MBA ZC417

Bayes Theorem

Dr Shekhar Rajagopalan

Chap 1-1
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 Prior & Posterior Probabilities - Example
The firm will shortly launch a variant of the existing soft drink.
Based on past data and industry reports, the R&A Department has assigned the
following probabilities to the possible market share: P(5%) = 20%, P(10%) = 50% and
P( 15%) = 30%.
Since the soft drink was targeted for the younger generation, a taste test was held at
a college campus. 35 of the 50 students who took the test said they would buy the
drink.
This new fact has to be factored into the earlier estimates to refine the probabilities.
The earlier probabilities are called Prior probabilities and the latter would be called
Posterior probabilities.

Bayes theorem provides the means for revising the prior probabilities.
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 Prior & Posterior Probabilities
Any manager, dealing with a situation of uncertainty, can assign probabilities to the
possible outcomes.

These probabilities may be a combination of subjective and objective probabilities.

The latter being based on historical data and reports.

These initial probabilities are termed as prior probabilities.

Later new information is received Survey or Product Test or some stray event.

This new information is factored in to generate the posterior probabilities.

Bayes theorem is the tool for revising the prior probabilities.

the probability model may be continuously updated as new data flow in!
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 Bayes Theorem
Suppose Eis are ALL the possible outcomes and the prior probabilities
have been assigned to them. The event F has occurred.

Required:
1. The Eis are mutually exclusive
2. The Eis collectively are all the possible events
3. P(F | Ei)s can be found

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 Bayes Theorem
Formulas

Required:
1. The Eis are mutually exclusive
2. The Eis collectively are all possible events
3. P(F | Ei)s can be found

The process of inverting the probabilities and the process of

continuously revising the probabilities as the new info flows appears
counterintuitive!
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A Simple Example

The VPs EA is often late returning from lunch. Based on observation, HR assigned
the following probabilities:
Lunch Probability he is late:
Out 40%
Company Canteen 19%
Cubicle 1%
HR knew that the probabilities of all 3 lunch choices were equal.

Today the EA came back late from lunch.

This information has to be factored into the table above!

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A Simple Example: Symbolic Representation

Events:
A1: Lunch Out, A2: Lunch at the canteen, A3: Lunch in the cubicle
Assumption: These are all the possibilities for the EA to have lunch
F: EA came late today

Prior Probabilities: P(A1) = P(A2) = P(A3) = 1/3

Conditional Probabilities: P(F|A1) = 0.40, P(F|A2) =0.19, P(FA3) = 0.01

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A Simple Example: The Tabular Approach
Events:
A1: Lunch Out, A2: Lunch at the canteen, A3: Lunch in the cubicle
Assumption: These are all the possibilities for the EA to have lunch
F: EA came late today
Prior Probabilities: P(A1) = P(A2) = P(A3) = 1/3
Event (E) P(E) P(F | E) (F& E) P(E|F)
Conditional Probabilities: P(F|A1) = 0.40, P(F|A2) =0.19, P(FA3) =
A1 1/3 0.40 .40/3 0.67
0.01
A2 1/3 0.19 .19/3 0.31
A3 1/3 0.01 .01/3 0.02
TOTAL 1.0 0.20 1.00

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Base Rate Fallacy

If presented with related base rate information (i.e. generic, general

information) and specific information (information only pertaining to a
certain case), the mind tends to ignore the former and focus on the
latter.*

*https://en.wikipedia.org/wiki/Base_rate_fallacy
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Base Rate Fallacy Example
The disease is present in 0.5% of the population. It is a deadly disease and death is
almost always inevitable.
But there is a cheap test that can detect the disease.
The True Positive is 99% while the False Positive is 5%.
Question: If you test positive, should you panic?

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Base Rate Fallacy Example
Events:
A1: You have the disease, A2: You do not have the disease
F: You have tested positive
Prior Probabilities: P(A1) = 0.005, P(A2) = 0.995
Conditional Probabilities: P(F|A1) = 0.99, P(F|A2) =0.05
Need to compute P(A1|F)

Event (E) P(E) P(F | E) (F& E) P(E|F)

A1 0.005 0.99 0.00495 0.0905
A2 0.995 0.05 0.04975 0.9095
TOTAL 1.0 0.0547 1.00

The 1% probability of having this deadly is not good, but the initial reaction, taking into
account the data on True Positives but not on the Base Rate, was not called for!
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 Bayes Theorem: Tabular Approach
Step 1
Identify the mutually exclusive events (Es) that make up the required Sample Space; Identify the Fact F.
Note down the P(E) and the conditional probabilities (F | E)
Prepare the table with 5 columns and (n+1) rows, where n is the size of the sample space
Step 2
Input the data of Step 1
Column 1 The events Es
Column 2 The prior probabilities P(E)s
Column 3 P(F | E)s
Step 3
Column 4 Compute the joint probabilities P(E&F) using P(E&F) = P(E) * P(F | E)
Step 4
Column 4. The last cell will contain P(E&F) = P(F)
Step 5
Column 5 Compute the posterior probabilities using P(E | F) = P(E & F) / P(F).

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Assignment

Page180 Ex 10
Page185 Ex 21
Page191 Ex 28
Page198 Ex 35
Page 205 Ex 42, Ex 45

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