Decision Making using Probability

Introduction
Last time we looked at simple probabilities and how we might derive them. This week we will look at more complicated notions of probability and how we can use probability in order to aid in management decision making.

Conditional Probability
So far we have only considered probabilities in isolation or where two events are independent, like two rolls of a dice. However in reality many events are related, for example the probability of it raining in 5 minutes time is dependent on whether or not it is raining now. If we have two events A and B, then P (A|B) is the probability of A given B, that is the probability that A will happen given the fact that B has already happened, for example P (Rain in 5 minutes|Raining now) Consider the following example, if 10 people are short listed for a job, if you assume you are all equally qualied for the post then initially you would rate your probability of getting the job as 0.1. If you then found out that out the person who got the job was a woman and you knew there were 6 women on the short list, then your probability of getting the job would change based on this information. 1 P (Job|Woman) = 6 P (Job|Man) = 0. You have adjusted your probabilities conditioning on the new information you have received. Generally if P (A|B) is the probability of A occurring given the fact that B has already occurred then P (A|B) = P (A and B) P (B)

If we consider a simple example rst, what is the probability of a card draw at random form a standard pack being a picture card, given the fact that it is a heart. We could just write this down. P (Picture | Heart) = 1 3 13

However using the above formula 13 52 12 P ( Picture ) = 52 13 12 3 P ( Picture and Heart ) = = 52 52 52 P ( Picture and Heart ) 3 P (Picture | Heart) = = P ( Heart ) 13 P ( Heart ) = This obviously is a very simple example of conditional probabilities, consider the following example. A record shop records the age and sex of 200 customers who buy CD singles. Male Female < 30 30 50 50+ 55 25 5 65 35 15

If a customer is selected at random what is the probability they are male and aged between 30 and 50. P (Male and 30 - 50) = 25 1 = 200 8

If a customer is selected at random what is the probability that they are aged between 30 and 50. P (30 - 50) = (25 + 35) 3 = 200 10

Given the fact that the customer is aged between 30 and 50, what is the probability they are male? P (Male | 30 - 50) = P (Male and 30 - 50) 5 = P (30 - 50) 12

0.1 Tree Diagrams

Tree diagrams or probability trees are simple clear ways of presenting probability information, especially if the information is conditional. Lets us rst consider an independent example. If we roll a dice twice what is the probability that we score a six on both rolls, this is in reality simple and we can just write this down as P (Six and Six) = 1 1 1 = 6 6 36

Consider drawing this as a tree diagram. An experiment with outcomes which can be represented with probabilities are represented by circles, called nodes and the outcomes as branches.

Then the probability of a six followed by a six is found by tracing that branch through the tree. We could also nd the probability of at least one six, or the probability of exactly one six. Consider a more complex example. If a worker arrives for work late there is a one in four chance of him being caught. The rst time he is caught he is given a caution, the second time he is sacked. Assuming he is late three days in a row we can express this as a tree diagram.

Using this diagram it is easy to calculate a whole set of probabilities. The termination of each of the branches of the tree are usually know as terminal nodes. The rst step is usually to calculate the probabilities at each of these nodes. We can then look at the probabilities of several different outcomes. P ( Not being Caught ) = P ( Late 3 times but not sacked ) = P ( Not caught 2nd and 3rd time | Caught 1st ) = Where such diagrams might be useful in real world situations is looking at the possibility of being given a false negative in a medical test or of rejecting a perfect component in a production run. A company is keen to increase the quality of its products as it has incurred large warranty claims. The production manager believes that 2 % of the output is defective. He has introduced a new quality control system which inspects nished goods before they are despatched. This system is however not fool proof and he believes that 1 % of perfect items are classed as rejects and 0.3 % of defective items are classed as perfect. This gives us two conditional probabilities. P (Reject | Perfect) = 0.01 P (Perfect | Reject) = 0.003 We can set this up in a probability tree

The company might be interested in the probability of a defective item getting to a customer. P (Defective and Accepted) = This compares with the probability of 0.02 before the new quality control system was introduced.

Expected Monetary Value and Decision Trees

The basic structure of probability trees can be progressed further to allow us to consider making decisions using probability. To do this we need one further concept, which is the idea of Expected Monetary Value (EMV). The expected monetary value of a single event is simply the probability of that event multiplied by the monetary value of that outcome. So if you had to pay out 5 if you pulled an ace from a pack of cards the EMV of that would be 1 5 = 0.38 13

EM V (Ace) =

This means that if you repeated this bet a large number of times you would come out 38 pence down. What however if there was an upside to the bet. If you rolled a six on a dice you had to pay 5 but if you rolled any other number you were paid 2.50. Would you take on this bet? Probability P (6) =
1 6 5 6

Outcome - 5 2.50

P (Not a 6) = This gives

1 5.00 = 0.833 6 5 EM V ( Not a Six ) = 2.50 = 2.0833 6 EM V ( Six ) = and hence the expected monetary value of the bet is EM V ( Bet ) = 0.833 + 2.083 = 1.25 So in the long run this would be a bet to take as has a positive expected monetary value. The expected monetary value of a project or bet is given by the following formula EM V = P (Event) Monetary value of event.

The expected monetary value of a project can be used as a major decision criteria in a large number of applications. A small company is trying to decide how to launch a new and innovative product. It could go for a direct approach launching onto the whole of the domestic market through traditional distribution channels, or it could launch only on the internet. A third option exists of licensing the product 4

to a larger company who will pay a licence fee irrespective of the success of the product. How should the company launch the product? The company has done some initial market research and the managing director believes the probability of the product being successful can be classed into three categories, high, medium or low. The following table expresses this and the likely prots in the event of each of these outcomes. High (0.2) Direct 100000 Internet 46000 Licence 20000 Medium (0.35) 55000 25000 20000 Low (0.45) -25000 15000 20000

This can be expressed as a decision tree. The decision points are represented by squares and once again the probabilistic nodes by circles. The monetary outcomes are listed down the left hand side of the tree.

The EMV of each decision can be calculated EMV( Direct ) = EMV( Internet ) = EMV( Licence ) =

The managing director should then choose to base the launch route based on the path which gives the largest expected monetary value.

Exercise for 23/11/2001

1. A company has installed a new computer system and some employees are having difculty logging on to the system. They have been given training and the problems which arose during training were recorded and various probabilities calculated. An employee has 0.9 probability of logging on successfully on the rst attempt. If successful at any time then they will also be successful on the next two attempts with the same probability as above. If not successful at any time then the employee looses condence and the probability of success on a subsequent attempt drops to 0.5. Use a tree diagram to nd the following probabilities. (a) An employee successfully logs on their rst three attempts. (b) An employee fails in their rst attempt but is successful in the two attempts after that. (c) Logs on only once in three attempts. (d) Does not manage to log on in three attempts. 2. A lm producer buys the rights to a book with the intention of making a lm. He knows from past experience the chances of making a successful lm are 40 %. A lm would cost 30 million to make, but would return 120 million. He could conduct detailed market research before making the lm, this would be costly at 5 million and past experience of this suggest it would indicate a successful lm 60 % of the time. However this sort of focus group based market research is not reliable with only a 70 % chance of it indicating the true success rate. The producer could sell the lm at any time but the amount he received for the rights would depend on the level of testing he had done. If the tests indicated a successful lm he could get 35 million for the rights, if they indicated a failure he could get 3 million and if he did no testing he could get 10 million. Use a decision tree to advise the producer on his best course of action. Note this decision tree contains three decision nodes.