Probability

Probability Tree (Tree Diagram)

 Helps you visualize all possible outcomes.

2
 Probability Tree (Tree Diagram)

Bender Company is a real estate development firm. It has a

contract to complete one construction project in a month.
However, there is uncertainty about the delivery of key
construction materials it needs to complete the project.
Bender estimates that the probability of getting the materials on
time are 2/3. If it receives the required materials on time, the
probability of meeting the deadline is 3/4. However, the
probability of meeting the project deadline drops to 1/5 if
materials are not received on time.
Draw a probability tree and compute the probability that the
project deadline will not be met.

3
 Probability Tree (Tree Diagram)
The Situation
Materials Project Completion Outcomes
Bender Company is a real estate
A = On time B = Meet deadline
development firm. It has a contract to
complete one construction project in a month.
However, there is uncertainty about the
delivery of key construction materials it needs
to complete the project.
P(B|A) = P(A  B) =

Bender estimates that the probability of

P(A) =
getting the materials on time are 2/3. If it P(A  B’) =
receives the required materials on time, the
probability of meeting the deadline is 3/4. P(B’|A) =
However, the probability of meeting the
project deadline drops to 1/5 if materials are
not received on time. Draw a probability tree
and compute the probability that the project
P(B|A’) = P(A’  B) =
deadline will not be met.
P(A’) =
P(A’  B’) =
P(B’|A’) =

4
 Bayes’ Theorem
 The prior (marginal) probability of an event B is revised
after event A has been considered to yield a posterior
(conditional) probability.

 In some situations, P(A) is not given. Therefore, the

most useful and common form of Bayes’ Theorem is:

5
 Example
Assume that 99% of the patients are
immune to a virus. There is a 0.5%
chance that the lab test erroneously I = Immune; N = Not immune; TI = Test says immune; TN = Test says not immune
indicates that the patient is not immune
to the virus when s/he is. On the other P(I) =
hand, there is a 95% chance that the P(N) =
test will report that a patient is not P(TN | I) =
immune when s/he is not immune. P(TI | I) =
P(TN | N) =
If an individual has a lab test done and P(TI I N ) =
the result indicates that s/he is not
immune, what is the probability that the
individual was actually immune?

6
 Example P(TN | I) P(I ∩ TN)
0.005 0.99*0.005= 0.00495

Probability Tree
P(I)
Assume that 99% of the patients are 0.99
immune to a virus. There is a 0.5%
chance that the lab test erroneously
P(TI | I) P(I ∩ TI)
indicates that the patient is not immune 0.995 0.99*0.995= 0.98505
to the virus when s/he is. On the other
hand, there is a 95% chance that the
test will report that a patient is not P(TN | N) P(N ∩ TN)
immune when s/he is not immune. 0.95 0.01*0.95= 0.0095

P(N)
If an individual has a lab test done and 0.01
the result indicates that s/he is not
immune, what is the probability that the
individual was actually immune?
P(N ∩ TI)
P(TI | N)
0.01*0.05= 0.0005
0.05

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Decision Analysis
 Decision Analysis
A framework and methodology for rational decision making when the outcomes
are uncertain.
A company is launching a new product. What will be the market response? Should the product be tested in a
small region first?

A mining company is deciding whether to expand its activity in one of its gold mines. Should it pay to investigate
the site further? What will be the actual costs? Profits?

9
 Hotel or Apartment?
Paradise Inc. (PI) is deciding between building a resort hotel in a tourist city and building an
apartment in a metro area. The hotel project is risky and very dependent on the economy, but the
reward is also very lucrative. On the other hand, the apartment project yields a lower but very
predictable profit.

Initially PI believes there is a 70% chance that the economy will be good, and 30% chance that it
will be bad. The following table summarizes the payoffs (NPV of profit) in millions of dollars PI
expects to receive for each scenario.

Economy
Project Good Bad
Hotel 15 7
Apartment 9.5 9.5

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 Payoff Table
• Table showing the estimated payoff for each alternative in every
possible state of nature
State of Nature
(possible outcomes)

Economy
Project Good Bad
Alternative Hotel 15 7
(decision to make)
Apartment 9.5 9.5
Chance 0.70 0.30
Prior Probabilities

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 Decision Criteria
Maximize the Maximum

Maximize the Minimum

Maximum Likelihood

Expected Value Criterion

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 Decision Criteria:
Maximize the Maximum: Focus only on the best that can happen for each alternative
and choose the alternative that gives the maximum payoff.

Economy
Project Good Bad
Hotel 15 7
Apartment 9.5 9.5
Chance 0.70 0.30

13
 Decision Criteria:
Maximize the Minimum: Focus only on the worst that can happen for each alternative,
and choose the alternative that gives the maximum payoff.

Economy
Project Good Bad
Hotel 15 7
Apartment 9.5 9.5
Chance 0.70 0.30

14
 Decision Criteria:
Maximum Likelihood: Focus on the most likely state of nature (given the prior probability) and
choose the alternative that gives the maximum payoff for that state of nature.

Economy
Project Good Bad
Hotel 15 7
Apartment 9.5 9.5
Chance 0.70 0.30

15
 Decision Criteria:
Expected Value:
Step 1) For each alternative, calculate the weighted average payoff (expected payoff)
Step 2) Choose the alternative with the largest expected payoff

Economy
Project Good Bad
Hotel 15 7 0.7*15.0 + 0.3*7.0 = 12.6

Apartment 9.5 9.5 0.7*9.5 + 0.3*9.5 = 9.5

Chance 0.70 0.30

16
 Decision Criteria: Expected Value
• The expected payoff for a particular decision alternative can be
interpreted as:

• The average payoff if the same situation were to be repeated numerous times.

• On the average, repeatedly using the Expected Value Criterion to make decisions will
lead to larger payoffs in the long run than any other criterion (assuming the prior
probabilities are valid).

17
 New Probability Information
Paradise Inc. (PI) is deciding between building a large resort hotel in a tourist city and building an apartment in a metro
area. The hotel project is risky and very dependent on the economy, but the reward is also very lucrative. On the other
hand, the apartment project yields a lower but very predictable profit.

PI believes there is a 70% chance that the economy will be good, and 30% chance that it will be bad. The following table
summaries the payoffs (NPV of profit) in millions of dollars PI expects to receive for each scenario.

Suppose a research can be conducted (cost $0.5m) before making the decision:

• In the past, when economy was good, research result would correctly predict “favorable” 85.7% of the time

• In the past, when economy was bad, research result would correctly predict “unfavorable” 77.7% of the time

Should PI conduct a research?

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 New Probability Information
Favorable given Good
Joint probability
P (F|G)
0.600 Favorable and Good
0.857
P(Favorable and Good) = P(Good) * P(Favorable given Good)

00) = 0.700 * 0.857 = 0.600

7
d (0.
o 0.143
Go 0.100 Unfavorable and Good
Unfavorable given Good
P (U|G)
P(Unfavorable and Good) = P(Good) * P(Unfavorable given Good)
= 0.700 * 0.143 = 0.100

Favorable given Bad

Ba P (F| B)
d( 0.067 Favorable and Bad
0.3 0.223
00
) P(Favorable and Bad) = P(Bad) * P(Favorable given Bad)
= 0.300 * 0.223 = 0.067

0.777
Unfavorable given Bad 0.233 Unfavorable and Bad
P (U|B)
P(Unfavorable and Bad) = P(Bad) * P(Unfavorable given Bad)
= 0.300 * 0.777 = 0.233

19
 New Probability Information
• Probability of Good given Favorable  P ( G | F ) = ?

• Probability of Bad given Unfavorable  P ( B | U ) = ?

20
 Decision Tree
Two types of nodes:
Choice
otel
H
• Decision Node, represented by a square,
indicates that a decision needs to be Ap
made at that point in the process a rtm
en
t
Economy
• Event Node (or chance node), Outcome? od
Go
represented by a circle, indicates that a
random event occurs at that point Ba
d

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 Complete Analysis

Good
f
tel Bad
Ho

abl
e c Apa
v or r
Fa t me
nt
Good
ch

b g
tel
ar

Ho
se

Unf Bad
Re

avo
r abl
o

e d
D

a Apa
r t me
nt
No Good
Re
se Hotel h
ar
ch e Bad

Apar
tm ent

22
 Complete Analysis

Good 14.5
f
tel Bad
Ho 6.5

abl
e c Apa
v or r 9.0
Fa t me
nt
Good 14.5
ch

b g
tel
ar

Ho
se

Unf Bad 6.5

Re

avo
r abl
o

e d
D

a Apa 9.0
r t me
nt
No Good 15.0
Re
se Hotel h
ar
ch e Bad 7.0

Apar 9.5
tm ent

23
 Complete Analysis

685)
(0.89 Good 14.5
f
tel (0.10 Bad
Ho 315)
6.5

67) le c
(0.6 orab Apa 9.0
v r
Fa t me
nt
042) d
(0.30 Goo 14.5
ch

b g
tel
ar

Ho
se

Unf (0.69 Bad 6.5

958)
Re

a
(0.3 vorab
o

33) le d
D

a Apa 9.0
r t me
nt 0)
No (0.70 Good 15.0
Re
se Hotel h
ar
ch e (0.30 Bad
0) 7.0

Apar 9.5
tm ent

24
 Complete Analysis

13.675 685)
(0.89 Good 14.5
f
tel (0.10 Bad
Ho 315)
6.5

67) le c
(0.6 orab Apa
9.0
v rt m
Fa ent
2)
8.903 (0.3004Good 14.5
ch

b g
tel
ar

Ho
se

Unf (0.69 Bad 6.5

958)
Re

a
(0.3 vorab
o

33) le d
D

a Apa 9.0
rt m
ent
)
No 12.6 (0.700 Good 15.0
Re
se Hotel h
ar
ch e (0.30 Bad
0) 7.0
Apar
tmen 9.5
t

25
 Complete Analysis

13.675 685)
(0.89 Good 14.5

l f
te (0.10 Bad
13.675 Ho 315)
6.5

67) le c
(0.6 orab Apa
9.0
v rt m
Fa ent
2)
8.903 (0.3004Good 14.5
ch

b g
tel
ar

9.0 Ho
se

Unf (0.69 Bad 6.5

958)
Re

a
(0.3 vorab
o

33) le d
D

a Ap 9.0
ar tme
nt )
No 12.6 (0.700 Good 15.0
Re 12.6 l
se Hote h
ar
ch e (0.30 Bad
0) 7.0
Apar
tmen 9.5
t

26
 Complete Analysis

13.675 685)
(0.89 Good 14.5

l f
te (0.10 Bad
13.675 Ho 315)
6.5

67) le c
(0.6 orab Apa
9.0
v rt m
12.118 Fa ent
2)
8.903 (0.3004Good 14.5
ch

b g
tel
ar

9.0 Ho
se

Unf (0.69 Bad 6.5

958)
Re

a
(0.3 vorab
o

33) le d
D

a Ap 9.0
ar tme
nt )
No 12.6 (0.700 Good 15.0
Re 12.6 l
se Hote h
ar
ch e (0.30 Bad
0) 7.0
Apar
tmen 9.5
t

27
 Complete Analysis  Don’t conduct research
 Do “Hotel”
13.675 685)
(0.89 Good 14.5

l f
te (0.10 Bad
13.675 Ho 315)
6.5

67) le c
(0.6 orab Apa
9.0
v rt m
12.118 Fa ent
2)
8.903 (0.3004Good 14.5
ch

b g
tel
ar

9.0 Ho
se

Unf (0.69 Bad 6.5

958)
Re

a
(0.3 vorab
o

12.6 33) le d
D

a Ap 9.0
ar tme
nt )
No 12.6 (0.700 Good 15.0
Re 12.6 l
s Hote h
ea e (0.30 Bad 7.0
rc 0)
h
Apar
tmen 9.5
t

28
 Investment Strategy
You are considering three major investment strategies (conservative,
speculative, countercyclical) and must choose one. You also believe that there
are three possible scenarios over the lives of these potential investments: an
improving, a stable, and a worsening economy. The estimated profits and losses
(in $ millions) as well as the prior probabilities are given in the table below.

Strategies/Outcome Improving Stable Worsening

Conservative 30 5 -10
Speculative 40 10 -30
Countercyclical -10 0 15
Prior Probabilities 0.1 ? ?

While the 0.1 is just about right as the prior probability of an improving economy, it is quite uncertain about
how to split the remaining probabilities between a stable and worsening economy

29
 Investment Strategy 0.1
30

e
ov
pr
Im
0.75
Stable 0.45
5
Strategies/Outcome Improving Stable Worsening
W
or

e
s en 0.45

ativ
Conservative 30 5 -10 -10

erv
Speculative 40 10 -30

ns
Co
Countercyclical -10 0 15 0.1
40

e
ov
Prior Probabilities 0.1 0.45 0.45

pr
-5

Im
Stable 0.45
10
Speculative
W
Which strategy should you choose under the or
se 0.45
n -30
expected value criteria?

Co
un
terc
0.1

ycli
-10

e
ov
c

pr
al
5.75

Im
Stable 0.45
0
W
or
se 0.45
n 15

30
 Investment Strategy 0.1
30

e
ov
pr
Im
Stable 0.7
5
Strategies/Outcome Improving Stable Worsening
W
or

e
s en 0.2

ativ
Conservative 30 5 -10 -10

erv
Speculative 40 10 -30

ns
Co
Countercyclical -10 0 15 0.1
40

e
ov
Prior Probabilities 0.1 0.7 0.2

pr
Im
Stable 0.7
10
Speculative
W
If the prior probabilities of a stable economy is or
se 0.2
n -30
0.7, which strategy should you choose under

Co
the expected value criteria?

un
terc
0.1

ycli
-10

e
ov
c

pr
al

Im
Stable 0.7
0
W
or
se 0.2
n 15

31
 Investment Strategy 0.1
30

e
ov
pr
Im
Stable 0.65
5
Strategies/Outcome Improving Stable Worsening
W
or

e
s en 0.25

ativ
Conservative 30 5 -10 -10

erv
Speculative 40 10 -30

ns
Co
Countercyclical -10 0 15 0.1
40

e
ov
Prior Probabilities 0.1 0.65 0.25

pr
Im
Stable 0.65
10
Speculative
W
If the prior probabilities of a stable economy is or
se 0.25
n -30
0.65, which strategy should you choose under

Co
the expected value criteria?

un
terc
0.1

ycli
-10

e
ov
c

pr
al

Im
Stable 0.65
0
W
or
se 0.25
n 15

32
 Investment Strategy
Prob of Stable Conservative Speculative Countercyclical

0.45 0.75
0.65 3.75
0.70 4.50

Conservative

0.2 0.4 0.6 0.8 1.0

33
 Investment Strategy
Prob of Stable Conservative Speculative Countercyclical

0.45 0.75 -5.00 5.75

0.65 3.75 3.00 2.00
0.70 4.50 5.00 2.75

Conservative
Speculative
Countercyclical

0.2 0.4 0.6 0.8 1.0

34