A PowerPoint Presentation Package to Accompany

Applied Statistics in Business &

Economics, 5th edition

David P. Doane and Lori E. Seward

Prepared by Lloyd R. Jaisingh

McGraw-Hill/Irwin Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter 5
Probability

Chapter Contents

5.1 Random Experiments

5.2 Probability
5.3 Rules of Probability
5.4 Independent Events
5.5 Contingency Tables
5.6 Tree Diagrams
5.7 Bayes’ Theorem
5.8 Counting Rules

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 Chapter 5
Probability

Chapter Learning Objectives

LO5-1: Describe the sample space of a random experiment.

LO5-2: Distinguish among the three views of probability.
LO5-3: Apply the definitions and rules of probability.
LO5-4: Calculate odds from given probabilities.
LO5-5: Determine when events are independent.

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 Chapter 5
Probability

Chapter Learning Objectives

LO5-6: Apply the concepts of probability to contingency tables.

LO5-7: Interpret a tree diagram.
LO5-8: Use Bayes’ Theorem to calculate revised probabilities.
LO5-9: Apply counting rules to calculate possible event
arrangements.

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 Chapter 5
LO5-1 5.1 Random Experiments

LO5-1: Describe the sample space of a random experiment.

Sample Space

• A random experiment is an observational process whose

results cannot be known in advance.
• The set of all possible outcomes (S) is the sample space
for the experiment.
• A sample space can be finite or infinite.

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 Chapter 5
LO5-1 5.1 Random Experiments
Sample Space
• For a single roll of a die, the sample space is:

• When two dice are rolled, the sample space is the

following pairs:

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5A-6
 Chapter 5
LO5-1 5.1 Random Experiments

Sample Space
• If the outcome is a continuous measurement, the sample space
cannot be listed but can be described by a rule.
• For example, the sample space for the length of a randomly chosen
cell phone call would be

S = {all X such that X > 0}.

The sample space to describe a randomly chosen student’s GPA would

be

S = {all X such that 0.00 ≤ X ≤ 4.00}.

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 Chapter 5
LO5-1 5.1 Random Experiments

Events
• An event is any subset of outcomes in the sample space.
• A simple event or elementary event, is a single outcome.
• A discrete sample space S consists of all the simple events (Ei):

S = {E1, E2, …, En}.

• For example, Amazon’s website for “Books & Music”

has seven categories that a shopper might choose:

S = {Books, DVD, VHS, Magazines, Newspapers,

Music, Textbooks}.

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 Chapter 5
LO5-1 5.1 Random Experiments

Events
Within this sample space, we could define compound events
“electronic media” as A = {Music, DVD, VHS} and “print periodicals” as
B = (Newspapers, Magazines}. This can be shown in a Venn diagram.

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 Chapter 5
LO5-2 5.2 Probability

LO5-2: Distinguish among the three views of probability.

Definitions
• The probability of an event is a number that measures
the relative likelihood that the event will occur.
• The probability of event A [denoted P(A)] must lie within
the interval from 0 to 1:

0 ≤ P(A) ≤ 1

If P(A) = 0, then the If P(A) = 1, then the event

event cannot occur. is certain to occur.
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 Chapter 5
LO5-2 5.2 Probability

Definitions
• In a discrete sample space, the probabilities of all simple
events must sum to one:
• P(S) = P(E1) + P(E2) + … + P(En) = 1
• For example, if on a shopping spree, the following percentages (on
the left) were recorded for the four methods of payments. We can
compute the equivalent probabilities which sum to 1.
credit card: 32% P(credit card) = .32
debit card: 15% P(debit card) = .15
Probability
cash: 35% P(cash) = .35
check: 18% P(check) = .18
Sum = 100% Sum = 1.0
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 Chapter 5
LO5-2 5.2 Probability

What is “Probability”?
• There are three ways of assigning probability listed in
Table 5.1. Many people mix them up or use them
interchangeably. Each approach will be considered
separately.

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 Chapter 5
LO5-2 5.2 Probability

Empirical Approach
• Use the empirical or relative frequency approach to
assign probabilities by counting the frequency (fi) of
observed outcomes defined on the experimental sample
space.
• For example, to estimate the default rate on student
loans:

P(a student defaults) = f /n = number of defaults

number of loans

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 Chapter 5
LO5-2 5.2 Probability

Law of Large Numbers

• The law of large numbers says that as the number of
trials increases, any empirical probability approaches its
theoretical limit.
• Flip a coin 50 times. We would expect the proportion of
heads to be near .50.
• However, in a small finite sample, any ratio can be
obtained (e.g., 1/3, 7/13, 10/22, 28/50, etc.).
• A large n may be needed to get close to .50.

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 Chapter 5
LO5-2 5.2 Probability

Law of Large Numbers

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 Chapter 5
LO5-2 5.2 Probability

Classical Approach
• A priori refers to the process of assigning probabilities
before the event is observed or the experiment is
conducted.
• A priori probabilities are based on logic, not experience.
• When flipping a coin or rolling a pair of dice, we do not
actually have to perform an experiment because the
nature of the process allows us to envision the entire
sample space.
• Instead of performing the experiment, we can use
deduction to determine the probability of an event.
• This is the classical approach to probability
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 Chapter 5
LO5-2 5.2 Probability
Classical Approach
• For example, the two-dice experiment has 36 equally
likely simple events. The P(that the sum of the dots on
the two faces equals 7) is

• The probability is
obtained a priori using
the classical approach
as shown in this Venn
diagram for 2 dice:
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 Chapter 5
LO5-2 5.2 Probability

Subjective Approach
• A subjective probability reflects someone’s informed
judgment about the likelihood of an event.
• Used when there is no repeatable random experiment.
• For example,
- What is the probability that a new truck
product program will show a return on
investment of at least 10 percent?
- What is the probability that the price of Ford’s
stock will rise within the next 30 days?

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 Chapter 5
LO5-3 5.3 Rules of Probability

LO5-3: Apply the definitions and rules of probability.

Complement of an Event

• The complement of an event A is denoted by

A′ and consists of everything in the sample space S
except event A.
• Since A and A′ together
comprise the entire sample
space, then
P(A) + P(A′ ) = 1 or
P(A′ ) = 1 – P(A)

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 Chapter 5
LO5-3 5.3 Rules of Probability

Union of Two Events

(Figure 5.5)
• The union of two events consists of all outcomes in the
sample space S that are contained either in event A or
in event B or in both (denoted A  B or “A or B”).

 may be read as
“or” since one or the
other or both events
may occur.

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 Chapter 5
LO5-3 5.3 Rules of Probability

Intersection of Two Events

• The intersection of two events A and B
(denoted by A  B or “A and B”) is the event consisting
of all outcomes in the sample space S that are
contained in both event A and event B.

 may be read as
“and” since both
events occur. This is
a joint probability.

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 Chapter 5
LO5-3 5.3 Rules of Probability

General Law of Addition

• The general law of addition states that the probability of
the union of two events A and B is:

When you add the A and B So, you have to

P(A) and P(B) subtract
together, you count P(A  B) to avoid
the P(A and B) A B overstating the
twice. probability.

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 Chapter 5
LO5-3 5.3 Rules of Probability

General Law of Addition

• For a standard deck of cards:

P(Q) = 4/52 (4 queens in a deck; Q = queen)

P(R) = 26/52 (26 red cards in a deck; R = red)
P(Q  R) = 2/52 (2 red queens in a deck)
P(Q  R) = P(Q) + P(R) – P(Q  R)

Q and R = 2/52 = 4/52 + 26/52 – 2/52

= 28/52 = .5385 or 53.85%

Q R
4/52 26/52

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 Chapter 5
LO5-3 5.3 Rules of Probability

Mutually Exclusive Events

• Events A and B are mutually exclusive (or disjoint) if
their intersection is the null set () which contains no
elements.
If A  B = , then P(A  B) = 0

Special Law of Addition

• In the case of mutually
exclusive events, the
addition law reduces to:
P(A  B) = P(A) + P(B)

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 Chapter 5
LO5-3 5.3 Rules of Probability

Collectively Exhaustive Events

• Events are collectively exhaustive if their union is the
entire sample space S.
• Two mutually exclusive, collectively exhaustive events
are dichotomous (or binary) events.

For example, a car repair is

either covered by the warranty
(A) or not (A’).

Note: This concept can be

Warranty No extended to more than two
Warranty events. See the next slide
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 Chapter 5
LO5-3 5.3 Rules of Probability

Collectively Exhaustive Events

There can be more than two mutually exclusive, collectively
exhaustive events, as illustrated below. For example, a
Wal-Mart customer can pay by credit card (A), debit card
(B), cash (C), or check (D).

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 Chapter 5
LO5-3 5.3 Rules of Probability

Conditional Probability
• The probability of event A given that event B has
occurred.
• Denoted P(A | B).
The vertical line “ | ” is read as “given.”

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 Chapter 5
LO5-3 5.3 Rules of Probability

Conditional Probability
• Consider the logic of this formula by looking at the Venn
diagram. The sample space is
restricted to B, an event that
has occurred.

A  B is the part of B that is

also in A.
The ratio of the relative size
of A  B to B is P(A | B).

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 Chapter 5
LO5-3 5.3 Rules of Probability
General Law of Multiplication
• The general law of multiplication states that the probability of
the intersection of two events A and B is:

Example: High School Dropouts

• Of the population aged 16–21 and not in college:
Unemployed 13.5%
High school dropouts 29.05%

Unemployed high school dropouts 5.32%

• What is the conditional probability that a member of this

population is unemployed, given that the person is a
high school dropout? 5-29
 Chapter 5
LO5-3 5.3 Rules of Probability
Example: High School Dropouts
• First define
U = the event that the person is unemployed
D = the event that the person is a high school dropout

P(U) = .1350 P(D) = .2905 P(UD) = .0532

• P(U | D) = .1831 > P(U) = .1350

• Therefore, being a high school dropout is related to being

unemployed.
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 Chapter 5
LO5-4 5.3 Rules of Probability

LO5-4: Calculate odds from given probabilities

Odds of an Event
• The odds in favor of event A occurring are

• The odds against event A occurring are

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 Chapter 5
LO5-4 5.3 Rules of Probability

Odds of an Event
• If the odds against event A are quoted as b to a, then
the implied probability of event A is:

• For example, if a race horse has a 4 to 1 odds against

winning, the P(win) is

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 Chapter 5
LO5-5 5.4 Independent Events

LO5-5: Determine when events are independent

• Event A is independent of event B if the conditional probability

P(A | B) is the same as the marginal probability P(A).
• P(U | D) = .1831 > P(U) = .1350, so U and D are not independent.
That is, they are dependent.
• Another way to check for independence: Multiplication Law

If P(A  B) = P(A)P(B) then event A is independent of event B

since
P ( A  B ) P ( A)  P ( B )
P( A | B)    P ( A)
P( B) P( B)

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 Chapter 5
LO5-5 5.4 Independent Events

Application of the Multiplication Law (for Independent Events)

• The probability of n independent events occurring simultaneously
is:
P(A1  A2  ...  An) = P(A1) P(A2) ... P(An)
if the events are independent

• To illustrate system reliability, suppose a website has 2 independent

file servers. Each server has 99% reliability. What is the total
system reliability? Let

F1 be the event that server 1 fails

F2 be the event that server 2 fails

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 Chapter 5
LO5-5 5.4 Independent Events

Application of the Multiplication Law (for Independent Events)

• Applying the rule of independence:

P(F1  F2 ) = P(F1) P(F2) = (.01)(.01) = .0001

• So, the probability that both servers are down is .0001.

• The probability that one or both servers is “up” is:

1 - .0001 = .9999 or 99.99%

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 Chapter 5
LO5-6 5.5 Contingency Table
LO5-6: Apply the concepts of probability to contingency tables.

Example: Salary Gains and MBA Tuition

• Consider the following cross-tabulation (contingency)
table for n = 67 top-tier MBA programs:

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 Chapter 5
LO5-6 5.5 Contingency Table

Example: Salary Gains and MBA Tuition

• Are large salary gains more likely to accrue to graduates

of high-tuition MBA programs?
• The frequencies indicate that MBA graduates of high-
tuition schools do tend to have large salary gains.
• Also, most of the top-tier schools charge high tuition.
• More precise interpretations of these data can be made
using the concepts of probability.

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 Chapter 5
LO5-6 5.5 Contingency Table

Marginal Probabilities
• The marginal probability of a single event is found by
dividing a row or column total by the total sample size.
• For example, find the marginal
probability of a medium salary gain (P(S2).
• P(S2) = 33/67 = .4925
• Conclude that about 49% of salary gains at the top-tier
schools were between $50,000 and $100,000 (medium
gain).

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 Chapter 5
LO5-6 5.5 Contingency Table

Marginal Probabilities
• Find the marginal probability of a medium salary gain P(S2).

P(S2) = 33/67 = .4925

• There is a 49% chance that a top-tier school’s MBA
student will experience a medium salary gain.
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 Chapter 5
LO5-6 5.5 Contingency Table

Joint Probabilities
• A joint probability represents the intersection of two
events in a cross-tabulation table.
• Consider the joint event that the school has low tuition
and large salary gains (denoted as P(T1  S3)).
• P(T1  S3) = 1/67 = .0149
• There is less than a 2% chance that a top-tier school has
both low tuition and large salary gains.

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 Chapter 5
LO5-6 5.5 Contingency Table
Conditional Probabilities

• Find the probability that the salary gains are small (S1)
given that the MBA tuition is large (T3).
• P(T3 | S1) = 5/32 = .1563

Independence

Conditional Marginal

P(S3 | T1)= 1/16 = .0625 P(S3) = 17/67 = .2537

• (S3) and (T1) are dependent.

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 Chapter 5
LO5-6 5.5 Contingency Table
Relative Frequencies
• Here are the resulting probabilities (relative frequencies). Each
value is divided by 67. For example,
P(T1 and S1) = 5/67 P(T2 and S2) = 11/67 P(T3 and S3) = 15/67

P(S1) = 17/67 P(T2) = 19/67

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 Chapter 5
LO5-7 5.6 Tree Diagrams
LO5-7: Interpret a tree diagram.
What is a Tree?
• A tree diagram or decision tree helps you visualize all possible
outcomes.
• Start with a contingency table.
• For example, this table gives expense ratios by fund type for 21 bond
funds and 23 stock funds.

• The tree diagram shows all events along with their marginal,
conditional, and joint probabilities. 5-43
 Chapter 5
LO5-7 5.6 Tree Diagrams
LO5-7: Interpret a tree diagram.
What is a Tree?
• To label the tree, we need to compute the conditional
probabilities.

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 Chapter 5
LO5-7 5.6 Tree Diagrams

Tree Diagram for Fund Type and Expense Ratios

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 Chapter 5
LO5-8 5.7 Bayes’ Theorem
LO8: Use Bayes’ Theorem to compute revised probabilities
• Thomas Bayes (1702-1761) provided a method (called Bayes Theorem) of
revising probabilities to reflect new probabilities.
• The prior (marginal) probability of an event B is revised after event A has
been considered to yield a posterior (conditional) probability.

• Bayes’s formula is:

• In some situations P(A) is not given. Therefore, the most useful and
common form of Bayes’ Theorem is:

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 Chapter 5
LO5-8 5.7 Bayes’ Theorem

General Form of Bayes’ Theorem

• A generalization of Bayes’s Theorem allows event B to
have as many mutually exclusive and collectively
exhaustive categories as we wish (B1, B2, …, Bn) rather
than just two dichotomous categories (B and B').

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 Chapter 5
LO5-8 5.7 Bayes’ Theorem

Example: Hospital Trauma Centers (Example 5.8)

(Table 5.18)
• Based on historical data, the percent of cases at 3 hospital trauma
centers and the probability of a case resulting in a malpractice suit
are as follows:

• Where
• A = event of a malpractice suit is filed by patient
Bi = event that a patient was treated at trauma center i (i = 1, 2, 3)
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 Chapter 5
LO5-8 5.7 Bayes’ Theorem
Example: Hospital Trauma Centers
• Applying the general form of Bayes’ Theorem,
• find P(B1 | A).

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 Chapter 5
LO5-8 5.7 Bayes’ Theorem

Example: Hospital Trauma Centers

• Conclude that the probability that the malpractice suit was filed in
hospital 1 is .1389, or 13.89%.
• All the posterior probabilities for each hospital can be calculated
and then compared:

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 Chapter 5
LO5-9 5.8 Counting Rules
LO9: Apply counting rules to calculate possible event
arrangements.
Fundamental Rule of Counting
• If event A can occur in n1 ways and event B can occur in
n2 ways, then events A and B can occur in n1 x n2 ways.
• In general, m events can occur n1 x n2 x … x nm ways.

Example: Stock-Keeping Labels

• How many unique stock-keeping unit (SKU)
labels can a hardware store create by using two
letters (ranging from AA to ZZ) followed by four
numbers (0 through 9)?
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 Chapter 5
LO5-9 5.8 Counting Rules

Example: Stock-Keeping Labels

• For example, AF1078: hex-head 6 cm bolts – box of 12;

RT4855: Lime-A-Way cleaner – 16 ounce
• LL3319: Rust-Oleum primer – gray 15 ounce
• There are 26 x 26 x 10 x 10 x 10 x 10 = 6,760,000
unique inventory labels.

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 Chapter 5
LO5-9 5.8 Counting Rules

Factorials
• The number of ways that n items can be arranged in a particular
order is n factorial.
• n factorial is the product of all integers from 1 to n.
• n! = n(n–1)(n–2)...1
• Factorials are useful for counting the possible arrangements of any
n items.
• There are n ways to choose the first, n-1 ways to choose the
second, and so on.
• A home appliance service truck must make 3 stops (A, B, C). In
how many ways could the three stops be arranged?
• 3! = 3 x 2 x 1 = 6

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 Chapter 5
LO5-9 5.8 Counting Rules

Permutations
• A permutation is an arrangement in a particular order of r
randomly sampled items from a group of n items and is
denoted by nPr

• In other words, how many ways can the r items be

arranged from n items, treating each arrangement as
different (i.e., XYZ is different from ZYX)?
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 Chapter 5
LO5-9 5.8 Counting Rules

Combinations
• A combination is an arrangement of r items chosen at
random from n items where the order of the selected
items is not important (i.e., XYZ is the same as ZYX).
• A combination is denoted nCr

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