Fundamentals Of Business Analytics

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Probability

Module 004 Probability

At the end of this module, you will be able to:
1. Understand the concept of Probability
2. Learn the probability rules
3. Understand the Bayes Theorem

INTRODUCTION: PROBABILITY

Probability is a measure of the relative likelihood of an event happening in the future. One method
of estimation of the likelihood of an event in the future is to use the relative frequency of events in
the past.
When someone tells you the probability of something happening, they are telling you how likely
that something is. When people buy lottery tickets, the probability of winning is usually stated, and
sometimes, it can be something like 1/10,000,000 (or even worse). This tells you that it is not very
likely that you will win.

In notational form:
P(x) = n(x)/n
where n(x) = number of times x happened and n = total number of outcomes (sample size). n(x) is
sometimes simplified as f, where f is used to represent the number of times (frequency) an
outcome:
p=f/n
where p is understood to be a probability of an event (outcome), f is the frequency of that outcome,
and n is the sample size.

PROBABILITY DISTRIBUTIONS

A Random Variable is a set of uncertain outcomes, resulting from an event of a random process.
The set of probabilities (likelihoods) of all outcomes of the random variable is called a probability

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distribution. As an example, consider the demand for a specific model of car next month. It is
uncertain how many cars will be sold; this quantity is considered to be a random variable and the
probabilities associated with each possible quantity of demand constitute the probability
distribution.
A probability distribution is a statistical function that describes all the possible values and
likelihoods that a random variable can take within a given range. This range will be bounded
between the minimum and maximum possible values, but precisely where the possible value is
likely to be plotted on the probability distribution depends on a number of factors. These factors
include the distribution's mean (average), standard deviation, skewness, and kurtosis.

Random variables, and their associated probability distributions, are categorized as either
Discrete or Continuous. For discrete random variables, the probability function that details the
probability distribution is called the probability mass function (pmf). For continuous random
variables the probability function is called the probability density function (pdf). Thus, for a
discrete random variable, the pmf is a single bar of the probability distribution (histogram). For a
continuous variable, the pdf is the height of the continuous probability distribution curve.
Recall that the probability that a random variable, X, has an outcome of x is defined, or calculated,
according to a probability function, f(x).

Probability of x = P(X=x) = f(x) = pmf or pdf

Depending on whether the random variable X is discrete or continuous, respectively.
The probability of a random variable being less than or equal to x is denoted as F(x), and is
referred to as the cumulative density function (cdf).

Probability ≤ x = P(X ≤ x) = F(x) = cdf

= The area under the f(x ) curve to the left of x = The left tail
If f(x) is a continuous function then F(x) is the integral of f(x) from −∞ to x:

Similarly, if f(x) is a continuous function then the compliment, 1 − F(x), is the integral of f(x) from x
to ∞:
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Figure 1. Notation for Probability Distribution

GENERAL PROBABILITY RULES

Table 1. Summary of General Probability Rules

The probability of an event not occurring is called the Complement and is 1 − P(A). Two outcomes
are called disjoint or mutually exclusive if they both cannot happen. For instance, for a single die
roll the outcomes 1 and 2 are disjoint since they both cannot occur. On the other hand, the
outcomes 1 and rolling an odd number are not disjoint since both occur if the outcome of the roll
is a 1.

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Calculating the probability of disjoint outcomes is easy. When rolling a die, the outcomes 1 and 2
are disjoint, and the probability that one of these outcomes will occur can be computed by adding
their separate probabilities as
P(1 or 2) = P(1) + (P(2) = 1/6 + 1/6 = 1/3

What about the probability of rolling a 1, 2, 3, 4, 5, or 6? Here again, all of the outcomes are disjoint
so we add the probabilities:

P(1or 2 or 3 or 4 or 5 or 6)
= P(1) + P(2) + P(3) + P(4) + P(5) + P(6)
= 1/6 + 1/6 + 1/6 + 1/6 + 1/6 + 1/6 = 1
This property is known as The Addition Rule, and guarantees the accuracy of this approach when
the outcomes are disjoint. Thus, in general:
OR = Additive
Two processes are independent if knowing the outcome of one provides no information about the
likelihood of the outcome of the other. For instance, flipping a coin and rolling a die are two
independent processes; knowing the coin was heads does not help determine the outcome of a die
roll. On the other hand, stock prices usually move up or down together, so they are not
independent. Thus, in general:
AND = Multiply

Some further important probability concepts as follows:

The Compliment of outcome x is all of the other outcomes that are not the outcome x. For
example, the complement to P(Heads) is P(Tails) and the complement to rolling a 1 on a single die
is 5/6. Typically, if the probability of the event x, is P(x) = p, then the compliment of the event:
P(x’) = 1-P(x)
or, more compactly
q = 1-p
where q is the compliment of p.

Conditional Probability is a probability that depends upon the occurrence of another event.
Mathematically, the conditional probability of an event, A, is the probability that the event will
occur given the knowledge that event B has already occurred. This probability is written P(A|B)
and is stated as
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Conditional probability is the opposite of independence. In conditional probability the answer is “it
depends” … for independence, “it does not depend.”

EXAMPLE: OR AND PROBABILITIES: THE PROBABILITY OF “SOME” RAIN

The probability of rain, as given in the newspaper, for the next 3 days is 30, 60, and 10%,
respectively. What is the probability of getting some rain?
1. Solve this problem using simulation.
• The spreadsheet shown in Fig. 2 consists of 1000 trials of 3 sequential days of rain or no rain
using the probabilities associated with each day.
2. Solve this problem using theory.
• There are two ways to solve this problem. The shortest way is to first compute the probability
of no rain using the AND rule to multiply to get the joint probability as follows:

P(No Rain) = P(No Rain 1 AND No Rain 2 AND No Rain 3)

= (1-0.30) * (1-0.60) * (1-0.10)
= 0.70 * 0.40 * 0.90
= 0.252
• Second, compute the probability of some rain as the complement of no rain:

P(Some Rain) = 1-P(No Rain)

= 1-0.252
= 0.748
= 74.8%
The most cumbersome way is to first enumerate all the possible 3-day events (outcomes). Next,
use the AND rule to compute the joint probability for each 3-day event—multiply the appropriate
probabilities to compute the probabilities for each possible outcome.
For example,
P(Rain all 3 days) = P(Rain 1 AND Rain 2 AND Rain 3)
= 0.30*0.60*0.10
= 1.8%
P(Rain on day 3 only) = P(No Rain 1 AND No Rain 2 AND Rain 3)
= 0.70*0.40*0.10
= 2.8%
Finally, use the OR rule to add them together as in Fig. 3.
Problems of this sort are typically solved using probability notation and equations to provide an
exact solution. But, the ease of solving this problem with simulation and the ability to explain the
simulation to others demonstrates the power of simulation.
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 Figure 2. One Thousand Trials of 3 Days of Weather

Figure 3. Theoretical Solution for the Probability of “Some” Rain Example

CONDITIONAL PROBABILITY AND BAYES’ THEOREM

Bayes' theorem, named after 18th-century British mathematician Thomas Bayes, is a
mathematical formula for determining conditional probability. Conditional probability is the
likelihood of an outcome occurring, based on a previous outcome occurring. Bayes' theorem
provides a way to revise existing predictions or theories (update probabilities) given new or
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additional evidence. In finance, Bayes' theorem can be used to rate the risk of lending money to
potential borrowers.

Bayes' theorem is also called Bayes' Rule or Bayes' Law and is the foundation of the field of
Bayesian statistics.
Applications of the theorem are widespread and not limited to the financial realm. As an example,
Bayes' theorem can be used to determine the accuracy of medical test results by taking into
consideration how likely any given person is to have a disease and the general accuracy of the test.
Bayes' theorem relies on incorporating prior probability distributions in order to generate
posterior probabilities. Prior probability, in Bayesian statistical inference, is the probability of an
event before new data is collected. This is the best rational assessment of the probability of an
outcome based on the current knowledge before an experiment is performed. Posterior
probability is the revised probability of an event occurring after taking into consideration new
information. Posterior probability is calculated by updating the prior probability by using Bayes'
theorem. In statistical terms, the posterior probability is the probability of event A occurring given
that event B has occurred.

Bayes' theorem thus gives the probability of an event based on new information that is, or may be
related, to that event. The formula can also be used to see how the probability of an event
occurring is affected by hypothetical new information, supposing the new information will turn
out to be true. For instance, say a single card is drawn from a complete deck of 52 cards. The
probability that the card is a king is four divided by 52, which equals 1/13 or approximately
7.69%. Remember that there are four kings in the deck. Now, suppose it is revealed that the
selected card is a face card. The probability the selected card is a king, given it is a face card, is four
divided by 12, or approximately 33.3%, as there are 12 face cards in a deck.

Where:
P(A)= The probability of A occurring
P(B)= The probability of B occurring
P(A∣B)=The probability of A given B
P(B∣A)= The probability of B given A
P(A⋂B))= The probability of both A and B occurring

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 EXAMPLES OF BAYES' THEOREM
Below are two examples of Bayes' theorem in which the first example shows how the formula can
be derived in a stock investing example using Amazon.com Inc. (AMZN). The second example
applies Bayes' theorem to pharmaceutical drug testing.

Deriving the Bayes' Theorem Formula

Bayes' theorem follows simply from the axioms of conditional probability. Conditional probability is
the probability of an event given that another event occurred. For example, a simple probability
question may ask: "What is the probability of Amazon.com's stock price falling?" Conditional
probability takes this question a step further by asking: "What is the probability of AMZN stock
price falling given that the Dow Jones Industrial Average (DJIA) index fell earlier?"

The conditional probability of A given that B has happened can be expressed as:
• If A is: "AMZN price falls" then P(AMZN) is the probability that AMZN falls; and B is: "DJIA is already
down," and P(DJIA) is the probability that the DJIA fell; then the conditional probability expression
reads as "the probability that AMZN drops given a DJIA decline is equal to the probability that
AMZN price declines and DJIA declines over the probability of a decrease in the DJIA index.

• P(AMZN|DJIA) = P(AMZN and DJIA) / P(DJIA)

P(AMZN and DJIA) is the probability of both A and B occurring. This is also the same as the
probability of A occurring multiplied by the probability that B occurs given that A occurs, expressed
as P(AMZN) x P(DJIA|AMZN). The fact that these two expressions are equal leads to Bayes' theorem,
which is written as:
• if, P(AMZN and DJIA) = P(AMZN) x P(DJIA|AMZN) = P(DJIA) x P(AMZN|DJIA)
• then, P(AMZN|DJIA) = [P(AMZN) x P(DJIA|AMZN)] / P(DJIA).

Where P(AMZN) and P(DJIA) are the probabilities of Amazon and the Dow Jones falling, without
regard to each other.
The formula explains the relationship between the probability of the hypothesis before seeing the
evidence that P(AMZN), and the probability of the hypothesis after getting the evidence
P(AMZN|DJIA), given a hypothesis for Amazon given evidence in the Dow.

Numerical Example Of Bayes' Theorem

As a numerical example, imagine there is a drug test that is 98% accurate, meaning 98% of the time
it shows a true positive result for someone using the drug and 98% of the time it shows a true
negative result for nonusers of the drug. Next, assume 0.5% of people use the drug. If a person
selected at random tests positive for the drug, the following calculation can be made to see whether
the probability the person is actually a user of the drug.
(0.98 x 0.005) / [(0.98 x 0.005) + ((1 - 0.98) x (1 - 0.005))] = 0.0049 / (0.0049
+ 0.0199) = 19.76%

Bayes' theorem shows that even if a person tested positive in this scenario, it is
actually much more likely the person is not a user of the drug.
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Books and Journals

Pinder, J. (2017). Introduction to Business Analytics Using Simulation, 125 London Wall, London EC2Y 5AS,
United Kingdom

Schniederjans, M. (2017), Business Analytics Principles, Concepts, and Applications, Pearson Education, Inc,
Upper Saddle River, New Jersey 07458

Online Reference:
https://www.investopedia.com/
https://www.managementstudyguide.com/
https://courses.lumenlearning.com/
https://machinelearningmastery.com/what-is-probability/

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