Chapter 01 Probability Concepts

and Applications
IIMT3636
Faculty of Business and Economics
The University of Hong Kong
Instructor: Dr. Yipu DENG
 2

Recap of Last Lecture

• Bayes’ Theorem
▪ Update prior probability assessment based on new information
➢ General form
➢ Venn diagram
• Random variables and probability distributions
▪ A mapping from all possible outcomes to real numbers.
▪ Discrete → histogram, cumulative probability graph
▪ Continuous → cumulative distribution function (CDF), probability
density function (PDF)
➢ The probability value of each outcome of the continuous RV is 0.
➢ In the graph of PDF, the area underneath the curve represents probability.
▪ Summary statistics → expected value and variance
• Binomial distribution & Bernoulli process
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Binomial Distribution
• The probability of obtaining specific outcomes in a Bernoulli
process is described by the binomial probability distribution.

• Characteristics of Bernoulli process

▪ Each trial in a Bernoulli process has only two possible outcomes (e.g.,
success vs. failure, yes vs. no, head vs. tail, etc.).
▪ The probability stays the same from one trial to the next.
▪ The trials are statistically independent.
▪ The number of trials is a positive integer.

• Example
▪ Tossing a coin for several times and counting the number of heads
 4

Binomial Distribution
• The binomial distribution is used to find the probability of a
specific number of successes out of 𝑛 independent trials of a
Bernoulli process.

• 𝑛 = the number of trials

• 𝑝 = the probability of success on any single trial
• 𝑟 = the number of successes
• ! means factorial (0! = 1)
𝑛!
• 𝑃 𝑟; 𝑛, 𝑝 = ∙ 𝑝𝑟 ∙ 1 − 𝑝 𝑛−𝑟
𝑟! 𝑛−𝑟 ! 5!
▪ P (Getting 4 heads in 5 tosses) = ? ∙ 0.54 ∙ 1 − 0.5 5−4
= 0.15625
4! 5−4 !

• If 𝑋~𝐵 𝑛, 𝑝 , then 𝐸 𝑋 = 𝑛𝑝 and 𝑉 𝑋 = 𝑛𝑝 1 − 𝑝 .

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Binomial Distribution in Excel

 6

Poisson Distribution
• 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.
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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?
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Poisson Distribution in Excel

 9

Binomial and Poisson Distributions

• It turns out the Poisson distribution is just a special case of the
binomial distribution — where the number of trials is very large,
and the probability of success in any given one is small.
• We can use a Binomial distribution with parameters (𝑛, 𝑝) to
approximate a Poisson distribution with rate 𝜆 by setting 𝑛 to a large
number and 𝑝 = 𝜆/𝑛.
▪ If n≥100 and np≤10, the approximation can be very good.
Poisson, l = 5
0.2

0.15

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
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Exponential Distribution
• 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 .
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Exponential Distribution
• Example 𝐹 𝑥 = 𝑃 𝑋 ≤ 𝑥 = 1 − 𝑒 −𝜆𝑥
▪ The service person can install new doors at a rate about 3 per
hour.
▪ The service time is exponentially distributed.
▪ What is the probability that the time to install a new door will be
30 minutes or less?

𝑃 𝑋 ≤ 0.5
= 1 − 𝑒 −3∗0.5
= 1 − 𝑒 −1.5 = 77.7%
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Exponential Distribution in Excel

 13

Exponential and Poisson Distributions

• Exponential and Poisson are related: if the number of
arrivals per time period follows Poisson(𝜆0 ), then the
time between arrivals (1/ 𝜆1 ) follows exponential
distribution EXP(𝜆1 ) with an identical rate 𝜆1 = 𝜆0 .

▪ 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.
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Exponential and Poisson Distributions

• Example
▪ Suppose customer arrivals at a retail store per hour follow
Poisson with mean 𝜆 = 3. Given that a customer arrived at
2:30pm, what is the probability that the next customer will arrive
before 3:00pm? (Hint: how to define the random variable?)

▪ 𝑃𝑃 𝑋 ≥ 1; 𝜆 = 1.5 or 𝑃𝐸 𝑌 ≤ 0.5; 𝜆 = 3
 15

Uniform Distribution
• A random variable 𝑋 is uniformly distributed if it takes
any value equally likely from a finite interval 𝑎, 𝑏 .
Probability density function Cumulative distribution function

𝑥−𝑎
= 𝑏−𝑎

1 1
• 𝐸 𝑋 = 𝑎+𝑏 ;𝑉 𝑋 = (𝑏 − 𝑎)2
2 12
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Uniform Distribution in Excel

• The 𝑟𝑎𝑛𝑑() function generates a number from a uniformly
distributed random variable on [0,1]

• For a general uniform distribution on [a,b], we can use

“= 𝑎 + 𝑟𝑎𝑛𝑑() ∗ 𝑏 − 𝑎 ”
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Normal Distribution
• The normal distribution is the most popular and useful
continuous probability distribution.
▪ E.g., return of a stock portfolio, forecast errors, and test scores.

• The probability density function is

1 𝑥−𝜇 2
−
𝑓 𝑥 = ∙ 𝑒 2𝜎2
𝜎 2𝜋

• 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 .
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Normal Distribution (PDF)

• 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
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Normal Distribution
• Normal distribution with different 𝜎. (always symmetric)

Same m, smaller s

Same m, larger s

m
 20

Normal Distribution
 21

Standard Normal Distribution

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
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Standard Normal Distribution: Example

• If 𝑋 follows normal distribution with mean 𝜇 = 100, 𝜎 =
15, and we are interested in finding the probability that X
is less than 130, then z = ?
▪ Hint: P(X ≤ x) = P (Z ≤ z)

𝑥−𝜇
𝑧=
𝜎
130−100
= =2
15
 23

P(Z<-z) = P(Z>z)

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

 24

In-class Exercise
• If 𝑋 follows normal distribution with mean 𝜇 = 100 and
s.d. 𝜎 = 22, then 𝑃 𝑋 < 120 = ?

𝑋−𝜇 120−𝜇
• 𝑃 𝑋 < 120 = 𝑃 𝑋 − 𝜇 < 120 − 𝜇 = 𝑃 <
𝜎 𝜎
𝑋−𝜇
• Define 𝑍 = .
𝜎
• 𝑃 𝑋 < 120 = 𝑃 𝑍 < 0.91 = 0.8186
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Finding the x value

• If 𝑋 follows normal distribution with mean 𝜇 = 100 and s.d.
𝜎 = 22 and we want 𝑋 to be less than a certain value with
probability 0.8, then how to find this value? Or 𝑃 𝑋 < ? =
0.8.

• Step 1: Finding the z value corresponding to 𝑃 𝑋 < 𝑥 .

▪ If we need 𝑥 for 𝑃 𝑋 < 𝑥 , find 𝑧 corresponding to 𝑃 𝑋 < 𝑥 .
𝑧0.8 = 0.84
If we need 𝑥 for 𝑃 𝑋 > 𝑥 , find 𝑧 corresponding to 1 − 𝑃 𝑋 > 𝑥 .
• Step 2: Setting 𝑥 to 𝑥𝑧 = 𝜇 + 𝑧 ∙ 𝜎.
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
 26

Haynes Construction Company

• Builds three- and four-unit apartment buildings
• Total construction time follows a normal distribution
• For triplexes, μ = 100 days and σ = 20 days
• Contract calls for completion in 125 days
• Late completion will incur a severe penalty fee
• Probability of completing in 125 days?

𝑃 𝑋 < 125 = 𝑃 𝑍 < 1.25 = 0.8944

m = 100 days
s = 20 days
x = 125 days
 27

Haynes Construction Company

• If finished in 75 days or less, bonus = $5,000. Probability of bonus?
• 𝑃 𝑋 < 75 = 𝑃 𝑍 < −1.25
• = 𝑃 𝑍 > 1.25 = 1 − 𝑃 𝑍 < 1.25 = 1 - 0.8944 = 0.1056

• What is the probability of completing between 110 and 125 days?

• 𝑃 110 < 𝑋 < 125 = 𝑃 𝑋 < 125 − 𝑃 𝑋 < 110
= 0.8944 – P(Z<0.5)
= 0.8944 – 0.6915
= 0.2029

110 days 125 days

 28

Haynes Construction Company

• Suppose Haynes can hire more workers to reduce the
mean construction time while keeping the standard
deviation constant (i.e., 20 days). Hence, to ensure a
penalty is avoided with probability 0.95, what should be
the new mean?

𝑋 ′ −𝜇
• Objective: find 𝜇 such that 𝑃 𝑋′ < 125 = 𝑃ቀ <
20
125−𝜇
ቁ = 0.95
20
• Step 1: 𝑧0.95 = 1.645
125−𝜇
• Step 2: find 𝜇 such that = 1.645; 𝜇 = 92.1
20
 29

Normal Distribution in Excel

 31

In-Class Exercise
• When a man passes the airport security check, they
discover a bomb in his bag. He explains. “Statisticians
show that the probability of one bomb being on an
airplane is 1/10,000. However, the chance that there are
two bombs on one plane is 1/10,000,000. So, I am much
safer …”

• Suppose the statisticians are right and it is impossible to

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.
 32

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

 33

In-Class Exercise
• A candidate for public office has claimed that 60% of
voters will vote for her. If 5 registered voters were
sampled, what is the probability that exactly 3 would say
they favor this candidate? (hint: utilize BINOM.DIST in
Excel)

Binomial distribution with n = 5, p = 0.6, r = 3, prob = 0.3456

Chapter 02
Decision Analysis
IIMT3636
Faculty of Business and Economics
The University of Hong Kong
Instructor: Dr. Yipu DENG
 2

The Science of Decision Making

• Making a decision is about choosing among alternatives.
▫ Whether to pursue a graduate study (BA or Marketing); whether to
seek a job
▫ Whether to buy a stock and how much money to invest (e.g., all, half,
1/3); other investment opportunities
▫ Whether to expand the product line and how to expand (e.g., new or
existing technology)

• Six Steps in Decision Making

▫ Clearly define the problem (Goal to achieve)
▫ List the possible alternatives
▫ Identify the possible outcomes or states of nature
▫ List the payoff of each alternative in each state of nature
▫ Select one of the decision theory models
▫ Apply the model and make your decision
 3

Thompson Lumber Company

• John Thompson, the founder and president, needs to make the
decision on whether to expand his product line by manufacturing
and marketing a new product.
• Define the problem
à whether to expand the product line
 4

Decision makers have

Thompson Lumber Company no control over it.

• List all possible alternatives (i.e., course of action or strategies)

• Identify possible outcomes/states of nature (e.g., high vs. low demand)
• List the payoff of the combination of alternatives and outcomes
• Select and apply the decision theory model, make decisions

STATE OF NATURE

FAVORABLE MARKET UNFAVORABLE MARKET

ALTERNATIVE (profit in $) (profit in $)

Construct a large plant 200,000 –180,000

Construct a small plant 100,000 –20,000
Do nothing 0 0

Decision/payoff table
 5

Types of Decision-Making Environments

• Decision making under certainty
▫ The decision maker knows with certainty the consequences of every
alternative or decision choice.
▫ Example: have $1,000 to invest for 1 year (open a savings account
with 4% interest vs. invest in a government bond with 6% interest)
• Decision making under risk
▫ 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
expected monetary value or minimize opportunity loss
• Decision making under uncertainty
▫ There are several possible outcomes for each alternative, and
decision maker does not know the probabilities of the various
outcomes.
▫ Example: the probability of success of a new product
 6

Decision Making under Risk

• EMV is the weighed sum of possible payoffs for each alternative.
STATE OF NATURE Expected
Monetary
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
Do nothing 0 0 0
Probability 0.45 0.55

If John maximizes the EMV, then he should choose to construct a small plant.
 7

Decision Making under Risk

• Scientific Marketing, Inc. offers analysis that will provide
certainty about market conditions. S.M. would charge
$65,000 for the information. Should John buy the
information?

• To make this decision, John has to evaluate the expected

value of perfect information (EVPI) by computing the
expected value with perfect information (EVwPI) and
the best EMV under risk.
 8

Decision Making under Risk

• EVwPI = ∑ best payoff in state 𝑖 . probability of state 𝑖

STATE OF NATURE Expected

Monetary
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
Do nothing 0 0 0
Best payoff 200,000 0 90,000
Probability 0.45 0.55 EVwPI

EVPI = EVwPI – Best EMV

= $90,000 – $34,000 = $56,000 < $65,000. Don’t buy!
 9

Decision Making under Risk

• To minimize expected opportunity loss (EOL)
• Opportunity loss = optimal payoff – actual payoff (in a given state of nature)

STATE OF NATURE Expected

Monetary
FAVORABLE
FAVORABLE Mkt UNFAVORABLE
UNFAVORABLE Mkt EOL
Value
ALTERNATIVE (Opp. Loss
MARKET in $)
(profit in $) (Opp. Loss
MARKET in $)
(profit in $) (EMV,
(in $)

Construct a large plant 0

200,000 180,000
–180,000 99,000
–9,000
Construct a small plant 100,000 20,000
–20,000 56,000
34,000
Do nothing 200,000
0 0 90,000
0
Probability 0.45 0.55
• Minimizing EOL always results in the same decision as maximizing
EMV.
• The minimum EOL always equal the EVPI.
 10

Decision Making under Risk

Favorable Market VwPI Unfavorable Market
OL2
OL3
VwPI
MV1
OL2
MV2 MV3 OL1 MV3
MV2
MV1
Option Option Option Option Option Option
1 2 3 1 2 3

EVwPI
EOL1 EOL2 EOL3

EMV1 EMV2 EMV3

Option 1 Option 2 Option 3

 11

In-class Exercise: Café du Donut

• The Café buys donuts each day for $40 per carton of 20 dozen
donuts. Any cartons not sold are thrown away at the end of
the day. If a carton is sold, the total revenue is $60.

DAILY DEMAND PROBABILITY CUMULATIVE

(CARTONS) PROBABILITY
• The original plan 4 0.05 0.05
is to order 6 5 0.15 0.2
cartons per day. 6 0.15 0.35

Should the Café 7 0.20 0.55

increase the 8 0.25 0.8

9 0.10 0.9
order size to 7?
10 0.10 1.0
Total 1.00
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In-class Exercise: Café du Donut

• Monetary Payoff (Profit) Table
• Cost = $40, revenue = $60
D=4 D=5 D=6 D=7 D=8 D=9 D = 10 EMV
4x60 6x40 6x60 6 x40
Q=6 0 60Go 120 120 120 120 120 105
-
-

O 120 120 10 120 120 105

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
EMVLQ =
6) = 0x0 .
05 + 60 x 0 .

15 + 120 x (0 .
15 +0 . 20 +
0 .
25 +0 .
10 + 0 -

10) =
105

• Should we reduce the order size from 6 to 5? What is the EMV of Q=5?

• If we can only choose between 6 and 7, what is the EVPI?