Chapter 3: Bayes Theory

Objective:
After completing this chapter you will be able to:
– Understand Bayes’ Theorem and Discrete Probability Mode Bayes’ Theorem and Continuous Probability
Distributions
– Application of Bayes Theory into Decision Making techniques
– The Evaluation of Subjective Probabilities
– Decision Analysis: An Overview
– Decision Trees
– Handling Additional Information Using Bayes’ Theorem
– Utility
– The Value of Information
Bayesian and Classical Statistics
Classical Statistical
Data Conclusion
Inference

Data Bayesian Statistical

Inference Conclusion
Prior
Information

Bayesian
Bayesianstatistical
statisticalanalysis
analysisincorporates
incorporatesaaprior
priorprobability
probability
distribution
distributionand
andlikelihoods
likelihoodsofofobserved
observeddata
datatotodetermine
determineaa
posterior
posteriorprobability
probabilitydistribution
distributionofofevents.
events.
 Example

•• AAmedical
medical test
test for
for aa rare
rare disease
disease (affecting
(affecting 0.1%
0.1% of
of the
the
population [[P ( I )  0.001 ])]) isis imperfect:
population imperfect:
–– When
Whenadministered
administeredto
toan
anill
illperson,
person,the
thetest
testwill
willindicate
indicateso
so
withprobability
with probability0.92
0.92 [[P ( Z I )  .92  P ( Z I )  .08]]
•• The
Theevent
event ( Z I ) isisaafalse
falsenegative
negative
–– When
Whenadministered
administeredto toaaperson
personwho whoisisnot notill,
ill,the
thetest
testwill
will
erroneouslygive
erroneously giveaapositive
positiveresult
result(false
(falsepositive)
positive)with
with
probability0.04
probability 0.04[[ P ( Z I )  0.04  P ( Z I )  0.96 ]]
•• The
Theevent
event( Z I ) isisaafalse
falsepositive.
positive. ..
 Applying Bayes’ Theorem

P ( I )  0.001 P(I Z ) 
P(I Z )
P(Z )
P(I Z )

P ( I )  0.999 P(I Z )  P(I Z )
P(Z I )P(I )

P(Z I )P(I )  P(Z I )P(I )
P ( Z I )  0.92 (.92)(0.001)

(.92)(0.001)  (0.04)(.999)
0.00092 0.00092
 
P ( Z I )  0.04 0.00092  0.03996 .04088
 .0225
 Decision Tree

Prior Conditional Joint

Probabilities Probabilities Probabilities

P ( Z I )  0.92 P ( Z  I )  (0.001)(0.92)  .00092

P ( Z I )  0.08
P ( I )  0.001 P ( Z  I )  (0.001)(0.08)  .00008

P ( Z I )  0.04
P ( I )  0.999 P ( Z  I )  (0.999)(0.04)  .03996

P ( Z I )  0.96
P ( Z  I )  (0.999)(0.96)  .95904
 Bayes’ Theorem and Discrete Probability Models

The
Thelikelihood
likelihoodfunction
functionisisthe
theset
setofofconditional
conditionalprobabilities
probabilities
P(x|)
P(x|)for
forgiven
givendata
datax,x,considering
consideringaafunction
functionofofan
anunknown
unknown
population parameter,..
populationparameter,
Bayes’
Bayes’theorem
theoremfor
foraadiscrete
discreterandom
randomvariable:
variable:
P(x  ) P( )
P( x) 
 P(x  i )P( i )
i

whereisisan
where anunknown
unknownpopulation
populationparameter
parametertotobe beestimated
estimated
from
fromthe
thedata.
data. The
Thesummation
summationininthe
thedenominator
denominatorisisover overall
all
possible
possiblevalues
valuesofofthe
theparameter interest,i,i,and
parameterofofinterest, andxxstands
standsfor
for
the
theobserved
observeddata
dataset.
set.
Prior Distribution and Likelihoods of 4 Successes
in 20 Trials

Likelihood
Likelihood
Prior
Prior Binomialwith
Binomial withnn==20
20and
andpp==0.100000
0.100000
Distribution
Distribution xx P(P(XX==x)x)
4.00 0.0898
4.00 0.0898
SS P(S)
P(S) Binomialwith
Binomial withnn==20
20and
andpp==0.200000
0.200000
xx P(P(XX==x)x)
0.1 0.05
0.1 0.05 4.00
4.00 0.2182
0.2182
0.2 0.15
0.2 0.15 Binomialwith
Binomial withnn==20
20and
andpp==0.300000
0.300000
xx P(P(XX==x)x)
0.3 0.20
0.3 0.20 4.00
4.00 0.1304
0.1304
Binomialwith
Binomial withnn==20
20and
andpp==0.400000
0.400000
0.4 0.30
0.4 0.30 xx P(P(XX==x)x)
4.00 0.0350
0.5 0.20
0.5 0.20 4.00 0.0350
Binomialwith
Binomial withnn==20
20and
andpp==0.500000
0.500000
0.6 0.10
0.6 0.10 xx P(P(XX==x)x)
4.00 0.0046
4.00 0.0046
1.00
1.00 Binomialwith
Binomial withnn==20
20and
andpp==0.600000
0.600000
xx P(P(XX==x)x)
4.00
4.00 0.0003
0.0003
 Prior Probabilities, Likelihoods, and
Posterior Probabilities

Prior
Prior Posterior
Posterior
Distribution Likelihood
Distribution Likelihood Distribution
Distribution
SS P(S) P(x|S)
P(S) P(x|S) P(S)P(x|S) P(S|x)
P(S)P(x|S) P(S|x)
0.1
0.1 0.05 0.0898
0.05 0.0898 0.00449
0.00449 0.06007
0.06007
0.2
0.2 0.15 0.2182
0.15 0.2182 0.03273
0.03273 0.43786
0.43786 93%
0.3
0.3 0.20 0.1304
0.20 0.1304 0.02608
0.02608 0.34890
0.34890 Credible
0.4
0.4 0.30 0.0350
0.30 0.0350 0.01050
0.01050 0.14047
0.14047 Set
0.5
0.5 0.20 0.0046
0.20 0.0046 0.00092
0.00092 0.01230
0.01230
0.6
0.6 0.10 0.0003
0.10 0.0003 0.00003
0.00003 0.00040
0.00040
1.00
1.00 0.07475
0.07475 1.00000
1.00000
 Example 3 -1:
Prior and Posterior Distributions

P o s te rio r D is trib utio n o f M arke t S hare P rio r D is trib utio n o f Marke t S hare

0.5 0.5

0.4 0.4

0.3 0.3

P (S)
P (S)

0.2 0.2

0.1 0.1

0.0 0.0
0.1 0.2 0.3 0.4 0 .5 0.6 0.1 0.2 0.3 0.4 0.5 0.6
S S
 Example 3-1:
A Second Sampling with 3 Successes in 16 Trials

Likelihood
Likelihood
PriorDistribution
Prior Distribution Binomialwith
Binomial withnn==16
16and
andpp==0.100000
0.100000
xx P(P(XX==x)x)
SS P(S)
P(S) 3.00
3.00 0.1423
0.1423
Binomialwith
withnn==16
16and
andpp==0.200000
0.200000
0.1 0.06007
0.1 0.06007 Binomial
xx P(P(XX==x)x)
0.2 0.43786
0.2 0.43786 3.00
3.00 0.2463
0.2463
Binomialwith
withnn==16
16and
andpp==0.300000
0.300000
Binomial
0.3 0.34890
0.3 0.34890 xx P(P(XX==x)x)
3.00
3.00 0.1465
0.1465
0.4 0.14047
0.4 0.14047 Binomialwith
Binomial withnn==16
16and
andpp==0.400000
0.400000

0.5 0.01230
0.01230 xx P(P(XX==x)x)
0.5 3.00
3.00 0.0468
0.0468
0.6 0.00040
0.6 0.00040 Binomialwith
Binomial withnn==16
16and
andpp==0.500000
0.500000
xx P(P(XX==x)x)
1.00000
1.00000 3.00
3.00 0.0085
0.0085
Binomialwith
Binomial withnn==16
16and
andpp==0.600000
0.600000
xx P(P(XX==x)x)
3.00
3.00 0.0008
0.0008
 Example 3-1:
Incorporating a second Sample
Prior
Prior Posterior
Posterior
Distribution Likelihood
Distribution Likelihood Distribution
Distribution
SS P(S)
P(S) P(x|S)
P(x|S) P(S)P(x|S)
P(S)P(x|S) P(S|x)
P(S|x)
0.1 0.06007
0.1 0.06007 0.1423
0.1423 0.0085480
0.0085480 0.049074
0.049074
0.2 0.43786
0.2 0.43786 0.2463
0.2463 0.1078449
0.1078449 0.619138
0.619138 91%
0.3 0.34890
0.3 0.34890 0.1465
0.1465 0.0511138
0.0511138 0.293444
0.293444 Credible Set
0.4 0.14047
0.4 0.14047 0.0468
0.0468 0.0065740
0.0065740 0.037741
0.037741
0.5 0.01230
0.5 0.01230 0.0085
0.0085 0.0001046
0.0001046 0.000601
0.000601
0.6 0.00040
0.6 0.00040 0.0008
0.0008 0.0000003
0.0000003 0.000002
0.000002
1.00000
1.00000 0.1741856
0.1741856 1.000000
1.000000
 Bayes’ Theorem and Continuous Probability
Distributions
Wedefine
We definef()
f()asasthe
theprior
priorprobability
probabilitydensity
densityofofthe
theparameter
parameter
. We
. Wedefine
definef(x|)
f(x|)as
asthe
theconditional
conditionaldensity
densityof
ofthe
thedata
datax,x,given
given
thevalue
the of.. This
valueof Thisisisthe
thelikelihood
likelihoodfunction.
function.

Bayes' theorem
Bayes' theoremfor
forcontinuous
continuousdistributions:
distributions:

ff ((xx))ff (()) ff ((xx))ff (())

ff ((xx))  Total area under f (x )
  ff ((xx))ff (())dd Total area under f (x )
 The Normal Probability Model
•• Normal
Normalpopulation
populationwith
withunknown meanand
unknownmean andknown
knownstandard
standard
deviation
deviation
•• Populationmean
Population meanisisaarandom
randomvariable
variablewith
withnormal
normal(prior)
(prior)
distributionand
distribution andmean
meanM Mand
andstandard
standarddeviation .
deviation.
•• Drawsample
Draw sampleofofsize
sizen:
n:
The posterior mean and variance of the normal population of
the population mean,  :
 1   n
 2 M   2 M
     1
M  =   
2

 1   n  1   n
 2  2  2  2
         
The Normal Probability Model: Example 3-2

M   15   8 n  10 M  1154
. s  684
.
 1   n
 2 M   2 M
     2 1
M  =   
 1   n  1   n 
 2   2  2   2
         
 1  10 
 2  15    1154
.
8   684
.
2  2 1
M  =   
 1   10   1   10 
 2     2   
 8   684
.
2   8   684
.
2 
2
M  = 11.77       2.077
.    1177
95% Credible Set: M   196 .  (196
. ) 2.077  [ 7.699 ,15841
. ]
 Example 3-2
Density

Posterior
Distribution

Likelihood

Prior
Distribution


11.54 15
11.77
The Evaluation of Subjective Probabilities

•• Based
Based on
on normal
normal distribution
distribution
––95%
95% of
of normal
normal distribution
distribution is
is within
within
22 standard
standard deviations
deviations of
of the
the mean
mean
••P(-1
P(-1 << xx << 31)
31) == .95=
.95= 15, = 88
15, =
––68%
68% of
of normal
normal distribution
distribution is
is within
within
11 standard
standard deviation
deviation of
of the
the mean
mean
••P(7
P(7 << xx << 23)
23) == .68 = 15,
.68 = = 88
15, =
 Decision Analysis

•• Elements
Elements of
of aa decision
decision analysis
analysis
–– Actions
Actions
•• Anything
Anythingthe
thedecision-maker
decision-makercancando
doatatany
anytime
time

–– Chance
Chanceoccurrences
occurrences
•• Possible
Possibleoutcomes
outcomes(sample
(samplespace)
space)

–– Probabilities
Probabilitiesassociated
associatedwith withchance
chanceoccurrences
occurrences
–– Final
Finaloutcomes
outcomes
•• Payoff,
Payoff,reward,
reward,ororloss
lossassociated
associatedwith
withaction
action

–– Additional
Additionalinformation
information
•• Allows
Allowsdecision-maker
decision-makertotoreevaluate
reevaluateprobabilities
probabilitiesand
andpossible
possiblerewards
rewardsand
and
losses
losses
–– Decision
Decision
•• Course
Courseofofaction
actiontototake
takeinineach
eachpossible
possiblesituation
situation
 Decision Tree
Case: New-Product Introduction
Chance
Chance Final
Final
Decision
Decision Occurrence
Occurrence Outcome
Outcome
Product
successful $100,000
(P=0.75)
Market

Product -$20,000
unsuccessful
Do not (P=0.25)
market
$0
 Payoff Table and Expected Values of
Decisions: New-Product Introduction

Productisis
Product
Action
Action Successful Not
Successful NotSuccessful
Successful
Marketthe
Market theproduct
product $100,000
$100,000 -$20,000
-$20,000
Donot
Do notmarket
marketthe
theproduct
product $0
$0 $0
$0

Theexpected
The expectedvalue
valueof ofXX,, denoted
denotedEE((XX):):
EE((XX))  xP((xx))
xP
allallxx
Outcome)) (100,
EE((Outcome (100,000 .75))((20
000)()(00.75 20,,000
000)()(00.25
.25))
== 750000
750000-5000
-5000==70,000 70,000
Solution to the New-Product Introduction
Decision Tree
Clipping the Nonoptimal Decision Branches
Expected
Expected Product
Payoff
Payoff successful
$100,000
$70,000
$70,000 (P=0.75)
Market

Product -$20,000
unsuccessful
(P=0.25)
Nonoptimal Do not
Nonoptimal
decisionbranch
branch market Expected
decision Expected $0
isisclipped
clipped Payoff
Payoff
$0
$0
 New-Product Introduction:
Extended-Possibilities

Outcome
Outcome Payoff Probability
Payoff Probability xP(x)
xP(x)
Extremelysuccessful
Extremely successful $150,000
$150,000 0.1
0.1 15,000
15,000
Verysuccessful
Very successful 120.000
120.000 0.2
0.2 24,000
24,000
Successful
Successful 100,000
100,000 0.3
0.3 30,000
30,000
Somewhatsuccessful
Somewhat successful 80,000
80,000 0.1
0.1 8,000
8,000
Barelysuccessful
Barely successful 40,000
40,000 0.1
0.1 4,000
4,000
Breakeven
Break even 00 0.1
0.1 00
Unsuccessful
Unsuccessful -20,000
-20,000 0.05
0.05 -1000
-1000
Disastrous
Disastrous -50,000
-50,000 0.05
0.05 -2,500
-2,500

ExpectedPayoff:
Expected Payoff: $77,500
$77,500
 New-Product Introduction:
Extended-Possibilities Decision Tree

Chance Payoff
Decision
Occurrence
0.1
$150,000
Expected
Expected 0.2 $120,000
Payoff
Payoff 0.3
$77,500 $100,000
$77,500 0.1
$80,000
0.1 $40,000
Market
0.1
0.05
$0
0.05
-$20,000
-$50,000
Do not
Nonoptimal
Nonoptimal market
decisionbranch
decision branch $0
isisclipped
clipped
 Example 3-3: Decision Tree

Not Promote $700,000

Pr=0.4
Pr=0.5 $680,000
Promote Pr=0.6
$740,000
Lease Pr=0.3
$800,000
Pr=0.15
$900,000
Pr=0.05
Not Lease
$1,000,000
Pr=0.9
$750,000
Pr=0.1
$780,000
 Example 3-3: Solution
Expected payoff:
Not Promote $700,000 $700,000
Expected payoff:
Pr=0.5 Pr=0.4
0.5*425000 $680,000
+0.5*716000=
$783,000 Promote Pr=0.6
Expected payoff: $740,000
$716,000 Pr=0.3
Lease Expected payoff:
$425,000 $800,000
Pr=0.15
$900,000
Pr=0.05
Not Lease
$1,000,000
Pr=0.9
Expected payoff: $750,000
$753,000 Pr=0.1
$780,000
 Handling Additional Information Using
Bayes’ Theorem
Successful Payoff
Market $95,000

Test indicates Failure -$25,000

success Do not market
-$5,000
Market Successful
Test $95,000
Test indicates
failure Failure
-$25,000
Do not market
-$5,000
Not test
Market Successful Pr=0.75
$100,000
Failure Pr=0.25
-$20,000
New-ProductDecision
New-Product Decision
Treewith
withTesting
Testing Do not market 0
Tree
 Applying Bayes’ Theorem

P(S)=0.75 P(IS|S)=0.9 P(IF|S)=0.1

P(F)=0.75 P(IS|F)=0.15 P(IF|S)=0.85
P(IS)=P(IS|S)P(S)+P(IS|F)P(F)=(0.9)(0.75)+(0.15)(0.25)=0.7125
P(IF)=P(IF|S)P(S)+P(IF|F)P(F)=(0.1)(0.75)+(0.85)(0.25)=0.2875
P(IS|S)P(S)
P(S| IS) =
P(IS|S)P(S)  P(IS| F)P(F)
( 0.9 )( 0.75)
  0.9474
( 0.9 )( 0.75)  ( 0.15)( 0.25)
P(F| IS)  1  P(S| IS)  1  0.9474  0.0526
P(IF|S)P(S)
P(S| IF) =
P(IF|S)P(S)  P(IF| F)P(F)
( 0.1)( 0.75)
  0.2609
( 0.1)( 0.75)  ( 0.85)( 0.25)
P(F| IF)  1  P(S| IF)  1  0.2609  0.7391
 Expected Payoffs and Solution
Payoff
$86,866 $86,866 P(S|IS)=0.9474
Market $95,000

P(IS)=0.7125 P(F|IS)=0.0526 -$25,000

Do not market
$66.003
$6,308 -$5,000
$6,308
Test Market P(S|IF)=0.2609
$95,000
P(IF)=0.2875
P(F|IF)=0.7391
-$25,000
Do not market
$70,000 -$5,000
$70,000 $70,000
Not test Market P(S)=0.75
$100,000
P(F)=0.25 -$20,000
Do not market
0
 Utility and Marginal Utility

Utilityisisaameasure
Utility measureofofthe
thetotal
totalworth
worthofofaaparticular
particularoutcome.
outcome.
ItItreflects
reflectsthe
thedecision
decisionmaker’s
maker’sattitude
attitudetoward
towardaacollection
collectionofof
Utility factorssuch
factors suchasasprofit,
profit,loss,
loss,and
andrisk.
risk.

Additional
Utility

Additional
Utility {
Dollars
}

Additional $1000 Additional $1000

 Utility and Attitudes toward Risk

Utility Utility Risk Taker

Risk Averse

Dollars Dollars
Utility Utility Mixed
Risk Neutral

Dollars Dollars
 Assessing Utility
Possible
Possible Initial
Initial Indifference
Indifference
Returns
Returns Utility
Utility Probabilities
Probabilities Utility
Utility
$1,500
$1,500 00 00
4,300
4,300 (1500)(0.8)+(56000)(0.2) 0.2
(1500)(0.8)+(56000)(0.2) 0.2
22,000
22,000 (1500)(0.3)+(56000)(0.7) 0.7
(1500)(0.3)+(56000)(0.7) 0.7
31,000
31,000 (1500)(0.2)+(56000)(0.8) 0.8
(1500)(0.2)+(56000)(0.8) 0.8
56,000
56,000 11 11

Utility
1.0

0.5

0.0 Dollars
0 10000 20000 30000 40000 50000 60000
 15-9 The Value of Information
Theexpected
The expectedvalue
valueofofperfect
perfectinformation
information(EVPI):
(EVPI):
EVPI == The
EVPI Theexpected
expectedmonetary
monetaryvalue
valueofofthe
thedecision
decisionsituation
situationwhen
when
perfectinformation
perfect informationisisavailable
availableminus
minusthe
theexpected
expectedvalue
valueofofthe
the
decisionsituation
decision situationwhen
whenno
noadditional
additionalinformation
informationisisavailable.
available.

ExpectedNet
Expected NetGain
Gainfrom
fromSampling
Sampling

Expected
Net Gain

Max

Sample Size
nmax
Example 15-6: The Decision
Tree
Airline Competitor’s Payoff
Fare Fare
$8 million
Competitor:$200
$200 Pr=0.6
Fare
8.4 Competitor:$300
Pr=0.4 $9 million

Competitor:$200 $4 million
$300 Pr=0.6
Fare
6.4
Competitor:$300
Pr=0.4
$10 million
 Example 15-6: Value of
Additional Information
•• IfIf no
no additional
additional information
information isis available,
available, the
the
best strategy
best strategy isis to
to set
set the
the fare
fare at
at $200
$200
–– E(Payoff|200)
E(Payoff|200)==(.6)(8)+(.4)(9)
(.6)(8)+(.4)(9)==$8.4
$8.4million
million
–– E(Payoff|300)
E(Payoff|300)==(.6)(4)+(.4)(10)
(.6)(4)+(.4)(10)==$6.4
$6.4million
million

•• With
With further
further information,
information, the
the expected
expected
payoff could
payoff could be:
be:
–– E(Payoff|Information)
E(Payoff|Information)==(.6)(8)+(.4)(10)=$8.8
(.6)(8)+(.4)(10)=$8.8million
million

•• EVPI=8.8-8.4
EVPI=8.8-8.4 == $.4
$.4 million
million