1

Welcome to DMD Recitation 1!

¡ Due electronically on Monday February 2, 2015
¡ Airline on Ground (AOG) case – work with your team!
¡ Exercises 2.13 and 2.30 – complete individually!
¡ Submit the PDF files on Stellar.

¡ Google Doc for Teams: bit.ly/DMD16-Teams

¡ To reduce background noise, please mute your phone/

computer!

¡ Please feel free to raise your hand or chat through WebEx if

you have any questions or comments!

15.730 - Decision Trees and Discrete Probability

 2

Data, Models,
Data Models
Data, and Decisions
Models, and Decisions
¡ Decision making is hard due to uncertainty

¡ Use data and build models

Making to decision
good make moreis hard
informed decisions

Data Uncertainty Models

15.730 - Decision Trees and Discrete Probability

 3

Outline
¡ Decision Analysis
¡ Tree construction
¡ EMV calculations
¡ Sensitivity Analysis

¡ Binomial Distribution
¡ Understand the formula
¡ Compute probabilities

15.730 - Decision Trees and Discrete Probability

 4

Decision Analysis
¡ Decision Tree
¡ Logical and systematic way of organizing and
representing various decisions and uncertainties

¡ Two types of nodes

¡ Decision node: point where we can choose
between alternatives
¡ Event node: point with uncertainty that we cannot
control

15.730 - Decision Trees and Discrete Probability

 5

Examples of Nodes

We have
control!

15.730 - Decision Trees and Discrete Probability

 6

Examples of Nodes

Outcome is
Random!

15.730 - Decision Trees and Discrete Probability

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Event Node Branches

¡ Mutually Exclusive:
No two outcomes can
happen simultaneously

¡ Collectively Exhaustive:
Set of all possible outcomes
represents the entire range of
possible outcomes
Sum of probabilities equals ONE

15.730 - Decision Trees and Discrete Probability

 8

Should We Play the Lottery?

+
- $0.9 $1,000,000

- $1

$0
15.730 - Decision Trees and Discrete Probability
 9

Should We Play the Lottery?

Compare EMVs of each +
decision and pick the $1,000,000
highest! - $0.9

- $1

$0
15.730 - Decision Trees and Discrete Probability
 10

Should We Play the Lottery?

Compare EMVs of each +
decision and pick the $1,000,000
highest! - $0.9

$0

- $1

$0
15.730 - Decision Trees and Discrete Probability
 11

Decision Analysis Procedure

¡ List choices (decision nodes)

¡ List uncertain events (event nodes)

¡ Construct a decision tree

¡ Determine the probabilities of each outcome

¡ Determine the numerical values of the endpoints

¡ Solve using backward induction

¡ Event nodes: calculate EMV
¡ Decision nodes: choose decision with highest EMV

¡ Perform sensitivity analysis (What-if scenarios)

15.730 - Decision Trees and Discrete Probability

 12

Kendall Crab and Lobster

Case
¡ Shortly before noon, Jeff Daniels, director of
Overnight Delivery Operations at Kendall Crab
and Lobster (KCL) watched the weather
channel:
¡ Weather forecast predicted 50% chance that the
storm hits Boston around 5pm

¡ With the chance of Logan airport closing,

business travelers were also nervously awaiting
further weather information
¡ In the past, if a storm of this magnitude hits, 1 in 5
come with strong winds that force Logan to close

15.730 - Decision Trees and Discrete Probability

 13

Operations
¡ Customers can order lobsters for next-day
delivery prior to 5pm on day before delivery
¡ Typical daily order of 3,000 lobsters
¡ At 5:30pm, trucks from United Express pick up the
lobsters and truck them to Logan airport
¡ At 6:30pm, packed lobsters are flown to a processing
and distributing facility in DC
¡ By 10:30am of next day, lobsters are delivered

15.730 - Decision Trees and Discrete Probability

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Earnings and Refund Policy

¡ Price charged to customers is $30/lobster, which
includes all transportation costs

¡ When KCL ships a lobster via United Express, its

unit contribution to earnings is $10/lobster

¡ If KCL cannot deliver the lobsters to customers, its

policy is to give each customer a $20 discount
coupon per lobster
¡ Market research has shown that ~70% of the
customers only redeem the coupons

15.730 - Decision Trees and Discrete Probability

 15

Changes to Operations Due to

Weather
¡ Rely on the Massachusetts Air Freight (MAF)
which operates 50 miles away from Boston
¡ If contacted before 5:30pm, MAF will pick up the
lobsters from KCL and deliver them to an airport in
Worcester to fly them to DC
¡ Additional transportation cost of using MAF is $13/
lobster in roughly 67% of the time, $19/lobster in the
remaining 33%

15.730 - Decision Trees and Discrete Probability

 16

Changes to Operations Due to

Weather
¡ Cancel orders and issue coupons
¡ If the lobsters are not packaged yet, the incremental
cost of cancelling the orders is ~$1/lobster
¡ If lobsters were already packages, incremental cost
is ~$1.25/lobster

¡ Deliver lobsters by truck to DC via the Eastern

Parcel Delivery (EPD)
¡ Arrangement needs to be made by noon!
¡ Cost is $4/lobster 50% of the time, $3/lobster 25% of
the time and $2/lobster 25% of the time.

15.730 - Decision Trees and Discrete Probability

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What is the Best Decision?

¡ List Decisions that can be made over time
Noon 5:00pm 5:30pm

15.730 - Decision Trees and Discrete Probability

 18

What is the Best Decision?

¡ List Decisions that can be made over time
Noon 5:00pm 5:30pm

1. Use EPD to
deliver by land
2. Wait until
5:00pm
3. Cancel orders
and issue
coupons

15.730 - Decision Trees and Discrete Probability

 19

What is the Best Decision?

¡ List Decisions that can be made over time
Noon 5:00pm 5:30pm

1. Use EPD to 1. USE MAF to

deliver by land deliver to
2. Wait until Worcester
5:00pm 2. Cancel orders
3. Cancel orders and issue
and issue coupons
coupons

15.730 - Decision Trees and Discrete Probability

 20

What is the Best Decision?

¡ List Uncertainties and their probability of occurrence
Noon 5:00pm 5:30pm

If EPD, additional
cost is uncertain:
- $4 w.p. 0.5
- $3 w.p. 0.25
- $2 w.p. 0.25

15.730 - Decision Trees and Discrete Probability

 21

What is the Best Decision?

¡ List Uncertainties and their probability of occurrence
Noon 5:00pm 5:30pm

If EPD, additional Storm:

cost is uncertain: - Yes w.p. 0.5
- $4 w.p. 0.5 - No w.p. 0.5
- $3 w.p. 0.25
- $2 w.p. 0.25

15.730 - Decision Trees and Discrete Probability

 22

What is the Best Decision?

¡ List Uncertainties and their probability of occurrence
Noon 5:00pm 5:30pm

If EPD, additional Storm:

cost is uncertain: - Yes w.p. 0.5
- $4 w.p. 0.5 - No w.p. 0.5
- $3 w.p. 0.25
- $2 w.p. 0.25 Logan Airport:
- Closed w.p. 0.2
- Open w.p. 0.8

15.730 - Decision Trees and Discrete Probability

 23

What is the Best Decision?

¡ List Uncertainties and their probability of occurrence
Noon 5:00pm 5:30pm

If EPD, additional Storm: If MAF, cost is uncertain:

cost is uncertain: - Yes w.p. 0.5 - $13 w.p. 0.67
- $4 w.p. 0.5 - No w.p. 0.5 - $19 w.p. 0.33
- $3 w.p. 0.25
- $2 w.p. 0.25 Logan Airport:
- Closed w.p. 0.2
- Open w.p. 0.8

15.730 - Decision Trees and Discrete Probability

 24

What is the Best Decision?

¡ List Uncertainties and their probability of occurrence
Noon 5:00pm 5:30pm

If EPD, additional Storm: If MAF, cost is uncertain:

cost is uncertain: - Yes w.p. 0.5 - $13 w.p. 0.67
- $4 w.p. 0.5 - No w.p. 0.5 - $19 w.p. 0.33
- $3 w.p. 0.25
- $2 w.p. 0.25 Logan Airport:
- Closed w.p. 0.2 If order canceled:
- Open w.p. 0.8 - Redeem w.p. 0.7
- Not w.p. 0.3

15.730 - Decision Trees and Discrete Probability

 25
Decision Tree

$3
.25

Wait

Noon 5:00pm 5:30pm

15.730 - Decision Trees and Discrete Probability
 26
Decision Tree

$3
.25

Wait
No s
0.5
torm

Noon 5:00pm 5:30pm

15.730 - Decision Trees and Discrete Probability
 27
Decision Tree

$3
.25

$19
Wait
No s
0.5
torm

Noon 5:00pm 5:30pm

15.730 - Decision Trees and Discrete Probability
 28
Calculating the Branch Values $10
profit/
lobster
(10-4)*3,000 = 18,000

$3
.25
(10-3)*3,000 = 21,000

(10-2)*3,000 = 24,000
Wait

Noon 5:00pm 5:30pm

15.730 - Decision Trees and Discrete Probability
 29
Calculating the Branch Values $10
profit/
lobster
18,000
$3
.25 21,000

24,000
Wait

Noon 5:00pm 5:30pm

15.730 - Decision Trees and Discrete Probability
 30
Calculating the Branch Values $10
profit/
lobster
18,000
$3
.25 21,000

24,000
Wait

(-1)*3,000 + (-20)*(0.7)*3,000 = -45,000

Noon 5:00pm 5:30pm

15.730 - Decision Trees and Discrete Probability
 31
Calculating the Branch Values $10
profit/
lobster
18,000
$3
.25 21,000

24,000
Wait

-45,000

Noon 5:00pm 5:30pm

15.730 - Decision Trees and Discrete Probability
 32
Calculating the Branch Values $10
profit/
lobster
18,000
$3
.25 21,000

24,000
Wait
No s

10*3,000 = 30,000
0.5
torm

-45,000 10*3,000 = 30,000

Noon 5:00pm 5:30pm

15.730 - Decision Trees and Discrete Probability
 33
Calculating the Branch Values $10
profit/
lobster
18,000
$3
.25 21,000

24,000
Wait
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 34
Calculating the Branch Values $10
profit/
lobster
18,000
$3
.25 21,000

24,000
Wait
(-1.25)*3,000 +
No s

30,000 (-20)*(0.7)*3,000 =
0.5

-45,750
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 35
Calculating the Branch Values $10
profit/
lobster
18,000
$3
.25 21,000

24,000
Wait
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 36
Calculating the Branch Values $10
profit/
lobster
18,000
(10-13)*3,000 = -9,000
$3
.25 21,000

$19
24,000
(10-19)*3,000 = -27,000
Wait
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 37
Calculating the Branch Values $10
profit/
lobster
18,000
-9,000
$3
.25 21,000

$19
24,000
Wait -27,000
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 38
Calculating the EMV

18,000
-9,000
$3
.25 21,000

$19
24,000
Wait -27,000
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 39
Calculating the EMV

18,000 0.67*(-9,000)+0.33*
(-27,000) = -15,000 -9,000
$3
.25 21,000

$19
24,000
Wait -27,000
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 40
Calculating the EMV

18,000
-9,000
$3 -15,000
.25 21,000

$19
24,000
Wait -27,000
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 41
Comparing the EMV

18,000
-9,000
$3 -15,000
.25 21,000

$19
24,000
Wait -27,000
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 42
Comparing the EMV

18,000
-9,000
$3 -15,000
.25 21,000
-15,000

$19
24,000
Wait -27,000
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 43
Calculating the EMV

18,000
-9,000
$3 -15,000
.25 21,000
-15,000

$19
24,000
Wait -27,000
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 44
Calculating the EMV

18,000
-9,000
$3 -15,000
.25 21,000
-15,000

$19
24,000
Wait -27,000
-45,750
No s

30,000
0.5

0.2*(-15,000)+0.8*
torm

-45,000 (30,000) = 21,000

30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 45
Calculating the EMV

18,000
-9,000
$3 -15,000
.25 21,000
-15,000

$19
24,000
Wait -27,000

21,000 -45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 46
Calculating the EMV

18,000
-9,000
$3 -15,000
.25 21,000
-15,000

$19
24,000
Wait -27,000

21,000 -45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 47
Calculating the EMV

18,000
-9,000
$3 -15,000
.25 21,000
0.5*(21,000) + -15,000

$19
0.5*(30,000) = 25,500
24,000
Wait -27,000

21,000 -45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 48
Calculating the EMV

18,000
-9,000
$3 -15,000
.25 21,000
-15,000

$19
24,000
Wait -27,000
25,000
21,000 -45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 49
Calculating the EMV

18,000
-9,000
$3 -15,000
.25 21,000
-15,000

$19
24,000
Wait -27,000
25,000
21,000 -45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 50
Calculating the EMV
0.5*(18,000) + 0.25*(21,000)
+ 0.25*24,000 = 20,250
18,000
-9,000
$3 -15,000
.25 21,000
-15,000

$19
24,000
Wait -27,000
25,000
21,000 -45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 51
Calculating the EMV

18,000
20,250 -9,000
$3 -15,000
.25 21,000
-15,000

$19
24,000
Wait -27,000
25,000
21,000 -45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 52
Comparing the EMV

18,000
20,250 -9,000
$3 -15,000
.25 21,000
-15,000

$19
24,000
Wait -27,000
25,000
21,000 -45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
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Comparing the EMV

18,000
20,250 -9,000
$3 -15,000
.25 21,000
-15,000

$19
25,000 24,000
Wait -27,000
25,000
21,000 -45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 54
Sensitivity Analysis

18,000
20,250 -9,000
$3 -15,000
.25 21,000
-15,000

$19
? 24,000
Wait -27,000
?
21,000 -45,750
No s

30,000
0

torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 55
Sensitivity Analysis

18,000
20,250 -9,000
$3 -15,000
.25 21,000
-15,000

$19
21,000 24,000
Wait -27,000
21,000
21,000 -45,750
No s

30,000
0

torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 56
Sensitivity Analysis To wait is
robust to
forecast
18,000
20,250 -9,000
$3 -15,000
.25 21,000
-15,000

$19
21,000 24,000
Wait -27,000
21,000
21,000 -45,750
No s

30,000
0

torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 57
Sensitivity Analysis

18,000
20,250 -9,000
$3 -15,000
.25 21,000
-15,000

$19
? 24,000
?
Wait -27,000
?
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 58
Sensitivity Analysis

18,000
20,250 -9,000
$3 -15,000
.25 21,000
p*(-15,000) +
-15,000

$19
(1-p)*(30,000)
? 24,000
Wait -27,000
?
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 59
Sensitivity Analysis

18,000
20,250 -9,000
$3 -15,000
.25 21,000
p*(-15,000) +
-15,000

$19
(1-p)*(30,000)
? 24,000
Wait -27,000
-45,750
No s

30,000
0.5

0.5*(30,000) +
torm

0.5*[p*(-15,000) +
-45,000 (1-p)*(30,000)]
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 60
Sensitivity Analysis | Breakeven
0.5*(30,000) + 0.5*[p*(-15,000)
+ (1-p)*(30,000)] = 20,250
18,000
20,250 -9,000
$3 -15,000
.25 21,000
p*(-15,000) +
-15,000

$19
(1-p)*(30,000)
? 24,000
Wait -27,000
-45,750
No s

30,000
0.5

0.5*(30,000) +
torm

0.5*[p*(-15,000) +
-45,000 (1-p)*(30,000)]
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 61
Sensitivity Analysis | Breakeven
p = 0.433
18,000
20,250 -9,000
$3 -15,000
.25 21,000
p*(-15,000) +
-15,000

$19
(1-p)*(30,000)
? 24,000
Wait -27,000
-45,750
No s

30,000
0.5

0.5*(30,000) +
torm

0.5*[p*(-15,000) +
-45,000 (1-p)*(30,000)]
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 62
Sensitivity Analysis | Breakeven
p = 0.433
18,000
20,250 -9,000
$3 -15,000
.25 21,000
-15,000

$19
24,000
Wait -27,000
20,250
-45,750
No s

30,000
0.5
torm

-45,000
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 63
Sensitivity Analysis | Breakeven
p = 0.433
18,000
20,250 -9,000
$3 -15,000
.25 21,000
p*(-15,000) +
-15,000

$19
(1-p)*(30,000)
24,000
Wait -27,000
-45,750
No s

30,000
0.5

0.5*(30,000) + If p ≤ 0.433, then wait

torm

0.5*[p*(-15,000) + and go with MAF

-45,000 (1-p)*(30,000)]
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 64
Sensitivity Analysis | Breakeven
p = 0.433
18,000
20,250 -9,000
$3 -15,000
.25 21,000
p*(-15,000) +
-15,000

$19
(1-p)*(30,000)
24,000
Wait -27,000
-45,750
No s

30,000
0.5

0.5*(30,000) + If p ≥ 0.433, then ship

torm

0.5*[p*(-15,000) + via trucks with EPD

-45,000 (1-p)*(30,000)]
30,000
Noon 5:00pm 5:30pm
15.730 - Decision Trees and Discrete Probability
 65

Result of Decision Analysis

¡ An optimal decision rule (for every possible
scenario): a “complete contingency plan”

¡ Insights:
¡ If risk neutral, then computing EMV is good enough
¡ But what if risk averse?
¡ Maybe we want to be on the safe side and just
ship by truck to DC!
¡ Variability might be important to look at

15.730 - Decision Trees and Discrete Probability

 66

Random Variables

Discrete
Continuous

15.730 - Decision Trees and Discrete Probability

 67
Simple questions
Probability and Random
Variables
. What is the p
probabilityy that the return is at least 12%?
. P(R 12) = P(R=12) + P(R=13) + P(R=14) = 0.25+0.21+0.09 = 0.55
¡ .Remember!
What is the probability that the return is less than 12%?
¡ Probabilities are always between 0 and 1
. P(R<12) = P(R=10) + P(R=11) = 0.22+0.23 = 0.45
¡ Considering all possible outcomes, the sum of their
. Notice that must
probabilities these
add two probabilities add up to
to ONE 1
R (% per year) Probability
10 0.22
11 0.23
12 0.25
13 0.21
14 0 09
0.09

15.730 - Decision Trees and Discrete Probability

 68
Simple questions
Complements
. What is the p
probabilityy that the return is at least 12%?
. P(R 12) = P(R=12) + P(R=13) + P(R=14) = 0.25+0.21+0.09 = 0.55
¡ .What
Whatis the probability
is the thatthat
probability return
theis return
at leastis12%
less than 12%?
P(R ≥ 12) = P(R=12) + P(R=13) + P(R=14) = 0.25 + 0.21 + 0.09 = 0.55
. P(R<12) = P(R=10) + P(R=11) = 0.22+0.23 = 0.45
¡ What is the probability that return is less than 12%?
. Notice that these two probabilities add up to 1
P(R < 12) = P(R=10) + P(R=11) = 0.22 + 0.23 = 0.45
R (% per year) Probability
10 0.22
11 0.23
12 0.25
13 0.21
14 0 09
0.09

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Simple questions
Complements
. What is the p
probabilityy that the return is at least 12%?
. P(R 12) = P(R=12) + P(R=13) + P(R=14) = 0.25+0.21+0.09 = 0.55
¡ .What
Whatis the probability
is the thatthat
probability return
theis return
at leastis12%
less than 12%?
P(R ≥ 12) = P(R=12) + P(R=13) + P(R=14) = 0.25 + 0.21 + 0.09 = 0.55
. P(R<12) = P(R=10) + P(R=11) = 0.22+0.23 = 0.45
¡ What is the probability that return is less than 12%?
. Notice that these two probabilities add up to 1
P(R < 12) = P(R=10) + P(R=11) = 0.22 + 0.23 = 0.45
R (% per year) Probability
10 0.22
11 0.23 0.55 + 0.45 = 1
12 0.25
13 0.21
14 0 09
0.09

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Example: return
Expected Valueon investment
R= 10*0.22 + 11*0.23 + 12*0.25 + 13*0.21 + 14*0.09 = 11.72
(Excel tip: SUMPRODUCT(column pi, column ri))

Interpretation: center of gravity

0.3
R (% per year) Probability 0.25
0.25 0.23
0.22
10 0.22 0.21
0.2
11 0.23
0.15
12 0.25
0.09
0.1
13 0 21
0.21
0.05
14 0.09
0
9 10 11 12 13 14 15

Distribution can be PbalancedR at the mean

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 71

Mean doesn(t
doesn t tell the whole
Expected Value Doesn’t Tell story
the Whole
Consider a secondStory!
portfolio with the following
p g return
distribution 0.57 0.6

S (% per year) Probability 0.5

0 43
0.43
10 0.57 0.4

11 0 0.3

12 0
02
0.2
13 0
0.1
14 0.43
0
9 10 11 12 13 14 15

The two portfolios have the same

average return: Distribution still balances at 11.72
S = 10*0.57
10*0 57 + 14*0
14*0.43
43 = 11
11.72
72 = R

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How are
How they
are they different?
different?
0.3
0.25
0.25 0.23
0 22
0.22
0.21
0.2

0.15

0 09
0.09
0.1

0.05

0
9 10 11 12 13 14 15

0.6 0.57

0.5
0.43

0.4

0.3

0.2

0.1

0
9 10 11 12 13 14 15

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Example
Variance calculation of variance
2
R
((10-11.72))2 * ((0.22))
0.3
0.25 + (11-11.72)2 * (0.23)
0.25 0.23
0.22
0.21
0.2 + (12-11.72)
(12-11 72)2 * (0.25)
(0 25)
0.15
+ (13-11.72)2 * (0.21)
0.09
0.1

0.05
+ (14-11.72)
(14 11 72)2 * (0
(0.09)
09)
0 = 1.6016
9 10 11 12 13 14 15

(10-11.72)2

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Example
Variancecalculation of variance
2
S ((10-11.72))2 * ((0.57))
0.57
0.6
+ (14-11.72)2 * (0.43)
0.5
0.43

0.4
= 3.9216
3 9216
2
0.3 > 1.6016 = R
0.2

0.1 Portfolio S has more variability in

its potential return than portfolio
0
9 10 11 12 13 14 15 R

(10-11.72)2

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Binomial Distribution
¡ Describes the distribution of
¡ the number of successes
¡ out of n independent “trials”
¡ where each trial has the same probability of success p

¡ Binomial(n,p)

¡ Need to properly define what “trial” and “success”

mean for our problem!

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Binomial Distribution
¡ Suppose we flip 4 coins n=4

¡ Success is obtaining a head with p = 1/3

¡ X = number of heads

1 2 3 4

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Binomial Distribution
¡ How can we obtain 2 heads?
1 2 3 4 1 2 3 4
H H T T T T H H

H T H T T H T H

H T T H T H H T

4! 4*3*2*1
= = 6 ways we can obtain 2 heads!
2!(4-2)! 2*1*(2*1)
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Binomial Distribution
¡ How can we obtain 2 heads?

¡ We can think of it a little differently!

¡ Total number of permutations
¡ To place the first head, we have 4 possibilities

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Binomial Distribution
¡ How can we obtain 2 heads?

¡ We can think of it a little differently!

¡ Total number of permutations
¡ To place the first head, we have 4 possibilities
¡ To place the second head, we have 3 possibilities

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Binomial Distribution
¡ How can we obtain 2 heads?

¡ We can think of it a little differently!

¡ Total number of permutations
¡ To place the first head, we have 4 possibilities
¡ To place the second head, we have 3 possibilities
¡ To place the first tail, we have 2 possibilities

H H

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Binomial Distribution
¡ How can we obtain 2 heads?

¡ We can think of it a little differently!

¡ Total number of permutations
¡ To place the first head, we have 4 possibilities
¡ To place the second head, we have 3 possibilities
¡ To place the first tail, we have 2 possibilities
¡ To place the second tail, we have 1 possibility

H H T

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Binomial Distribution
¡ How can we obtain 2 heads?

¡ We can think of it a little differently!

¡ Total number of permutations
¡ To place the first head, we have 4 possibilities
4*3*2*1
¡ To place the second head, we have 3 possibilities
¡ To place the first tail, we have 2 possibilities
= 4!
¡ To place the second tail, we have 1 possibility

H T H T

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Binomial Distribution
¡ How can we obtain 2 heads?

¡ We can think of it a little differently!

¡ Total number of permutations = 4!
¡ But we don’t care about the order of the heads or the tails!
¡ Suppose we choose the following break-down

H T H T

¡ In how many ways can I place the heads in the grey bins?

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Binomial Distribution
¡ How can we obtain 2 heads?

¡ We can think of it a little differently!

¡ Total number of permutations = 4!
¡ But we don’t care about the order of the heads or the tails!
¡ Suppose we choose the following break-down

H T H T

¡ In how many ways can I place the heads in the grey bins? 2!
¡ In how many ways can I place the tails in the red bins?

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Binomial Distribution
¡ How can we obtain 2 heads?

¡ We can think of it a little differently!

¡ Total number of permutations = 4!
¡ But we don’t care about the order of the heads or the tails!
¡ Suppose we choose the following break-down

H T H T

¡ In how many ways can I place the heads in the grey bins? 2!
¡ In how many ways can I place the tails in the red bins? (4-2)!

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Binomial Distribution
¡ How can we obtain 2 heads?

¡ We can think of it a little differently!

¡ Total number of permutations = 4!
¡ But we don’t care about the order of the heads or the tails!
¡ Suppose we choose the following break-down

H T H T

¡ In how many ways can I place the heads in the grey bins? 2!
¡ In how many ways can I place the tails in the red bins? (4-2)!
¡ Since we do not care about the order: 4!/(2! * 2!)

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Binomial Distribution
¡ P(X=2) = probability that we obtain 2 heads and the remaining
are tails
¡ Each grey bin has a probability p=1/3 to have a head
1/3 * 1/3 = (1/3)2
¡ Each red bin has a probability 1-p = 2/3 to have a tail

2/3 * 2/3 = (2/3)4-2

H T H T

4! (1/3)2 * (2/3)4-2
2!(4-2)!
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Binomial Distribution
¡ In general, if X is Binomial(n,p)
¡ X can take on only the values 0,1,…,n-1,n
¡ The probability that we have x successes out of n trials

n! * (p)x * (1-p)n-x
x!(n-x)!
Number of combinations
with x successes out of n Probability that the
trial remaining (n-k) trials are
Probability that x failures
trials are
successes
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 89

Binomial RVs
¡ Expected value

E[X] = np

¡ Variance

Var(X) = np(1-p)

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 90

Revisiting Taylor Swift

15.730 - Decision Trees and Discrete Probability 90

 91

Revisiting Taylor Swift

n = 50.9M, p = 0.005

E(X) = 254,500
Std(X) = 503
CV(X) = Std(X)/E(X) = 0.0019
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91
 92

Revisiting Taylor Swift

n = 50.9M, p = 0.005

E(X) = 254,500
Std(X) = 503
CV(X) = Std(X)/E(X) = 0.0019 Same p: E(X) = 0.67
Std(X) = 0.816
15.730 - Decision Trees and Discrete Probability CV(X) = 1.219
92
 93

Revisiting Taylor Swift

n = 50.9M, p = 0.005

E(X) = 254,500
Std(X) = 503
CV(X) = Std(X)/E(X) = 0.0019 P = 0.0005: E(X) = 0.0067
Std(X) = 0.258
15.730 - Decision Trees and Discrete Probability CV(X) = 3.862
93
 94

Binomial Distribution -
Example
¡ United’s first class cabin has 10 seats in each plane.

¡ Overbooking policy is to sell up to 11 first class tickets since

cancellations and no-shows are always possible

¡ Suppose that for a given flight

¡ 11 first class tickets are sold
¡ Each passenger has 80% chance of showing up for the flight
¡ Whether a passenger shows up is independent of other passengers

¡ Can we model this as a binomial distribution?

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Binomial Distribution -
Example
¡ United’s first class cabin has 10 seats in each plane.

¡ Overbooking policy is to sell up to 11 first class tickets since

cancellations and no-shows are always possible

¡ Suppose that for a given flight

¡ 11 first class tickets are sold
¡ Each passenger has 80% chance of showing up for the flight
¡ Whether a passenger shows up is independent of other passengers

¡ Can we model this as a binomial distribution? YES!

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Binomial Distribution -
Example
¡ United’s first class cabin has 10 seats in each plane.

¡ Overbooking policy is to sell up to 11 first class tickets since

cancellations and no-shows are always possible

¡ Suppose that for a given flight

¡ 11 first class tickets are sold
¡ Each passenger has 80% chance of showing up for the flight
¡ Whether a passenger shows up is independent of other passengers

¡ Trial = Passengers, Success = Showing up n =11, p = 0.8

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Binomial Distribution -
Example
¡ X = number of passengers that show up

¡ X is Binomial(11, 0.8)

¡ What is the probability that 10 passengers show up?

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Binomial Distribution -
Example
¡ X = number of passengers that show up

¡ X is Binomial(11, 0.8)

¡ What is the probability that 10 passengers show up?

P(X=10) = 11! (0.8)10 * (1-0.8)11-10

10!(11-10)!
= 11 * (0.8)10 * 0.2 ~ 0.236

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 99

Binomial Distribution -
Example
¡ X = number of passengers that show up

¡ X is Binomial(11, 0.8)

¡ What is the probability that the airline gets away with booking?

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 100

Binomial Distribution -
Example
¡ X = number of passengers that show up

¡ X is Binomial(11, 0.8)

¡ What is the probability that the airline gets away with booking?
P(X<=10)

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Binomial Distribution -
Example
¡ X = number of passengers that show up

¡ X is Binomial(11, 0.8)

¡ What is the probability that the airline gets away with booking?
P(X<=10) = P(X=0) + P(X=1) + … + P(X=10)

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Binomial Distribution -
Example
¡ X = number of passengers that show up

¡ X is Binomial(11, 0.8)

¡ What is the probability that the airline gets away with booking?
P(X<=10) = P(X=0) + P(X=1) + … + P(X=10)
¡ Or alternatively:

P(X<=10) = 1 – P(X>10) = 1 – P(X=11)

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Binomial Distribution -
Example
¡ X = number of passengers that show up

¡ X is Binomial(11, 0.8)

¡ What is the probability that the airline gets away with booking?
P(X<=10) = P(X=0) + P(X=1) + … + P(X=10)
¡ Or alternatively:

P(X<=10) = 1 – P(X>10) = 1 – P(X=11)

=1– 11! 0.811 * (1-0.8)11-11
11!(11-11)!
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Binomial Distribution -
Example
¡ X = number of passengers that show up

¡ X is Binomial(11, 0.8)

¡ What is the probability that the airline gets away with booking?
P(X<=10) = P(X=0) + P(X=1) + … + P(X=10)
¡ Or alternatively:

P(X<=10) = 1 – P(X>10) = 1 – P(X=11)

=1– 11! 0.811 * (1-0.8)11-11
11!(11-11)!
~ 0.914
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 105

Binomial Distribution -
Example
¡ X = number of passengers that show up

¡ X is Binomial(11, 0.8)

¡ What if the airline overbooked by selling

¡ 11 seats: P(X<=10) ~ 0.914

¡ 12 seats: P(X<=10) ~ 0.725

¡ 13 seats: P(X<=10) ~ 0.498

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Extensions
¡ Given some additional data
¡ Fares prices
¡ Cost of too many passengers showing up (refunds,
damage to customer relations, etc.)

¡ Is it worthwhile to overbook flights?

¡ Check our assumptions

¡ Is 80% an accurate probability?
¡ Are passengers really independent?

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Alternate Model
¡ We can define the “success” to be a passenger not showing
up

¡ Y = number of passengers not showing up is Binomial(11,0.2)

¡ P(X=10) = P(exactly 10 passengers show up)

= P(exactly 1 passenger does not show up)

= P(Y=1) = 11!
0.21 * (1-0.2)11-1
1!(11-1)!

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Wrap-up
¡ Due electronically on Monday February 2, 2015
¡ AOG case – work with your team!
¡ Exercises 2.13 and 2.30 – complete individually!
¡ Submit the PDF files on Stellar.

¡ Google Doc for Teams: bit.ly/DMD16-Teams

¡ Office hours for 30 minutes!

¡ Feel free to raise your hand and unmute yourself

to ask questions!

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Office Hour

15.730 - Decision Trees and Discrete Probability