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ECON 131

Lecture 2

Probability Trees and Random Variables

Goals:

Understand the concept of independence

Know how to analyze conditional probability problems with

probability trees

Understand what a random variable is

Be able to compute measures of central tendency,

Probability trees

probability tree: a way of deriving probabilities from conditional

information. They are most useful when one has information

that can be arranged sequentially.

Probability Tree Rules:

The tree is drawn on its side.

It starts from a circle called a chance node.

The branches of the tree at each node correspond to possible

outcomes. We label the branches with conditional probabilities.

The probabilities at the end of the tree are joint probabilities obtained

by multiplication.

Example: Draw a probability tree for two independent fair coin tosses.

Sometimes, conditioning on one event does not provide any information about the

probability of another event.

Example: The outcome of the first of two coin flips.

We call this independence.

Definition: Two events, A and B, are independent if

Prob(A | B) = Prob(A)

In words: The conditional probability = the marginal probability

(of the unconditioned event).

Note: Independent is not the same as mutually exclusive.

An (Equivalent) Alternative Definition

Using the multiplication rule, we can define (and check) the

independence of two events, A and B, with the formula:

In words:

The joint probability = the product of the marginals

(for independent events).

Independence

Independence

Example: The internet survey.

None

Dial-up

DSL

Cable

T1/Fiber

Other

Urban

.098

.039

.088

.071

.001

.019

.316

Suburban

.159

.086

.130

.114

.008

.024

.521

Rural

.074

.035

.030

.016

.000

.008

.163

.331

.160

.248

.201

.009

.051

How about events that are close to independent?

Interpretation?

2.9

Independence

Independence

Example: The internet survey.

None

Dial-up

DSL

Cable

T1/Fiber

Other

Urban

.098

.039

.088

.071

.001

.019

.316

Suburban

.159

.086

.130

.114

.008

.024

.521

Rural

.074

.035

.030

.016

.000

.008

.163

.331

.160

.248

.201

.009

.051

(orange circle)

Interpretation?

(green circles)

2.9

Random Variables

random variable: an experiment with numerical outcomes

Two examples:

Rolling two dice and counting the number of spots

A week passes and the stock market goes up or down some %

Notation. We denote a random variable with a capital letter, like X or Y.

Terminology. We will say things like:

Let the random variable X be the outcome of rolling two fair dice

By which we mean: There is an experiment (i.e., roll two dice), with a

numerical outcome space (e.g., {2, 3, ..., 12}). We will denote the actual

outcome (before we know it) by the symbol X.

Events. An event is a result of the relevant experiment, as in: the event

X = 4; or, the event X is odd

By which we mean: The outcome of the experiment is 4;

or, the outcome of the experiment is one of the list {3, 5, 7, 9, 11}.

So, summing up the terminology:

We write things like: Prob{ X = 4} = 3/36

We say this as: The probability of the event `X equals 4 is 3/36

Or sometimes just: The probability that X equals 4 is 3/36

10

Most economics applications involve numerical outcomes (e.g.,

Computers can more easily manipulate numerical versus character

experimental outcomes.

We can compute averages and other measures of central tendency.

E.g.: Expected auto sales under a carbon tax.

We can determine how uncertainty in one thing (e.g., gas prices)

11

Variance

Associates

Variance

Associates

The President of VA is not pleased with performance.

The President of VA is not pleased with performance.

VA has had good and bad years in the past, but cumulatively it is just

breaking

VA has had

good and bad years in the past, but cumulatively it is

even.

just breaking even.

Out of frustration, he hires a consultant...

Out of frustration,

he hires aHarbus,

consultant

Poindexter

III

Poindexter Harbus, III (FILS `93)

Before we start the case, what are the key features of this market?

Before we start the case, what are the key features of this market?

12

Market characterized by:

1. Capacity Constraints

2. Uncertain Demand

These are common features of many markets:

Leasing firms in general (office space, fleets, rental cars, etc)

Heavy mfg (ships, aircraft, heavy machinery)

Power generation

Internet/Telecomm services

Queues: bank tellers, ATMs, McDonalds

Because it takes a long time to put in place more capacity,

markets like these are thought to be key to the understanding

macroeconomic business cycles.

3.13

Here is the information Poindexter initially has:

Demand

Prob

0

0.2

Fear Us

1

2

3

0.1 0.4 0.1

4

0.2

Demand

Prob

0

0.1

Oops

1

2

0.2 0.4

3

0.2

4

0.1

3.14

Here is the information Poindexter initially has:

Demand

Prob

0

0.2

Fear Us

1

2

3

0.1 0.4 0.1

4

0.2

Demand

Prob

0

0.1

Oops

1

2

0.2 0.4

3

0.2

4

0.1

Fear Us Expected Demand:

0 + .1 + .8 + .3 + .8 =

0 .1 + 1 .2 + 2 .4 + 3 .2 + 4 .1 =

0 + .2 + .8 + .6 + .4 =

Total expected demand equals the sum of expected demands = 4

3.15

Poindexter makes the following tables and calculates the

expected cash flow from each customer:

F earUs' Cash F low Distribution ($ in 000s)

Demand

0

1

2

3

Prob

0.2

0.1

0.4

0.1

Revenue

$0

$150

$300

$450

Costs

$300

$300

$300

$300

Cash F low

($300)

($150)

$0

$150

4

0.2

$600

$300

$300

Demand

0

1

2

3

Prob

0.1

0.2

0.4

0.2

Revenue

$0

$150

$300

$450

Costs

$300

$300

$300

$300

Cash F low

($300)

($150)

$0

$150

4

0.1

$600

$300

$300

Expected

300

300

0

300

300

0

16

Poindexter

Reports

Variance

Associates

Poindexter Reports

VAeach

should

expect 4 of their 8 planes to be on the ground each month.

month.

Under VAs current business policies, the expected cash flow each

Under VAs current business policies, the expected

month

is in each

fact $0.

cash flow

month is in fact $0.

How did Poindexter arrive at his figures?

3.9

17

Copyright 2010 C. Lanier Benkard

Expected Value

Expected Value

Expected Value. If X is a r.v., the expected value (or expectation) of X is

E(X) =

outcomes

1. If X is a r.v. and a,b are numbers,

E(a + bX) = a + bE(X)

In our example,

E(profits) = price * E(demand) - total costs

2. If X and Y are r.v.s, then E(X + Y) = E(X) + E(Y).

In our example,

E(total profits) = E(profits from FearUs) + E(profits from Oops)

3.12

18

New Strategy

Poindexters proposal:

Sell off one plane, and keep only 7 to meet demand.

To satisfy the customers, offer a new policy:

If a customer ever asks for a plane and VA does not have one, VA will pay

new strategy?

First, what do we need to know to answer this

question?

19

New Strategy

Poindexters proposal:

Sell off one plane, and keep only 7 to meet demand.

To satisfy the customers, offer a new policy:

If a customer ever asks for a plane and VA does not have one, VA will pay

new strategy?

First, what do we need to know to answer this

question?

...the probability distribution of total demand.

20

Poindexter multiplies the marginals to get the following probability table:

Oops

Demand

0

1

2

3

4

0

0.02

0.04

0.08

0.04

0.02

0.2

Fear Us Demand

1

2

3

0.01 0.04 0.01

0.02 0.08 0.02

0.04 0.16 0.04

0.02 0.08 0.02

0.01 0.04 0.01

0.1 0.4 0.1

4

0.02

0.04

0.08

0.04

0.02

0.2

0.1

0.2

0.4

0.2

0.1

Total Dem.

Prob

.02

.05

.14

.17

.24

.17

.14

.05

.02

3.14

21

The Analysis

of the

7 Plane Option

The

7 Plane

Strategy

From this he creates a table to compute expected cash flow:

Expected Cash Flow Calculation - ($ in 000s)

Expected

$597

$ 3

$525

$ 69

3.15

22

The president likes this.

But now he wonders: Can I get by with fewer planes?

We expect demand to be only 4 planes

He reasons:

If thats what we expect, we should just carry four planes.

Instead of carrying enough to handle the maximum demand, well carry

and Oops with a free plane if were short.

planes?

23

The president likes this.

But now he wonders: Can I get by with fewer planes?

We expect demand to be only 4 planes

He reasons:

If thats what we expect, we should just carry four planes.

Instead of carrying enough to handle the maximum demand, well carry

and Oops with a free plane if were short.

planes?

Yes! $96k

Other

Options?

Other options?

We calculate

thethe

distribution

of of

cash

ofthe

thealternative

alternative

We calculate

distribution

cashflows

flowsunder

under each

each of

strategies:

strategies:

Cash Flows in $000s

Total Dem. 0

1

2

3

4

5

6

7

8

E(Demand)

Prob

0.02 0.05 0.14 0.17 0.24 0.17 0.14 0.05 0.02

4

Cash Flow

E(Cash Flow)

4 Planes ($300) ($150) $0 $150 $300 $150 $0 ($150) ($300)

$ 96

5 Planes ($375) ($225) ($75) $75 $225 $375 $225 $75 ($75)

$ 135

6 Planes ($450) ($300) ($150) $0 $150 $300 $450 $300 $150

$ 123

7 Planes ($525) ($375) ($225) ($75) $75 $225 $375 $525 $375

$69

8 Planes ($600) ($450) ($300) ($150) $0 $150 $300 $450 $600

$0

3.17

25

131a Econometrics and Data Analysis I

Uh, ohSomethings

wrong

Moving

on: The Analysis Continues

VAs accountant, Flim Flambert, joins the fray.

He is concerned about VAs monthly

cash

flow

He

is position.

concerned about VAs monthly

Specifically, Flim is concerned with the risk of cash flows under the old and

Specifically,

concerned

withrisk,

the risk

of cash flows

under in

new

strategies. ToFlim

get aismeasure

of this

he computes

the variance

the old

and new strategies. To get a measure of this risk, he

monthly

income.

computes the variance in monthly income.

I cantIreconcile

Poindexters

probabilities

with our with

past our

cash flows. We

cant reconcile

Poindexters

probabilities

have more

variance

in our

Poindexters

figures imply.

past cash

flows.

Wecash

haveflows

morethan

variance

in our cash

3.18

26

Variance

of

a

Random

Variable

The variance of a r.v. is a measure of how dispersed its outcomes are.

variance: a measure of how dispersed the outcomes of a random

Variance. variable

If X is a r.v.,

arethe variance of X is

Var(X) =

outcomes

Standard Deviation.

SD(X) =

Var(X)

in the expected value as a predictor of an uncertain outcome.

expected value as a predictor of an uncertain outcome

Higher variance is viewed as higher risk in financial contexts.

Fact:

Higher

variance

is viewed

as +higher

financial contexts

If a,b

are numbers,

Var(a

bX) =risk

b2 *in Var(X)

If a and b are numbers, Var(a+bX) = b2 * Var(X)

3.19

27

Variance Calculations

Variance Calculations

To calculate measures of spread for each, we construct the following tables:

Information Common to Both Variance Calculations ($ in 000s)

Total Demand

0

1

2

3

4

5

6

7

8

Cash Flow

($600)

($450) ($300) ($150) $0 $150 $300 $450

$600

E(Cash Flow)

0

0

0

0

0

0

0

0

0

Square Dev

360000 202500 90000 22500 0 22500 90000 202500 360000

Probability

Sq Dev*Prob

Probability

Sq Dev*Prob

0.02

0.05

0.14 0.17 0.24 0.17 0.14

0.05

7200

10125 12600 3825

0

3825 12600 10125

Flambert's Table for Variance Calculation ($ in 000s)

0.08

0.09

0.08

0.1 0.23 0.14 0.19

28800 18225 7200 2250

0 3150 17100

0.03

6075

0.02

7200

0.06

21600

Variance

Poindexters Calculations

Flamberts Calculations

67,500

104,400

Standard Dev

259.8

323.1

3.20

28

Copyright 2010 C. Lanier Benkard

Variance

Analysis

What

went

wrong?

To reconcile

the discrepancy

between

Flim

To reconcile

the discrepancy

betweentheir

theirvariance

variance estimates,

estimates, Flim

and Poindexter

create

a probability

from

and Poindexter

create

a probabilitytable

tablefor

forthe

themonthly

monthly demand

demand from

each each

customer:

customer:

NEW (Flambert)

Oops

Demand

0

0 0.08

1 0.07

2 0.03

3 0.01

4 0.01

0.2

Fear Us Demand

1

2

3

4

0.02

0

0

0 0.1

0.05 0.07

0 0.01 0.2

0.02 0.21 0.03 0.11 0.4

0.01

0.1 0.06 0.02 0.2

0 0.02 0.01 0.06 0.1

0.1

0.4

0.1

0.2

OLD (Poindexter)

Oops

Demand

0

1

2

3

4

0

0.02

0.04

0.08

0.04

0.02

0.2

Fear Us Demand

1

2

3

0.01 0.04 0.01

0.02 0.08 0.02

0.04 0.16 0.04

0.02 0.08 0.02

0.01 0.04 0.01

0.1 0.4 0.1

4

0.02

0.04

0.08

0.04

0.02

0.2

0.1

0.2

0.4

0.2

0.1

What do you infer from the new probability table about demand

What do you infer from the new probability table about demand patterns

patterns of the two customers?

of the two customers?

3.21

Graphical Interpretation

Graphical Interpretation

Poindexter's Total Demand

Fear Us Demand

0.2

Probability

Probability

0.25

0.4

0.35

0.3

0.25

0.2

0.15

0.1

0.05

0

0.15

0.1

0.05

0

Demand

Demand

0.4

0.35

0.3

0.25

0.2

0.15

0.1

0.05

0

0.25

Probability

Probability

Oops Demand

0.2

0.15

0.1

0.05

0

Demand

Demand

3.22

30

Covariance

Covariance

How do we quantify this association? Covariance.

Covariance. If X and Y are two random variables, then

Cov(X,Y) =

joint outcomes

* (Joint prob of X and Y)

Intuition:

Cov(X,Y) > 0:

Cov(X,Y) < 0:

Cov(X,Y) = 0:

or when X goes down, Y tends to go down.

when X goes up, Y tends to go down;

or when X goes down, Y tends to go up.

no (linear) association between X and Y

The covariance measures the linear association between two random variables.

Fact: If a,b,c,d are numbers, Cov( a+bX , c+dY ) = b d Cov(X,Y)

3.23

31

What is the covariance of FearUs and Oops demands?

Flim has discovered that the two random variables (FearUs demand

and Oops demand) are not independent. They covary.

32

Copyright 2010 C. Lanier Benkard

Calculating theCovariance

Covariance in Demand

Calculating

of Demands

Product

Oops (X)

0

1

2

3

4

0

1

2

3

4

0

1

2

3

4

0

1

2

3

4

0

1

2

3

4

Fear Us (Y)

0

0

0

0

0

1

1

1

1

1

2

2

2

2

2

3

3

3

3

3

4

4

4

4

4

Prob

0.08

0.07

0.03

0.01

0.01

0.02

0.05

0.02

0.01

0

0

0.07

0.21

0.1

0.02

0

0

0.03

0.06

0.01

0

0.01

0.11

0.02

0.06

E[X]

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

E[Y]

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

2

X-E[X]

-2

-1

0

1

2

-2

-1

0

1

2

-2

-1

0

1

2

-2

-1

0

1

2

-2

-1

0

1

2

Y-E[Y]

-2

-2

-2

-2

-2

-1

-1

-1

-1

-1

0

0

0

0

0

1

1

1

1

1

2

2

2

2

2

4

2

0

-2

-4

2

1

0

-1

-2

0

0

0

0

0

-2

-1

0

1

2

-4

-2

0

2

4

Prod * Prob

0.32

0.14

0

-0.02

-0.04

0.04

0.05

0

-0.01

0

0

0

0

0

0

0

0

0

0.06

0.02

0

-0.02

0

0.04

0.24

Covariance:

0.82

(X-E[X])*(Y-E[Y])

3.28

33

What is the covariance of FearUs and Oops demands?

Flim has discovered that the two random variables (FearUs demand

and Oops demand) are not independent. They covary.

How does this affect Poindexters original expected value and variance

calculations?

The expected value calculation is still correct.

Poindexters variance calculation is not correct.

Why?

34

If X and Y are two random variables, then:

Var(X + Y) = Var(X) + Var(Y) + 2 Cov(X,Y)

Intuition: If two r.v.s negatively covary, they will tend to cancel each

other out and reduce the variance of the sum; if they positively

covary, they will tend to magnify the variance of the sum.

So: Why did independence matter here?

X, Y independent implies Cov(X, Y) = 0

35

Because the monthly demand from FearUs and the monthly demand from

Oops have positive covariance, it follows that the true variance in VAs profits

is larger than what one would get using Poindexters independence

assumption.

Some further questions:

What effect does the covarying demand have on outages?

What impact does covarying demand have on VAs expected cash flow? With

What is the optimal number of planes to hold with covarying demand?

36

Total Dem. 0

1

2

3

4

5

6

7

8

E(Demand)

Prob

0.08 0.09 0.08 0.1 0.23 0.14 0.19 0.03 0.06

4

Cash Flow

4 Planes ($300) ($150) $0

$150

$300

$150

$0

($150) ($300)

$45

Options?

5 Planes ($375) Other

($225) ($75)

$75

$225

$375

$225

$75

($75)

$96

6 Planes ($450) ($300) ($150) $0

$150

$300

$450

$300

$150

$105

7 Planes ($525) ($375)

($225) ($75)

$75

$225

$525

$375

$57

We calculate

the distribution

of cash$375

flows under

each

of the alternative

8 Planes ($600) ($450)strategies:

($300) ($150)

$0

$150

$300

$450

$600

$0

Econ 131a Econometrics and Data Analysis I

Uncorrected

Cash Flow:

Total Dem. 0

1

2

3

4

5

6

7

8

E(Demand)

Prob

0.02 0.05 0.14 0.17 0.24 0.17 0.14 0.05 0.02

4

Cash Flow

E(Cash Flow)

4 Planes ($300) ($150) $0 $150 $300 $150 $0 ($150) ($300)

$ 96

5 Planes ($375) ($225) ($75) $75 $225 $375 $225 $75 ($75)

$ 135

6 Planes ($450) ($300) ($150) $0 $150 $300 $450 $300 $150

$ 123

7 Planes ($525) ($375) ($225) ($75) $75 $225 $375 $525 $375

$69

8 Planes ($600) ($450) ($300) ($150) $0 $150 $300 $450 $600

$0

3.29

37

Several concepts including independence, probability tree, random

Some economics:

This kind of problem shows up in any firm that faces uncertain demand and has

capacity constraints.

Examples: Manufacturing, telecommunication, financial services, semiconductor

fabrication, airline overbooking

Boeing Corp manages this problem well. It offers option contracts that share

demand and price risk with customers

Big lesson: Its often important to study demand as a random variable (with a

probability distribution)Firms shouldnt assume its constant at the expected value

or plan based on the maximum possible.

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