins Mining Profitable

We know: P(M) = .70, P(C) = .48, P(M C) = .36
Thus: P(M  C) = P(M) + P(C) - P(M  C)
= .70 + .48 - .36
= .82
This result is the same as that obtained earlier using
the definition of the probability of an event.
 Mutually Exclusive Events

Two events are said to be mutually exclusive if the

events have no sample points in common. That is,
two events are mutually exclusive if, when one event
occurs, the other cannot occur.
Sample
Space S
Event A Event B
 Mutually Exclusive Events

Addition Law for Mutually Exclusive Events

P(A B) = P(A) + P(B)

 Conditional Probability

The probability of an event given that another event

has occurred is called a conditional probability.
The conditional probability of A given B is denoted
by P(A|B).
A conditional probability is computed as follows:
P( A  B)
P ( A| B ) 
P( B)
 Example: Bradley Investments

Conditional Probability

Collins Mining Profitable given

Markley Oil Profitable

P (C  M ) . 36
P (C | M )   . 51
P( M ) . 70
 Multiplication Law

The multiplication law provides a way to compute

the probability of an intersection of two events.
The law is written as:

P(A  B) = P(B)P(A|B)

Similarly,
P(A  B) = P(A)P(B|A)
 Example: Bradley Investments

Multiplication Law

Markley Oil and Collins Mining Profitable

We know: P(M) = .70, P(C|M) = .51
Thus: P(M  C) = P(M)P(M|C)
= (.70)(.51)
= .36
This result is the same as that obtained earlier
using the definition of the probability of an event.
 Independent Events

Events A and B are independent if P(A|B) = P(A).

Multiplication Law for Independent Events

P(A  B) = P(A)P(B)

The multiplication law also can be used as a test to see

if two events are independent.
 Example: Bradley Investments

Multiplication Law for Independent Events

Are M and C independent?

DoesP(M  C) = P(M)P(C) ?

We know: P(M  C) = .36, P(M) = .70, P(C) = .48

But: P(M)P(C) = (.70)(.48) = .34
.34soM and C are not independent.
 Bayes’ Theorem

Often we begin probability analysis with initial or

prior probabilities.
Then, from a sample, special report, or a product test
we obtain some additional information.
Given this information, we calculate revised or
posterior probabilities.
Bayes’ theorem provides the means for revising the
prior probabilities.
Application
Application
Prior New
New Posterior
Posterior
of
of Bayes’
Bayes’
Probabilities
Probabilities Information
Information Probabilities
Probabilities
Theorem
 Example: L. S. Clothiers

A proposed shopping center will provide strong

competition for downtown businesses like L. S.
Clothiers. If the shopping center is built, the owner
of L. S. Clothiers feels it would be best to relocate.
The shopping center cannot be built unless a
zoning change is approved by the town council. The
planning board must first make a recommendation,
for or against the zoning change, to the council. Let:
A1 = town council approves the zoning change
A2 = town council disapproves the change
Prior Probabilities
Using subjective judgment: P(A1) = .7, P(A2) = .3
 Example: L. S. Clothiers

New Information
The planning board has recommended against the
zoning change. Let B denote the event of a negative
recommendation by the planning board.
Given that B has occurred, should L. S. Clothiers
revise the probabilities that the town council will
approve or disapprove the zoning change?
Conditional Probabilities
Past history with the planning board and the town
council indicates the following:
P(B|A1) = .2 P(B|A2) = .9
 Example: L. S. Clothiers

Tree Diagram

P(B|A1) = .2 P(A1  B) = .14

P(A1) = .7
P(Bc|A1) = .8 P(A1  Bc) = .56

P(B|A2) = .9 P(A2  B) = .27

P(A2) = .3

P(Bc|A2) = .1 P(A2  Bc) = .03

 Bayes’ Theorem

To find the posterior probability that event Ai will

occur given that event B has occurred we apply Bayes’
theorem.
P ( Ai ) P ( B| Ai )
P ( Ai | B ) 
P ( A1 ) P ( B| A1 )  P ( A2 ) P ( B| A2 ) ...  P ( An ) P ( B| An )

Bayes’ theorem is applicable when the events for

which we want to compute posterior probabilities are
mutually exclusive and their union is the entire
sample space.
 Example: L. S. Clothiers

Posterior Probabilities
Given the planning board’s recommendation not to
approve the zoning change, we revise the prior
probabilities as follows.
P ( A1 ) P ( B| A1 ) (. 7 )(. 2 )
P ( A1| B )  
P ( A1 ) P ( B| A1 )  P ( A2 ) P ( B| A2 ) (. 7)(. 2 )  (. 3)(. 9)
= .34
Conclusion
The planning board’s recommendation is good news
for L. S. Clothiers. The posterior probability of the
town council approving the zoning change is .34
versus a prior probability of .70.
 Tabular Approach

Step 1 Prepare the following three columns:

Column 1 - The mutually exclusive events for which
posterior probabilities are desired.
Column 2 - The prior probabilities for the events.
Column 3 - The conditional probabilities of the new
information given each event.
 Tabular Approach

(1) (2) (3) (4) (5)

Prior Conditional
Events Probabilities Probabilities
Ai P(Ai) P(B|Ai)

A1 .7 .2
A2 .3 .9
1.0
 Tabular Approach

Step 2 In column 4, compute the joint probabilities

for each event and the new information B by using the
multiplication law.
Multiply the prior probabilities in column 2 by
the corresponding conditional probabilities in column
3. That is, P(Ai B) = P(Ai) P(B|Ai).
 Tabular Approach

(1) (2) (3) (4) (5)

Prior Conditional Joint
Events Probabilities Probabilities Probabilities
Ai P(Ai) P(B|Ai) P(Ai B)

A1 .7 .2 .14
A2 .3 .9 .27
1.0
 Tabular Approach

Step 3 Sum the joint probabilities in column 4. The

sum is the probability of the new information P(B).
We see that there is a .14 probability of the
town council approving the zoning change and a
negative recommendation by the planning board.
There is a .27 probability of the town council
disapproving the zoning change and a negative
recommendation by the planning board.
The sum .14 + .27 shows an overall probability
of .41 of a negative recommendation by the planning
board.
 Tabular Approach

(1) (2) (3) (4) (5)

Prior Conditional Joint
Events Probabilities Probabilities Probabilities
Ai P(Ai) P(B|Ai) P(Ai B)

A1 .7 .2 .14
A2 .3 .9 .27
1.0 P(B) = .41
 Tabular Approach

Step 4 In column 5, compute the posterior

probabilities using the basic relationship of conditional
probability.
P ( Ai  B )
P ( Ai | B ) 
P( B)

Note that the joint probabilities P(Ai B) are in

column 4 and the probability P(B) is the sum of column 4.
 Tabular Approach

(1) (2) (3) (4) (5)

Prior Conditional Joint Posterior
Events Probabilities Probabilities Probabilities Probabilities
Ai P(Ai) P(B|Ai) P(Ai B) P(Ai |B)

A1 .7 .2 .14 .3415
A2 .3 .9 .27 .6585
1.0 P(B) = .41 1.0000
End of Chapter 4