Statistics for finance Chapter -5- Hypothesis Testing

CHAPTER 5

HYPOTHESIS TESTING
Introduction
In Chapter 4, Estimation, we used the information obtained in a simple random sample to

construct a confidence interval estimate of the unknown value of a population parameter. In

this chapter, hypothesis testing, we start with an assumed value of a population parameter: then

we shall use sample evidence to decide wither the assumed value is unreasonable and should be

rejected or whether it should be accepted.

The assumptions we make about the values of population parameters are called hypotheses.

Sample evidence is used to test the reasonableness of hypotheses; hence, the statistical inferences

made in this chapter are referred to as hypothesis testing. A procedure based on sample

evidence and probability theory to determine whether the hypothesis in a reasonable statement.

In hypotheses testing we begin by making a tentative assumption about a population parameter.

A hypothesis is something that has not yet been proven to be true. It is some statement about a

population parameter or about a population distribution.

The Null and Alternative Hypothesis

We said above that hypothesis is a statement about a population parameter or about a

population distribution. In any testing of hypotheses problem, we are faced with a pair of

hypotheses such that one and only one of them is always true. One of this pair is called the null

hypothesis and the other one the alternative hypothesis.

This tentative assumption is called the null hypothesis, and is denoted by Ho- it is the

assumption we wish to test.

A null hypothesis is an assertion about the value of a population parameter. It is an assertion that we

hold as true unless we have sufficient statistical evidence to conclude otherwise.

For example, a null hypothesis might assert that the population mean is equal to 1,000. Unless

we obtain sufficient evidence that it is not 1,000, we will accept it as 1,000. We write the null

hypothesis compactly as: H0: μ =1,000

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Statistics for finance Chapter -5- Hypothesis Testing

Another hypothesis is the alternative hypothesis, which is the opposite of what is stated in the null

hypothesis. This alternative hypothesis specifies all possible values of the population parameter that are

not specified in the null hypothesis, and in denoted by Ha.

The hypothesis testing procedure involves using data from a sample to test the two competing

statements indicated by Ho and Ha. In the process of hypothesis testing, the null hypothesis is

initially assumed to be true.

Ho: μ =1,000

Ha: μ ≠ 1,000

We use the symbol H1 (or Ha) to denote the alternative hypothesis.

The null and alternative hypotheses assert exactly opposite statements. Obviously, both H0 and

H1 cannot be true and one of them will always be true. Thus, rejecting one is equivalent to

accepting the other. At the end of our testing procedure, if we come to the conclusion that H0

should be rejected, this also amounts to saying that H1 should be accepted and vice versa.

Example

1. The manager of a hotel has stated that the mean guest bill for a weekend is Br. 400 or less. A

member of the hotel’s accounting staff has noticed that the total charges for guest bills have been

increasing in recent months. The accountant will use a sample of weekend guest bills to test the

manager’s claim.
Required: State the null and alternative hypotheses
Solution
Ho: μ  Birr 400
Ha:   Birr 400
2. Production workers at XY Company have been trained in their jobs by using two different

training programs. The company training director would like to know whether there is a

difference in mean productivity for workers trained in the two programs.

Required: Develop the null and alternative hypotheses.
Solution
Ho: 1 = 2 or 1 - 2 = 0
Ha: 1  2 1 - 2  0

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Statistics for finance Chapter -5- Hypothesis Testing

3. The manager at a drugstore claims that the company’s employees are honest. However, there

have been many shortages from the cash register lately.

Required: Specify the null and alternative hypothesis
Solution:
Ho: Employees are honest
Ha: Employees are dishonest

N.B In many situations, the choice of Ho and Ha is not obvious; in such cases, judgment on the part of

the user is needed to select the proper form of Ho and Ha. However, the equality part of the

expression (either =, or) always appears in the null hypothesis.

Type I and Type II Errors

There are four possible outcomes of any hypothesis test, two of which are correct and two of

which are incorrect. The incorrect ones are called type I and Type II errors.

Type I Error

A type I error is committed if we wrongly reject the null hypothesis which is actually true. In

short, rejecting a true Ho is called Type I error. The possibility of committing a Type I error is

represented by Alpha (), or the level of significance.

Type II Error

A Type II error is committed by failing to reject a false null hypothesis. That is to say that,

accepting a null hypothesis when it is false is called a Type II error. The probability of

committing a Type II error is represented by beta ().

(Null Hypothesis)
State of Nature
Ho True Ho False
Accept Ho Correct Decision Wrong Decision
(No Error) (Type II Error)
Reject Ho Wrong Decision Correct Decision
(Type I Error) (No Error)
One – Tailed Vs Two – Tailed Tests
Two – Tailed test
If the alternate hypothesis not states the direction (i.e.), the test of significance has two tails
Example: Ho: μ = 20
H1: μ  20
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Statistics for finance Chapter -5- Hypothesis Testing
The dividing point between the region where the null hypothesis is rejected and accepted is called
critical value.
One Tailed test
If the alternate hypothesis states the direction, the test of significance has one tail
Example: Ho: μ > 20
H1: μ < 20
Steps in Hypothesis Testing
A summary of the steps that can be applied to any hypothesis test are:
1. Determine/state the null and alternative hypotheses.
Eg. Ho:   
Ha:   
2. Select the test statistic that will be used to decide whether or not to reject the null
hypothesis
3. Select the level of significance to develop the rejection rule that indicates the values of the
test statistic that will lead to the rejection of Ho.
Eg.  = 0.05 Z012 = 1.96  Reject Ho if /Sample Z/  1.96
4. Collect the sample data, and compute the value the test statistic. A test statistic is a
random variable whose value is used to determine whether we reject the null hypothesis.
E.g sample Z=2.0
5. Compare the value of the test statistic to the critical value(s) and make the decision (either
reject Ho or accept HO).
Hypothesis Test about a population mean
i) Popn Normal, Standard deviation known
In hypothesis testing if the population in normal and standard deviation is known, we use Z-
Value to test the hypothesis; regardless of the sample size, n. It is also applicable when n  30
regardless of the pop distn. We use “t” table only if sample size is less than 30 and population
standard deviation is unknown, otherwise we use Z table.
Example:
(1) Addis Tire Share Company claims that its tires have a mean life of 35,000 miles. A random
sample of 16 of these tires is tested if the sample mean in 33,000 miles. Assume that the
population standard deviation is 3,000 miles and the lives of tires are approximately
normally distributed. Test the share company’s claim using a 5% level of significance.
Solution
1. Ho:  = 35,000 miles 2. Z – Distribution, two tailed test
Ha:  ≠ 35,000 miles
3.  = 0.05 4. X = 33,000 miles
/2 = 0.025  = 3,000 miles
Z0.025 = ± 1.96 n = 16 tires
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Statistics for finance Chapter -5- Hypothesis Testing
Reject Ho if /Sample Z/ > 1.96 Zcal =?
33,000  35,000
Zcal    2.67
3,000
16
5. Reject Ho because /-2.67/ > 1.96
(2) A Employees’ union is on strike for higher wages. The union claims that the mean salary for
teachers is at most Birr 8,400 per year. The legislator does not want to reject the union’s
claim, however, unless the evidence is very strong against. Assume that salaries follow a
normal distribution and the population standard deviation is known to be Br. 3000. A
random sample of 64 teachers is obtained, and the sample mean is Br, 9,400. Test if the
legislator accepts the unions’ claim or not at 1% significance level.
Solution:
1. Ho:  ≤ Birr 8,400 2. Z – distribution, Right – tailed test
Ha:   Birr 8,400
3.  = 0.01
Z = Z0.01 = 2.33
Reject Ho if sample Z  + 2.33
4. n = 64
X = Birr 9,400
 = Birr 3,000
Sample Z =?
9,400  8,400
Z 9, 400   2.67
3,000
64
5. Reject Ho because + 2.67  2.33
Hypothesis testing about: Population normal,  unknown, n small
As explained in chapter 4, Interval Estimation, use of the t-distribution is appropriate when  is
unknown, the sample size is small (n30), and population is normally distributed. When we use
the t-distribution, it replaces Z as test statistic.

X  S
t SX 
SX n
Example:
#1.A contractor assumes that construction workers are idle 75 minutes or less per day. Random
samples of 25 construction workers were taken and the mean idle time was found to be 84
minutes per day with a sample standard deviation of 20 minutes. Assume that the population is
approximately normally distributed; use a 5% level of significance test the contractor’s
assumption.
Solution
1. Ho:  ≤ 75 minutes
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Statistics for finance Chapter -5- Hypothesis Testing

Ha:   75 minutes
t – distribution, Right – tailed test
 = 0.05
n = 25
 = n – 1 = 25 – 1 = 24
t, = t0.05,24 = 1.711
 Reject Ho if sample t  1.711
n = 25
X = 84 minutes
S = 20 minutes
Sample t =?
84  75
t 84   2.25
20
25
Reject Ho; because + 2.25  1.711. Workers are idle for more than 75 minutes per day.

# 2.A director of a secretarial school claims that its graduates can type at least 50 words per
minute on average. Suppose you want to hire some of these graduates if the director’s claim is
true; and you test the typing speed of 18 of the graduates and obtain a mean of 40 wards per
minute with a sample variance of 720. Assuming the typing speed for the graduates of the
secretarial school is normally distributed, test the director’s claim and decide whether to hire the
graduates or not, using a 5% level of significance.
Solution
1. Ho:   50 words
Ha:  50 words
t – distribution, Left – tailed test
 = 0.05
n = 18
=n–1
= 18 – 1 = 17
t, = t0.05, 17 = 1.74
 Reject Ho if sample t  -1.74
X = 40 words
n = 18
s = 720
2

tcal =?
40  50
tcal   1.58
720
18
Do not reject Ho because –1.58 > -1.74

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Statistics for finance Chapter -5- Hypothesis Testing

Hypothesis testing about a population proportion (p)

A proportion is a value between 0 and 1 that expresses the part of the whole that possesses a
given characteristic. Similar to that of hypothesis testing about a population mean, hypothesis
testing about a population proportion has three terms.
1. Ho: P = y 2. Ho: P  y 3. Ho: P  y
Ha: P  y Ha: Py Ha: P y
The first form is a two – tailed test, whereas the second and third forms are one – tailed tests.
The specific form used depends up on the application of interest. Hypothesis testing about a
population proportion is based on the difference between the sample proportion p and the
hypothesized value P.
Examples
#1.A magazine claims that 25% of its readers are college students. A random sample of 200
readers is taken. It is found that 42 of these readers are college students. Use a 10% level of
significance and test the magazine’s claim.
Solution
1. Ho: P = 0.25
Ha: P  0.25
2. Z – distribution; two tailed test
3.  = 0.1 /2 = 0.05
Z/2 = Z0.05 = 1.64
Reject Ho if /sample Z/  1.64
4. n = 200
x = 42
p = 0.21
Sample Z =?
0.21  0.25
Z 0.21   1.31
0.25 * 0.75
200
5. Do not reject Ho because / -1.31/ < 1.64

#2.An Economist states that more than 35% or of Addis’s labor force in unemployed you don’t
know if the economists estimate is too high or too low. You want to test the economists claim
using a 5% level of significance. You obtain a random sample of 400 people in the labor force, of
whom 128 are unemployed. Would you reject the economist’s claim?
Solution
1. Ho: P ≤ 0.35
Ha: P > 0.35
2. Z – distribution , right-tailed test
3.  = 0.05
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Statistics for finance Chapter -5- Hypothesis Testing
Z 0.05 = 1.64
Reject Ho if sample Z > 1.64
4. n = 400
x = 128
p = 0.32
Sample Z =?
0.32  0.35
Z 0.32   1.26
0.35 * 0.65
400
5. Do not reject Ho because / -1.31/ < 1.64
Hypothesis testing about the difference in two means
As hypothesis testing about a population mean or population proportion, hypothesis testing
about the difference between two means has three forms. That is, the null hypothesis can take
three forms along with the corresponding alternative hypothesis.

1. Ho: 1-2 = 0 2. Ho: 1-2 =  0 3. Ho: 1-2 =  0

Ha: 1-2  0 Ha: 1-2 =0 Ha: 1-2 =  0
Two tailed test One tailed test
The general formula for determining the z value for testing a hypothesis concerning the
difference between two means, according to whether the s values for the two populations are
known, is

As implied by the above formulas, we may begin with any particular hypothesized difference,
(1 2)0, that is to be tested. However, the usual null hypothesis is that the two samples have
been obtained from populations with means that are equal. In this case (1 2)0 = 0, and the
above formulas are simplified as follows:

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Statistics for finance Chapter -5- Hypothesis Testing

Where:

The computed z of + 3.32 is in the region of rejection of the hypothesis testing model portrayed
in Fig. 5.1 below. Therefore, the null hypothesis is rejected, and the alternative hypothesis, that
the average weekly wage in the two firms is different, is accepted.

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