Statistics for

Business and Economics

Chapter 1: Probability

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Chapter Goals
After completing this chapter, you should be able to:
• Explain basic probability concepts and definitions
• Use a Venn diagram or tree diagram to illustrate
simple probabilities
• Apply common rules of probability
• Compute conditional probabilities
• Determine whether events are statistically
independent
• Use Bayes’ Theorem for conditional probabilities

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 3.1 Important Terms

• Random Experiment – a process leading to an

uncertain outcome
• Basic Outcome – a possible outcome of a random
experiment
• Sample Space – the collection of all possible
outcomes of a random experiment
• Event – any subset of basic outcomes from the
sample space

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 Important Terms
(continued)

• Intersection of Events – If A and B are two events in

a sample space S, then the intersection, A ∩ B, is the
set of all outcomes in S that belong to both A and B

A AB B

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 Important Terms
(continued)

• A and B are Mutually Exclusive Events if they have

no basic outcomes in common
• i.e., the set A ∩ B is empty

A B

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 Important Terms
(continued)

• Union of Events – If A and B are two events in a

sample space S, then the union, A U B, is the set of
all outcomes in S that belong to either
A or B

S The entire shaded

area represents
A B AUB

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 Important Terms
(continued)

• Events E1, E2, … Ek are Collectively Exhaustive events

if E1 U E2 U . . . U Ek = S
• i.e., the events completely cover the sample space

• The Complement of an event A is the set of all basic

outcomes in the sample space that do not belong to
A. The complement is denoted
A
S
A
A
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 Examples
Let the Sample Space be the collection of all
possible outcomes of rolling one die:

S = [1, 2, 3, 4, 5, 6]

Let A be the event “Number rolled is even”

Let B be the event “Number rolled is at least 4”
Then
A = [2, 4, 6] and B = [4, 5, 6]
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 Examples
(continued)

S = [1, 2, 3, 4, 5, 6] A = [2, 4, 6] B = [4, 5, 6]

Complements:
A  [1, 3, 5] B  [1, 2, 3]
Intersections:
A  B  [4, 6] A  B  [5]
Unions:
A  B  [2, 4, 5, 6]
A  A  [1, 2, 3, 4, 5, 6]  S
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 Examples
(continued)

S = [1, 2, 3, 4, 5, 6] A = [2, 4, 6] B = [4, 5, 6]

• Mutually exclusive:
• A and B are not mutually exclusive
• The outcomes 4 and 6 are common to both

• Collectively exhaustive:
• A and B are not collectively exhaustive
• A U B does not contain 1 or 3

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 3.2 Probability

• Probability – the chance that

1 Certain
an uncertain event will occur
(always between 0 and 1)

0 ≤ P(A) ≤ 1 For any event A .5

0 Impossible
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Assessing Probability
• There are three approaches to assessing the probability
of an uncertain event:

1. classical probability
NA number of outcomes that satisfy the event
probability of event A  
N total number of outcomes in the sample space

• Assumes all outcomes in the sample space are equally likely to occur

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 Counting the Possible Outcomes

• Use the Combinations formula to determine the number

of combinations of n things taken k at a time

n!
C n

k! (n  k)!
k
• where
• n! = n(n-1)(n-2)…(1)
• 0! = 1 by definition

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Assessing Probability
Three approaches (continued)
2. relative frequency probability
nA number of events in the population that satisfy event A
probability of event A  
n total number of events in the population
• the limit of the proportion of times that an event A occurs in a large number of
trials, n

3. subjective probability

an individual opinion or belief about the probability of occurrence

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Probability Postulates
1. If A is any event in the sample space S, then
0  P(A)  1

2. Let A be an event in S, and let Oi denote the basic outcomes.

Then
P(A)   P(Oi )
A

(the notation means that the summation is over all the basic outcomes in A)

3. P(S) = 1

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 3.3
Probability Rules
• The Complement rule:

P(A)  1 P(A) i.e., P(A)  P(A)  1

• The Addition rule:

• The probability of the union of two events is

P(A  B)  P(A)  P(B)  P(A  B)

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A Probability Table
Probabilities and joint probabilities for two events A
and B are summarized in this table:

B B

A P(A  B) P(A  B ) P(A)

A P(A  B) P(A  B ) P(A)

P(B) P( B ) P(S)  1.0

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 Addition Rule Example

Consider a standard deck of 52 cards, with four suits:

♥♣♦♠
Let event A = card is an Ace
Let event B = card is from a red suit

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 Addition Rule Example
(continued)

P(Red U Ace) =

Color
Type Red Black Total
Ace
Non-Ace
Total 5

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Conditional Probability
• A conditional probability is the probability of one
event, given that another event has occurred:

P(A  B) The conditional

P(A | B)  probability of A given
P(B) that B has occurred

P(A  B) The conditional

P(B | A)  probability of B
P(A) given that A has
occurred

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 Conditional Probability Example

 Of the cars on a used car lot, 70% have air

conditioning (AC) and 40% have a CD player
(CD). 20% of the cars have both.

• What is the probability that a car has a CD player,

given that it has AC ?

i.e., we want to find P(CD | AC)

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 Conditional Probability Example
(continued)
 Of the cars on a used car lot, 70% have air conditioning
(AC) and 40% have a CD player (CD).
20% of the cars have both.
CD No CD Total
AC
No AC
Total

P(CD|AC)=?

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 Multiplication Rule

• Multiplication rule for two events A and B:

P(A  B)  P(A | B)P(B)

• also

P(A  B)  P(B | A)P(A)

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 Multiplication Rule Example
P(Red ∩ Ace) = P(Red| Ace)P(Ace)

number of cards that are red and ace

 
total number of cards

Color
Type Red Black Total
Ace
Non-Ace

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Statistical Independence
• Two events are statistically independent if
and only if:

P(A  B)  P(A)P(B)
• Events A and B are independent when the probability of one event is
not affected by the other event
• If A and B are independent, then

P(A | B)  P(A) if P(B)>0

P(B | A)  P(B) if P(A)>0

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 Statistical Independence Example
 Of the cars on a used car lot, 70% have air conditioning
(AC) and 40% have a CD player (CD).
20% of the cars have both.
CD No CD Total
AC .2 .5 .7
No AC .2 .1 .3
Total .4 .6 1.0

 Are the events AC and CD statistically independent?

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 3.4
Bivariate Probabilities
Outcomes for bivariate events:

B1 B2 ... Bk

A1 P(A1B1) P(A1B2) ... P(A1Bk)

A2 P(A2B1) P(A2B2) ... P(A2Bk)

. . . . .
. . . . .
. . . . .

Ah P(AhB1) P(AhB2) ... P(AhBk)

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 Joint and
Marginal Probabilities

• The probability of a joint event, A ∩ B:

number of outcomes satisfying A and B
P(A  B) 
total number of elementary outcomes

• Computing a marginal probability:

P(A)  P(A  B1 )  P(A  B 2 )    P(A  Bk )

• Where B1, B2, …, Bk are k mutually exclusive and collectively
exhaustive events
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 Marginal Probability Example

P(Ace)

Color
Type Red Black Total
Ace
Non-Ace
Total
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Using a Tree Diagram
Given AC or P(AC ∩ CD) =
no AC:
P(AC ∩ CD) =

All
Cars

P(AC ∩ CD) =

P(AC ∩ CD) =
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Odds
• The odds in favor of a particular event are given by
the ratio of the probability of the event divided by
the probability of its complement
• The odds in favor of A are

P(A) P(A)
odds  
1- P(A) P(A)

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Odds: Example
• Calculate the probability of winning if the odds of
winning are 3 to 1:
3 P(A)
odds  
1 1- P(A)

• Now multiply both sides by 1 – P(A) and solve for P(A):

3 x (1- P(A)) = P(A)

3 – 3P(A) = P(A)
3 = 4P(A)
P(A) = 0.75
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Overinvolvement Ratio
• The probability of event A1 conditional on event B1 divided by
the probability of A1 conditional on activity B2 is defined as
the overinvolvement ratio:

P(A1 | B1 )
P(A1 | B 2 )

• An overinvolvement ratio greater than 1 implies that event A1

increases the conditional odds ration in favor of B1:

P(B1 | A1 ) P(B1 )

P(B2 | A1 ) P(B2 )

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 3.5
Bayes’ Theorem
P(A | E i )P(E i )
P(E i | A) 
P(A)
P(A | E i )P(E i )

P(A | E 1 )P(E 1 )  P(A | E 2 )P(E 2 )    P(A | E k )P(E k )

• where:
Ei = ith event of k mutually exclusive and collectively
exhaustive events
A = new event that might impact P(Ei)

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Bayes’ Theorem Example
• A drilling company has estimated a 40% chance of
striking oil for their new well.
• A detailed test has been scheduled for more
information. Historically, 60% of successful wells
have had detailed tests, and 20% of unsuccessful
wells have had detailed tests.
• Given that this well has been scheduled for a
detailed test, what is the probability
that the well will be successful?

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 Bayes’ Theorem Example
(continued)

• Let S = successful well

U = unsuccessful well
• P(S) = .4 , P(U) = .6 (prior probabilities)
• Define the detailed test event as D
• Conditional probabilities:
P(D|S) = .6 P(D|U) = .2
• Goal is to find P(S|D)

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 Bayes’ Theorem Example
(continued)

Apply Bayes’ Theorem:

P(D | S)P(S)
P(S | D) 
P(D | S)P(S)  P(D | U)P(U)
(.6)(.4)

(.6)(.4)  (.2)(.6)
.24
  .667
.24  .12
So the revised probability of success (from the original estimate of .4), given
that this well has been scheduled for a detailed test, is .667
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Chapter Summary
• Defined basic probability concepts
• Sample spaces and events, intersection and union of
events, mutually exclusive and collectively exhaustive
events, complements
• Examined basic probability rules
• Complement rule, addition rule, multiplication rule
• Defined conditional, joint, and marginal probabilities
• Reviewed odds and the overinvolvement ratio
• Defined statistical independence
• Discussed Bayes’ theorem
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