 Probability is the likelihood that an outcome

occurs. Probabilities are expressed as values

between 0 and 1.
 An experiment is the process that results in an
outcome.
 The outcome of an experiment is a result that
we observe.
 The sample space is the collection of all
possible outcomes of an experiment.
Probabilities may be defined from one of three
perspectives:
 Classical definition: probabilities can be deduced
from theoretical arguments
 Relative frequency definition: probabilities are
based on empirical data
 Subjective definition: probabilities are based on
judgment and experience
Roll 2 dice
 36 possible rolls (1,1), (1,2),…(6,5), (6,6)

 Probability = number of ways of rolling a number

divided by 35; e.g., probability of a 3 is 2/36
Suppose two consumers try a new product.
 Four outcomes:
1. like, like
2. like, dislike
3. dislike, like
4. dislike, dislike
 Probability at least one dislikes product = 3/4
 Use relative frequencies as probabilities
 Probability a computer is repaired in 10 days = 0.076
 Label the n outcomes in a sample space as O1, O2, …,
On, where Oi represents the ith outcome in the sample
space. Let P(Oi) be the probability associated with the
outcome Oi.
 The probability associated with any outcome must be
between 0 and 1.
0 ≤ P(Oi) ≤ 1 for each outcome Oi (5.1)
 The sum of the probabilities over all possible outcomes
must be equal to 1.
P(O1) + P(O2) + … + P(On) = 1 (5.2)
 An event is a collection of one or more
outcomes from a sample space.
 Rule 1. The probability of any event is the sum of
the probabilities of the outcomes that comprise
that event.
Consider the events:
 Rolling 7 or 11 on two dice
Probability = 6/36 + 2/36 = 8/36.
 Repair a computer in 7 days or less
Probability =
= O1 + O2 + O3 + O4 + O5 + O6 + O7
= 0 + 0 + 0 + 0 + .004 + .008 + .020
= 0.032
 If A is any event, the complement of A, denoted
Ac, consists of all outcomes in the sample space
not in A.
 Rule 2. The probability of the complement of any
event A is P(Ac) = 1 – P(A).
Dice example:
 A = {7, 11}
P(A) = 8/36
 Ac = {2, 3, 4, 5, 6, 8, 9, 10, 12}
 Using Rule 2:
P(Ac) = 1 − 8/36 = 28/36
 The union of two events contains all outcomes
that belong to either of the two events.
◦ If A and B are two events, the probability that some
outcome in either A or B (that is, the union of A and B)
occurs is denoted as P(A or B).
 Two events are mutually exclusive if they have no
outcomes in common.
 Rule 3. If events A and B are mutually exclusive,
then P(A or B) = P(A) + P(B).
Dice Example:
 A = {7, 11}: P(A) = 8/36
 B = {2, 3, 12}: P(B) = 4/36
 P(A or B) = Union of events A and B
= P(A) + P(B)
= 8/36 + 4/36 = 12/36
 The notation (A and B) represents the intersection of
events A and B – that is, all outcomes belonging to
both A and B .
 Rule 4. If two events A and B are not mutually
exclusive, then P(A or B) = P(A)+ P(B) - P(A and B).
Dice Example:
 A = {2, 3, 12}: P(A) = 4/36
 B = {even number} : P(B) = 18/36
 (A and B) = {2, 12}: P(A and B) = 2/36
 P(A or B) = P(A) + P(B)− P(A and B)
= 4/36 + 18/36− 2/36
= 20/36
 The probability of the intersection of two events is
called a joint probability.
 The probability of an event, irrespective of the
outcome of the other joint event, is called a
marginal probability.
 A sample of 100 individuals were asked to evaluate their preference for
three new proposed energy drinks in a blind taste test.
 The sample space consists of two types of outcomes corresponding to each
individual: gender (F = female or M = male) and brand preference (B1, B2,
or B3).
 Define a new sample space consisting of the outcomes that reflect the
different combinations of outcomes from these two sample spaces.
◦ O1 = the respondent is female and prefers brand 1
◦ O2 = the respondent is female and prefers brand 2
◦ O3 = the respondent is female and prefers brand 3
◦ O4 = the respondent is male and prefers brand 1
◦ O5 = the respondent is male and prefers brand 2
◦ O6 = the respondent is male and prefers brand 3
 The probability of each of these events is the intersection of the gender and
brand preference event. For example, P(O1) = P(F and B1)
 Energy Drink Survey
 The joint probabilities of gender and brand preference
are calculated by dividing the number of respondents
corresponding to each of the six outcomes listed above
by the total number of respondents, 100.
◦ E.g., P(F and B1) = P(O1) = 9/100 = 0.09

Joint
probabilities
 The marginal probabilities for gender and brand
preference are calculated by adding the joint
probabilities across the rows and columns
◦ E.g., the event F, (respondent is female) is comprised of the
outcomes O1, O2, and O3, and therefore P(F) = P(F and B1) +
P(F and B2) + P(F and B3) = 0.37

Marginal
probabilities
 Calculations of marginal probabilities leads to the
following probability rule:

 Rule 5. If event A is comprised of the outcomes

{A1, A2, …, An} and event B is comprised of the
outcomes {B1, B2, …, Bn}, then

P(Ai) = P(Ai and B1) + P(Ai and B2) + … + P(Ai and Bn)
 Events F and M are mutually exclusive, as are events B1, B2, and B3
since a respondent may be only male or female and prefer exactly
one of the three brands. We can use Rule 3 to find, for example,
P(B1 or B2) = 0.34 + 0.23 = 0.57.
 Events F and B1, however, are not mutually exclusive because a
respondent can be both female and prefer brand 1. Therefore, using
Rule 4, we have P(F or B1) = P(F) + P(B1) – P(F and B1) = 0.37 +
0.34 – 0.09 = 0.62.
 Conditional probability is the probability of
occurrence of one event A, given that another
event B is known to be true or has already
occurred.
 Suppose we know a respondent is male. What is the probability that
he prefers Brand 1?
 Using cross-tabulation: Of 63 males, 25 prefer Brand 1, so the
probability of preferring Brand 1 given that a respondent is male =
25/63
 Using joint probability table: divide the joint probability 0.25 (the
probability that the respondent is male and prefers brand 1) by the
marginal probability 0.63 (the probability that the respondent is male).
 Apple Purchase History
 The PivotTable shows the count of the
type of second purchase given that
each product was purchased first.
 Probability of purchasing an
iPad given that a customer already
purchased an iMac = 2/13
 The conditional probability of an event A given
that event B is known to have occurred is

 We read the notation P(A|B) as “the probability of

A given B.”
 P(B1|M) = P(B1 and M)/ P(M) = (0.25)/(0.63) = 0.397

 P(B1|F) = P(B1 and F)/ P(F) = (0.09)/(0.37) = 0.243

 Summary of conditional probabilities:

 Applications in marketing and advertising.

 P(A and B) = P(A | B) P(B)
 P(B and A) = P(B | A) P(A)
◦ Note: P(A and B) = P(B and A)

 Multiplication law of probability:

 Suppose B1, B2, . . . , Bn are mutually exclusive
events whose union comprises the entire sample
space. Then
 “Texas Hold ‘Em” Poker
 Probability of pocket aces (two aces in hand)
 A1 = Ace on first card; A2 = Ace on second card
 P(A1 and A2) = P(A2|A1) P(A1)
= (3/51) (4/52)
= 0.004525
 Two events A and B are independent if
P(A | B) = P(A).
 Energy Drink Survey example: the probability of
preferring a brand depends on gender.
 Thus, we may say that brand preference and
gender are not independent.
 Are Gender and Brand Preference Independent?
 P(B1) = 0.34

 P(B1|M) = 0.397

 Because 0.397 ≠ 0.34, Gender and Brand Preference

are not independent.
 If two events are independent, then we can
simplify the multiplication law of probability in
equation (5.4)

 by substituting P(A) for P(A | B):

Dice Rolls:
 Rolling pairs of dice are independent events since
they do not depend on the previous rolls.
 A = {roll a sum of 6 on first roll}
 B = {roll a sum of 2, 3, or 12 on second roll}
 Using formula (5.5): P(A and B) = P(A) P(B)
= (5/36) (4/36) = 0.0154
 A random variable is a numerical description of
the outcome of an experiment.
 A discrete random variable is one for which the
number of possible outcomes can be counted.
 A continuous random variable has outcomes
over one or more continuous intervals of real
numbers.
Examples of discrete random variables:
 outcomes of dice rolls
 whether a customer likes or dislikes a product
 number of hits on a Web site link today
Examples of continuous random variables:
 weekly change in DJIA
 daily temperature
 time between machine failures
 A probability distribution is a characterization of
the possible values that a random variable may
assume along with the probability of assuming
these values.
 We may develop a probability distribution using
any one of the three perspectives of probability:
classical, relative frequency, and subjective.
 We can calculate the relative frequencies from a sample
of empirical data to develop a probability distribution.
Because this is based on sample data, we usually call
this an empirical probability distribution.
 An empirical probability distribution is an approximation
of the probability distribution of the associated random
variable, whereas the probability distribution of a random
variable, such as one derived from counting arguments,
is a theoretical model of the random variable.
 We could simply specify a probability distribution
using subjective values and expert judgment.
 This is often done in creating decision models for
phenomena for which we have no historical data.
 Distribution of an expert’s assessment of how the
DJIA might change next year.
 For a discrete random variable X, the probability
distribution of the discrete outcomes is called a
probability mass function and is denoted by a
mathematical function, f(x).
◦ The symbol xi represents the ith value of the random
variable X and f(xi) is the probability.
 Properties:
◦ the probability of each outcome must be between 0 and 1
◦ the sum of all probabilities must add to 1
 xi = values of the random variable X, which
represents sum of the rolls of two dice
◦ x1 = 2, x2 = 3, …, x10 = 11, x11 = 12
 f(x1) = 1/36 = 0.0278; f(x2) = 2/36 = 0.0556, etc.
 A cumulative distribution function, F(x), specifies
the probability that the random variable X
assumes a value less than or equal to a specified
value, x; that is,
F(x) = P(X ≤ x)
 Probability of rolling a 6 or less = F(6) = 0.1667
 Probability of rolling between 4 and 8:

= P(4 ≤ X ≤ 8) = P(3 < X ≤ 8) = P(X ≤ 8) – P(X ≤ 3)

= 0.7222 – 0.0833 = 0.6389
 The expected value of a random variable
corresponds to the notion of the mean, or
average, for a sample.
 For a discrete random variable X, the expected
value, denoted E[X], is the weighted average of all
possible outcomes, where the weights are the
probabilities:
 Rolling two dice
◦ E[X] = 2(0.0278) + 3(0.0556) + 4(0.0833) + 5(0.1111) +
6(0.1389) + 7(0.1667) + 8(0.1389) + 9(0.1111) +
10(0.0833) + 11(0.0556) + 12(0.0278) = 7
The Apprentice
 Teams were required to select an artist (mainstream or avant-garde)
and sell their art for the most money possible. A back-of-the-
envelope expected value calculation would have easily predicted
the winner.
Deal or No Deal
 Contestant had 5 briefcases left with $100, $400, $1000, $50,000 or
$300,000 in them.
 Expected value of briefcases is $70,300.

 Banker offered contestant $80,000 to quit, which was higher than

the expected value. The probability of choosing the $300,000
briefcase was only 0.2, so the decision should have been easy to
make.
 The expected value is a “long-run average” and is
appropriate for decisions that occur on a repeated
basis.
 For one-time decisions, however, you need to
consider the downside risk and the upside
potential of the decision.
 Cost of raffle ticket is $50
 1000 raffle tickets are sold.
 Winning prize is $25,000
 E[X] = −$25
 If you played this game repeatedly over the long run, you
would lose an average of $25.00 each time you play.
 For any one game, you would either lose $50 or win
$24,950.
◦ Is the risk of losing $50 worth the potential of winning $24,950?
 Full and discount airfares are available for a flight.
 Full-fare ticket costs $560
 Discount ticket costs $400
 X = ticket price paid
 p = 0.75 (the probability of selling a full-fare ticket)
 E[X] = 0.75($560) + 0.25(0) = $420

 The airline should not discount full-fare tickets

because the expected value of a full-fare ticket is
greater than the cost of a discount ticket.
 Break-even point: $400 = p($560) or p = 0.714
 The variance, Var[X ], of a discrete random
variable X is a weighted average of the squared
deviations from the expected value:
 Rolling two dice
 Two possible outcomes, “success” and “failure,” each
with a constant probability of occurrence; p is the
probability of a success and 1 – p is the probability of a
failure
 Typically, x = 1 represents “success” and x = 0
represents “failure”
 Probability mass function:

 E[X] = p
 Var[X] = p(1 − p)
 The Bernoulli distribution can be used to model whether
an individual responds positively (x = 1), or negatively
(x = 0) to a telemarketing promotion.
 For example, if you estimate that 20% of customers
contacted will make a purchase, the probability
distribution that describes whether or not a particular
individual makes a purchase is Bernoulli with p = 0.2
 Models n independent replications of a Bernoulli experiment, each
with a probability p of success.
◦ X represents the number of successes in these n experiments
 Probability mass function:

 The number of ways of choosing x distinct items from a group of n

items and is

where n! (n factorial) = n(n - 1)(n - 2) . . . (2)(1), and 0! is defined as 1.

 Expected value = np; variance = np(1 – p)
 Suppose 10 individuals receive a telemarking promotion. Each
individual has a 0.2 probability of making a purchase. Find the
probability that exactly 3 of the 10 individuals make a purchase.
 The probability distribution that x individuals out of 10 calls will make
a purchase is:

 Excel function:
=BINOM.DIST(number_s, trials, probability_s, cumulative)
 If cumulative is set to TRUE, then this function will provide
cumulative probabilities; otherwise the default is FALSE, and it
provides values of the probability mass function, f(x).
 The probability that exactly 3 of 10 individuals will make
a purchase is P(x = 3): =BINOM.DIST(3,10,0.2,TRUE) =
0.20133
 The probability that 3 or fewer of 10 individuals will make
a purchase is P(x ≤ 3): =BINOM.DIST(3,10,0.2,FALSE)
= 0.87913
  The binomial distribution is symmetric when
p = 0.5; positively skewed when p < 0.5,
and negatively skewed when p > 0.5.

Example of
negatively-skewed
distribution
 Models the number of occurrences in some unit of
measure (often time or distance).
 There is no limit on the number of occurrences.
 The average number of occurrence per unit is a constant
denoted as λ.
 Probability mass function:

 Expected value = λ; variance = λ

 Suppose the average number of customers arriving at a
Subway restaurant during lunch hour is λ =12 per hour.
 The probability that exactly x customers arrive during the
hour is given by the Poisson distribution with a mean of
12.

 Excel function: =POISSON.DIST(x, mean, cumulative)

 With l = 12, the probability that X = 1 is
=POISSON.DIST(A7,$B$3,FALSE) = 0.00007
 The probability that X ≤ 4 is
=POISSON.DIST(A10,$B$3,TRUE) = 0.00760
 A probability density function is a mathematical
function that characterizes a continuous random variable
 Properties
 f(x) ≥ 0 for all values of x
 Total area under the density function equals 1.
 P(X = x) = 0
 Probabilities are only defined over intervals.
 P(a ≤ X ≤ b) is the area under the density function between
a and b.
 The uniform distribution characterizes a continuous
random variable for which all outcomes between a
minimum (a) and a maximum (b) are equally likely.
 Density function:

 Cumulative distribution function:

 Expected value = (a + b)/2; variance = (b – a)2/12

 Sales revenue for a product varies uniformly each week between
$1000 and $2000.
 Probability that sales revenue will be less than x = $1,300.
◦ F(1,300) = (1,300 - 1,000) / (2,000 - 1,000) = 0.30

 Probability that revenue will be between $1,500 and $1,700.

◦ P(1,500 ≤ X ≤ 1,700) = P(X ≤ 1,700) - P(X ≤ 1,500) = F(1,700) - F(1,500)
= F(1,700) - F(1,500) = 0.7 – 0.5 = 0.2
 A variation of the uniform distribution is one for
which the random variable is restricted to integer
values between a and b (also integers); this is
called a discrete uniform distribution.
◦ Example: roll of a single die. Each of the numbers 1
through 6 have a 1/6 probability of occurrence.
 f(x) is a bell-shaped curve
 Characterized by 2 parameters:
 (mean)
 (standard deviation)
 Properties
1. Symmetric
2. Mean = Median = Mode
3. Range of X is unbounded
4. Empirical rules apply
Excel function:
=NORM.DIST(x, mean, standard_deviation, cumulative).
◦ NORM.DIST(x, mean, standard_deviation, TRUE) calculates the
cumulative probability
◦ If cumulative is set to FALSE, the function simply calculates the
value of the density function f(x), which has little practical
application.
 The distribution for customer demand (units per month) is normal
with mean = 750 and standard deviation = 100
 Find the probability that demand will be:
1. at most 900 units/month
2. exceed 700 units/month
3. be between 700 and 900 units/month
 Probability that demand will be at most 900 units,
or P(X ≤ 900):
◦ =NORM.DIST(900,750,100,TRUE) = 0.9332.
 Probability that demand will exceed 700 units, or P(X >
700).
◦ =1-NORM.DIST(700,750,100,TRUE) = 1 - 0.3085 = 0.6915
 Probability that demand will be between 700 and 900, or
P(700 < X < 900):
◦ =NORM.DIST(900,750,100,TRUE) -
NORM.DIST(700,750,100,TRUE) =0.9332 - 0.3085 = 0.6247
Normal Inverse function:
=NORM.INV(probability, mean, stdev)
provides the x value with F(x) = probability
 What level of demand would be exceeded at most
10% of the time?
 Find x such that F(x) = 0.90:
= NORM.INV(0.90, 750, 100) = 878.155
 A standard normal distribution is a normal distribution
with a mean of 0 and standard deviation of 1.
◦ A standard normal random variable is denoted by Z.
◦ The scale along the z-axis represents the number of standard
deviations from the mean of zero.
◦ The Excel function =NORM.S.DIST(z) finds probabilities for the
standard normal distribution.
 Verify the empirical rules using Excel.
 Example: The probability within one standard deviation
of the mean is P(-1 < Z < 1)
= NORMS.DIST(1) – NORMS.DIST(-1)
= 0.84134 – 0.15866
= 0.6827
~ 68%
 Table 1 of Appendix A

 We may compute probabilities for any normal random

variable X having a mean  and standard deviation  by
converting it to a standard normal random variable Z:
 From Example 5.30, what is the
probability that demand will be at
least 900 units/month?
 z = (900 − 750)/100 = 1.50
 Using Table 1 in Appendix A, we
find:
 P(X < 900) = P(Z < 1.50) = 0.93319
 Models the time between randomly occurring events
 Density function:

 Cumulative distribution function:

 Mean =  = 1/l
 Excel function:
◦ =EXPON.DIST(x, lambda, cumulative)
If the number of events occurring
during an interval of time has a
Poisson distribution, then the
time between events is
exponentially distributed.
 The mean time to failure of a critical engine component is µ = 8,000
hours. What is the probability of failing before 5000 hours?
 P(X < x) =EXPON.DIST(x, lambda, cumulative)
 λ = 1/8000
 P(X < 5000) =EXPON.DIST(5000, 1/8000, TRUE)
= 0.4647
 Triangular Distribution
 Lognormal Distribution
 Beta Distribution
 A random number is one that is uniformly
distributed between 0 to 1.
 Excel function: =RAND( )
Probability distribution Intervals for random sampling

1. Generate a random number

2. Find the interval in which it falls
3. Use the associated outcome as the sample
 Sample from the probability distribution of predicted
change in the Dow Jones Industrial Average index
 Compute F(x) and assign intervals to outcomes
 Generate random numbers using the Excel function
=RAND( )
◦ E.g. Cell J2: =VLOOKUP(I2,$E2:$G$10,3)
 A value randomly generated from a specified probability
distribution is called a random variate.
◦ Example: Uniform distribution

 Analysis Toolpak Random Number Generation Tool

◦ Can sample from uniform, normal, Bernoulli, binomial, Poisson,
patterned, and discrete distributions.
◦ Can also specify a random number seed – a value from which a
stream of random numbers is generated. By specifying the same
seed, you can produce the same random numbers at a later time.
 Generate 100 outcomes
from a Poisson distribution
with a mean of 12
◦ Number of Variables = 1.
◦ Number of Random Numbers
= 100
◦ Distribution = Poisson
◦ Dialog changes and prompts
you to enter Lambda (mean
of Poisson) = 12
(Histogram created manually)
 Normal: =NORM.INV(RAND( ), mean, stdev)
 Standard normal: =NORM.S.INV(RAND( ))
 In finance, one way of evaluating capital budgeting
projects is to compute a profitability index: PI = PV / I,
 PV is the present value of future cash flows
 I is the initial investment
 What is the probability distribution of PI when PV is
estimated to be normally distributed with a mean of $12
million and a standard deviation of $2.5 million, and the
initial investment is also estimated to be normal with a
mean of $3.0 million and standard deviation of $0.8
million.?
 Column F:
=NORM.INV(RAND( ), 12, 2.5)
 Column G:
=NORM.INV(RAND( ), 3, 0.8)
 Analytic Solver Platform provides Excel functions
to generate random variates for many distributions
 An energy company was considering offering a new product and
needed to estimate the growth in PC ownership.
 Using the best data and information available, they determined that
the minimum growth rate was 5.0%, the most likely value was 7.7%,
and the maximum value was 10.0% (a triangular distribution).
◦ A portion of 500 samples that were generated using the function
PsiTriangular(5%, 7.7%, 10%):
 Using sample data may limit our ability to predict
uncertain events that may occur because potential
values outside the range of the sample data are not
included.
 A better approach is to identify the underlying probability
distribution from which sample data come by “fitting” a
theoretical distribution to the data and verifying the
goodness of fit statistically.
◦ Examine a histogram for clues about the distribution’s shape
◦ Look at summary statistics such as the mean, median, standard
deviation, coefficient of variation, and skewness
 Sample data on passenger demand for 25 flights

◦ The histogram shows a relatively symmetric distribution. The

mean, median, and mode are all similar, although there is
moderate skewness. A normal distribution is not unreasonable.
 Sample data on service times for 812 passengers at an
airport’s ticketing counter

◦ It is not clear what the distribution might be. It does not appear to
be exponential, but it might be lognormal or another distribution.
 A better approach that simply visually examining a
histogram and summary statistics is to analytically fit the
data to the best type of probability distribution.
 Three statistics measure goodness of fit:
◦ Chi-square (need at least 50 data points)
◦ Kolmogorov-Smirnov (works well for small samples)
◦ Anderson-Darling (puts more weight on the differences between
the tails of the distributions)
 Analytic Solver Platform has the capability of fitting a
probability distribution to data.
1. Highlight the data
Analytic Solver Platform >
Tools > Fit
2. Fit Options dialog
Type: Continuous
Test: Kolmorgov-Smirnov
Click Fit button
 The best-fitting distribution is called an Erlang
distribution.