Week 4 - ADM2303

Class Discussion – Review
Your company bids for two contracts. You believe that the probability of
getting contract 1 is 0.8. If you get contract 1, the probability that you also
get contract 2 will be 0.2, and if you don’t get contract 1, the probability
that you get contract 2 will be 0.3.
a) Are the outcomes of the two contract bids independent? Explain.
b) Draw the probability tree.
c) Find the probability that you get both contracts.
d) Find the probability that you get neither contract.
e) Let X be the number of contracts you get. Find the probability model
for X.
f) Find the expected value and standard deviation of X.
Copyright © 2018 Pearson Canada Inc.

Class Discussion – Review - Answer

Class Discussion – Review - Answer

Business Statistics
Third Canadian Edition
Chapter 9
Random Variables and
Probability Distributions
9.3 Adding and Subtracting Random
Variables (1 of 10)
Our example insurance company expected to pay out an average of
$200 per policy, with a standard deviation of about $3868. The expected
profit then was $500 − $200 = $300 per policy. Suppose that the
company decides to lower the price of the premium by $50 to $450. It’s
pretty clear that the expected profit would drop an average of $50 per
policy, to $450 − $200 = $250. This is an example of changing a
random variable by a constant.
What about the standard deviation? We know that adding or subtracting

a constant from data shifts the mean but doesn’t change the variance or
standard deviation. The same is true of random variables.
Variables (2 of 10)
Adding a constant c to X:
E( X  c ) = E ( X )  c,
Var ( X  c ) = Var ( X ),and
SD( X  c ) = SD( X ).
Multiplying X by a constant a:
E (aX ) = aE ( X ),and
Var (aX ) = a 2Var ( X ).
SD(aX ) = a SD( X ).

Variables (3 of 10)
This insurance company sells policies to more than just one person. We’ve
just seen how to compute means and variances for one person at a time.
What happens to the mean and variance when we have a collection of
customers? The profit on a group of customers is the sum of the individual
profits, so we’ll need to know how to find expected values and variances for
sums. To start, consider a simple case with just two customers, whom we’ll
call Mr. Ecks and Ms. Wye. With an expected payout of $200 on each policy,
we might expect a total of $200 + $200 = $400 to be paid out on the two
policies - nothing surprising there.

Variables (4 of 10)
In other words, we have the Addition Rule for Expected Values of
Random Variables: The expected value of the sum (or difference) of
random variables is the sum (or difference) of their expected values:
E ( X  Y ) = E ( X )  E (Y ).

Variables (5 of 10)
The variability is another matter. Is the risk of insuring two people the
same as the risk of insuring one person for twice as much? We wouldn’t
expect both clients to die or become disabled in the same year. In fact,
because we’ve spread the risk, the standard deviation should be smaller.
Indeed, this is the fundamental principle behind insurance. By spreading
the risk among many policies, a company can keep the standard
deviation quite small and predict costs more accurately. It’s much less
risky to insure thousands of customers than one customer when the total
expected payout is the same, assuming that the events are
independent.

Variables (6 of 10)
But how much smaller is the standard deviation of the sum? It turns out
that if the random variables are independent, we have the Addition Rule
for Variances of Random Variables: The variance of the sum or
difference of two independent random variables is the sum of their
individual variances:
Var ( X  Y ) = Var ( X ) + Var (Y )

if X and Y are independent .
SD( X  Y ) = Var ( X ) + Var (Y ).
Note: we always add the Variances (even when subtracting the Random
Variables)
Variables (7 of 10)
Illustration: The expected annual payout per insurance policy is $200
and the variance is $14,960,000. If the payout amounts are doubled,
what are the new expected value and variance?
E ( 2 X ) = 2E ( X ) = 2  200 = $400
Var ( 2 X ) = 22Var ( X ) = 4  14,960,000 = 59,840,000
Compare this to the expected value and variance on two independent

policies at the original payout amount.
E ( X + Y ) = E ( X ) + E (Y ) = 2  200 = $400
Var ( X + Y ) = Var ( X ) + Var (Y ) = 2  14,960,000 = 29,920,00
Note: The expected values are the same but the variances are different.

Variables (8 of 10)
Let’s compare the variance of writing two independent policies with the
variance of writing only one for twice the size. If the company had insured
only Mr. Ecks for twice as much, the variance would have been twice as
big as with two independent policies, even though the expected payout is
the same.
Of course, variances are in squared units. The company would prefer to
know standard deviations, which are in dollars. The standard deviation of
the payout for two independent policies is
SD( X  Y ) = Var ( X ) + Var (Y ) = 29,920,000 = $5469.92

But the standard deviation of the payout for a single policy of twice the
size is twice the standard deviation of a single policy: SD(2X) = 2SD(X) =
2(3867.82) = $7735.64, or about 40% more than the standard deviation of
the sum of the two independent policies, $5469.92.
Variables (9 of 10)
DEALING WITH CORRELATION: Everything we’ve said up to now
about adding and subtracting random variables has assumed that the
variables are uncorrelated.
Notice that the correlation affects the variance and hence the standard
deviation of the random variable, but it does not affect the expected
value.
Correlation not only affects the difference between two random variables;
it also affects their sum.

Variables (10 of 10)
The expected value behaves as expected:
The variance is the one we need to watch out for:

Variables – Example
Assuming the two funds are independent, what are the relative
advantages and disadvantages of putting $1000 into one, or splitting the
$1000 and putting $500 into each? Compare the means and SDs of the
profit from the two strategies.

Variables – Example - Answer

Variables – Example - Answer

Review Section 9.3 – Exercise 1
Given independent random variables, X and Y, with means and standard
deviations as shown, find the mean and standard deviation of each of the
variables in (a) to (d).
a) X − 20
b) 0.5Y
c) X + Y
d) X − Y

Review Section 9.3 – Exercise 1 - Answer

Canada’s annual exports to India are $2.8 billion on average with a
standard deviation of $0.35 billion. Canada’s annual imports from India
are $3.1 billion on average with a standard deviation of $0.25 billion.
Calculate the mean and standard deviation of Canada’s balance of trade
with India (i.e., exports – imports). State your assumptions clearly.


Assume the next year expected price of stock ABC (denote by x) is $10
with a standard deviation of $1 and the expected price of stock XYZ
(denote by y) is $15 with a standard deviation of 2$.
What is the expected value and a standard deviation of a portfolio that

consist of 2 stocks ABC and 3 stocks XYZ?
a) If stock prices are independent?

b) If stock prices are positively correlated with correlation of 0.8?


9.4 Introduction to Discrete Probability
Distributions (1 of 3)
The Uniform Distribution
If X is a random variable with possible outcomes 1, 2, …, n and

P ( X = i ) = 1/ n for each i, then we say X has a discrete Uniform distribution
U[1, …, n].
If I’m a fair die,
Example: Tossing a fair die is described by each probability
the Uniform model U[1, 2, 3, 4, 5, 6], with (1,2,3,4,5,6) is
P ( X = i ) = 1/ 6. the same: 1/6.

P(x)
m n
The uniform probability distribution is a

probability distribution that has equal
probabilities for all possible outcomes of the
random variable
Definition: A Bernoulli Trial is a trial with the following characteristics:
1) There are only two possible outcomes (success and failure) for each
trial.
2) The probability of success, denoted p, is the same for each trial. The
probability of failure is q = 1 – p.
3) The trials are independent.
One of the important requirements for Bernoulli trials is that the trials be
independent.
In theory, we need to sample from a population that’s infinitely big. However,

if the population is finite, it’s still okay to proceed as long as the sample is
smaller than 10% of the population.
When the Independence Condition and the 10% Condition are both
satisfied, we can use two probability distributions to model different aspects
of Bernoulli trials: the Geometric distribution and the Binomial distribution.
9.6 The Binomial Distribution
The Binomial Distribution: Predicting the number of successes in a series
of Bernoulli trials.
Binomial Model for Bernoulli Trials
n = Number of trials
p = Probability of success (and q = 1 − p = probability of failure)
X = Number of successes in n trials
n n n!
P ( X = x ) =   p x q n − x ,where   =
x  x  x !(n − x )!
Mean:  = np
Standard deviation:  = npq
( x)
Example evaluating n : For 2 successes in 5 trials,
 5 5! (5  4  3  2  1) (5  4)
 2 2!(5 − 2)! (2  1  3  2  1) = (2  1) = 10.
= =
9.6 The Binomial Distribution - Example
Suppose Google tests five websites. What’s the probability
that exactly two of them have problems (two “successes”)?
We are interested in the number of successes in the five trials, which
we’ll denote by X. We want to find P(X = 2).
Whenever the random variable of interest is the number of successes in
a series of Bernoulli trials, it’s called a binomial random variable.
It takes two parameters to define this Binomial probability distribution:
the number of trials, n, and the probability of success, p.
Suppose that, in this phase of development, 10% of the sites exhibited
some sort of problem, so that p = 0.10. Exactly two successes in five
trials means two successes and three failures.

The 10 ways of getting two successes, S, and hence three failures, F, out
of five websites are as follows:
SSFFF, SFSFF, SFFSF, SFFFS, FSSFF, FSFSF, FSFFS, FFSSF,
FFSFS, FFFSS.
 5 5! (5  4  3  2  1) (5  4)
Remember:   = = = = 10.
 2 2!(5 − 2)! (2  1  3  2  1) (2  1)
How many ways can you have one success, S, and hence four
failures, F, out of five websites?

So there are 10 ways to get two successes in five websites, and the
probability of each is (p)2(1 − p)3. To find the probability of exactly two
successes in five trials, we multiply the probability of any particular order
by this number:
In general, we can write the probability of exactly x successes in n trials

as n n n!
P ( X = x ) =   p x q n − x ,where   =
x  x  x !(n − x )!

Let’s use a binomial distribution table
Note: replace the comma by a period. Therefore, 0,0729 should be 0.0729

If the probability that any single website has a display problem is 0.10,
what’s the expected number of websites with problems if we test 100
sites? You probably said 10 and you would be correct.
E(X) = np = 100 x 0.1 = 10 websites with problems

The standard deviation is less obvious
 = npq = 100 x 0.1x 0.9 = 3 websites
To summarize, a Binomial probability model describes the distribution of

the number of successes in a specified number of trials.

9.6 The Binomial Distribution; n = 10, p = 0.5
When p = 0.5, the Binomial distribution is symmetric
 10 
P ( X = x ) =   0.5 x x 0.510− x
x
Mean:  = np = 10 x 0.5 = 5
Standard deviation:  = npq = 10 x 0.5 x 0.5 = 2.5 = 1.581

When p < 0.5 it is skewed to the right
 10 
P ( X = x ) =   0.25 x x 0.7510− x
x
Mean:  = np = 10 x 0.25 = 2.5

When p > 0.5 it is skewed to the left
 10 
P ( X = x ) =   0.75 x x 0.2510− x
x
Mean:  = np = 10 x 0.75 = 7.5

9.6 The Binomial Distribution - Rules
 n  x n− x
P( X = x ) =    p  q = P( X  x ) − P( X  x − 1 )
 x
x
 n  i n −i
P( X  x ) =     p  q
i =0  i 
P( X  x ) = 1 − P( X  x )
P( X  x ) = P( X  x − 1 )
P( X  x ) = 1 − P( X  x ) = 1 − P( X  x − 1 )
P( x1  X  x2 ) = P( X  x2 ) − P( X  x1 − 1 )
P( X = n ) = p n
P( X = 0 ) = ( 1 − p )n = q n Copyright © 2018 Pearson Canada Inc.
9.6 The Binomial Distribution - Rules

P(X = x)
0.3000
0.2500
0.2000
0.1500
0.1000
0.0500
0.0000
0 1 2 3 4 5 6 7 8 9 10
Binomial Dist b(x; 10, 0.4)

• A feasibility study conducted in Ottawa
found that 40% of people preferred the
Axcedull soap.
• 10 consumers are randomly chosen
• What is the probability that exactly 5
consumers prefer the Axcedull soap?
P(X = 5) = b(5, 10, 0.4) = 0.2007
 10  10 −5
P(X = 5) =    (0.40) 5
 (0.60)
 5 
10!
=  (0.01024)  (0.07776) = 0.2007
5!(10 − 5)!
P(X = x)
0.3000
0.2508
0.2500 P(X = 5) = 0.2007
0.2150
0.2007
0.2000
0.1500
0.1209
0.1115
0.1000
0.0500 0.0403 0.0425
0.0060 0.0106
0.0016 0.0001
0.0000
0 1 2 3 4 5 6 7 8 9 10
Binomial Distribution b(x; 10, 0.4)

9.6 The Binomial Distribution - Lululemon
A major application of the Binomial distribution in business is quality
control. A Canadian company that outsources manufacturing abroad
needs to monitor products not just when they roll off the overseas
production line but also when they’re imported into Canada. Its
customers will also probably check them when they’re received. Some
companies, like SGS Canada of Mississauga, Ontario, specialize in
monitoring, testing, and inspecting for quality-control purposes.
lululemon, which creates yoga-inspired athletic clothing, is one of SGS’s
clients, and SGS provides independent tests of lululemon’s fabrics at the
start of each season, checking a range of properties, including content,
shrinkage, and colour fastness. Copyright © 2018 Pearson Canada Inc.
No production process is perfect, so let’s suppose that we operate a
manufacturing facility where, on average, 1% of our products do not
measure up to our standards. We take samples of 10 products every
hour in our production facility and test them. n = 10 & p = 1%
The probability of 1 out of 10 failing when p = 1% is
The probability of 2 out of 10 failing when p = 1% is

Note: replace the comma by a period. Therefore, 0,9044 should be 0.9044

Review Sections 9.4 & 9.6 – Exercise
Only 4% of people have Type AB blood. A bloodmobile has 12 vials of
blood on a rack. If the distribution of blood types at this location is
consistent with the general population, what’s the probability that
Canadian Blood Services finds AB blood in
a) None of the 12 samples?

b) At least two samples?
c) Three or four samples?
d) The bloodmobile received 300 donations in one day. Assuming that
the frequency of AB blood is 4%, determine the mean and standard
deviation of the number of donors who are AB.

Review Sections 9.4 & 9.6 – Exercise -
Answer

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Class Discussion – Review

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

What about the standard deviation? We know that adding or subtracting

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Var ( X  Y ) = Var ( X ) + Var (Y )

SD( X  Y ) = Var ( X ) + Var (Y ).

Compare this to the expected value and variance on two independent

Copyright © 2018 Pearson Canada Inc.

SD( X  Y ) = Var ( X ) + Var (Y ) = 29,920,000 = $5469.92

Copyright © 2018 Pearson Canada Inc.

The variance is the one we need to watch out for:

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

What is the expected value and a standard deviation of a portfolio that

a) If stock prices are independent?

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

If X is a random variable with possible outcomes 1, 2, …, n and

Copyright © 2018 Pearson Canada Inc.

The uniform probability distribution is a

In theory, we need to sample from a population that’s infinitely big. However,

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

In general, we can write the probability of exactly x successes in n trials

Copyright © 2018 Pearson Canada Inc.

Note: replace the comma by a period. Therefore, 0,0729 should be 0.0729

Copyright © 2018 Pearson Canada Inc.

E(X) = np = 100 x 0.1 = 10 websites with problems

 = npq = 100 x 0.1x 0.9 = 3 websites

To summarize, a Binomial probability model describes the distribution of

Copyright © 2018 Pearson Canada Inc.

Standard deviation:  = npq = 10 x 0.5 x 0.5 = 2.5 = 1.581

Mean:  = np = 10 x 0.25 = 2.5

Mean:  = np = 10 x 0.75 = 7.5

Standard deviation:  = npq = 10 x 0.75 x 0.25 = 1.875 = 1.369

Copyright © 2018 Pearson Canada Inc.

Binomial Dist b(x; 10, 0.4)

0.0500 0.0403 0.0425

Binomial Distribution b(x; 10, 0.4)

The probability of 1 out of 10 failing when p = 1% is

The probability of 2 out of 10 failing when p = 1% is

Copyright © 2018 Pearson Canada Inc.

Note: replace the comma by a period. Therefore, 0,9044 should be 0.9044

Copyright © 2018 Pearson Canada Inc.

a) None of the 12 samples?

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

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