Statistics for

Business and Economics

7th Edition

Chapter 4

Discrete Random Variables and

Probability Distributions

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-1
 Chapter Goals
After completing this chapter, you should be
able to:
 Interpret the mean and standard deviation for a

discrete random variable

 Use the binomial probability distribution to find

probabilities
 Describe when to apply the binomial distribution

 Use the hypergeometric and Poisson discrete

probability distributions to find probabilities

 Explain covariance and correlation for jointly

distributed discrete random variables

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-2
 4.1 Introduction to
Probability Distributions
 Random Variable
 Represents a possible numerical value from

a random experiment
Random
Variables

Ch. 4 Discrete Continuous Ch. 5

Random Variable Random Variable

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-3
 Discrete Random Variables
 Can only take on a countable number of values
Examples:

 Roll a die twice

Let X be the number of times 4 comes up
(then X could be 0, 1, or 2 times)

 Toss a coin 5 times.

Let X be the number of heads
(then X = 0, 1, 2, 3, 4, or 5)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-4
 4.2
Discrete Probability Distribution
Experiment: Toss 2 Coins. Let X = # heads.
Show P(x) , i.e., P(X = x) , for all values of x:

4 possible outcomes
Probability Distribution
T T x Value Probability
0 1/4 = .25
T H 1 2/4 = .50
2 1/4 = .25
H T
Probability

.50

H H .25

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

0 1 2 x Ch. 4-5
 4.3
Probability Distribution
Required Properties

 P(x)  0 for any value of x

 The individual probabilities sum to 1;

 P(x)  1
x

(The notation indicates summation over all possible x values)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-6
 Cumulative Probability Function

 The cumulative probability function, denoted

F(x0), shows the probability that X is less than or
equal to x0

F(x 0 )  P(X  x 0 )

 In other words,
F(x 0 )   P(x)
xx0

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-7
 Expected Value
 Expected Value (or mean) of a discrete
distribution (Weighted Average)
μ  E(X)   xP(x)
x

x P(x)
 Example: Toss 2 coins, 0 .25
x = # of heads, 1 .50
compute expected value of x: 2 .25

E(x) = (0 x .25) + (1 x .50) + (2 x .25)

= 1.0

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-8
 Variance and Standard
Deviation
 Variance of a discrete random variable X

σ  E(X  μ)   (x  μ) P(x)
2 2 2

 Standard Deviation of a discrete random variable X

σ  σ2  x
(x  μ) 2
P(x)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-9
 Standard Deviation Example

 Example: Toss 2 coins, X = # heads,

compute standard deviation (recall E(x) = 1)

σ  (x
x
 μ) 2
P(x)

σ  (0  1)2 (.25)  (1  1)2 (.50)  (2  1)2 (.25)  .50  .707

Possible number of heads

= 0, 1, or 2

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-10
 Functions of Random Variables

 If P(x) is the probability function of a discrete

random variable X , and g(X) is some function of
X , then the expected value of function g is

E[g(X)]   g(x)P(x)
x

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-11
 Linear Functions
of Random Variables

 Let a and b be any constants.

 a) E(a)  a and Var(a)  0

i.e., if a random variable always takes the value a,

it will have mean a and variance 0

 b) E(bX)  bμX and Var(bX)  b σ

2 2
X

i.e., the expected value of b·X is b·E(x)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-12
 Linear Functions
of Random Variables
(continued)
 Let random variable X have mean µx and variance σ2x
 Let a and b be any constants.
 Let Y = a + bX
 Then the mean and variance of Y are
μY  E(a  bX)  a  bμX

σ 2
Y  Var(a  bX)  b σ 2 2
X

 so that the standard deviation of Y is

σY  b σX

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-13
 Probability Distributions
Probability
Distributions

Ch. 4 Discrete Continuous Ch. 5

Probability Probability
Distributions Distributions

Binomial Uniform

Hypergeometric Normal

Poisson Exponential

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-14
 4.4
The Binomial Distribution
Probability
Distributions

Discrete
Probability
Distributions

Binomial

Hypergeometric

Poisson

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-15
 Bernoulli Distribution

 Consider only two outcomes: “success” or “failure”

 Let P denote the probability of success
 Let 1 – P be the probability of failure
 Define random variable X:
x = 1 if success, x = 0 if failure
 Then the Bernoulli probability function is

P(0)  (1 P) and P(1)  P

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-16
 Bernoulli Distribution
Mean and Variance

 The mean is µ = P

μ  E(X)   xP(x)  (0)(1 P)  (1)P  P

X

 The variance is σ2 = P(1 – P)

σ 2  E[(X  μ)2 ]   (x  μ)2 P(x)

X

 (0  P) (1 P)  (1 P) P  P(1 P)

2 2

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-17
 Sequences of x Successes
in n Trials

 The number of sequences with x successes in n

independent trials is:

n!
C  n
x
x! (n  x)!
Where n! = n·(n – 1)·(n – 2)· . . . ·1 and 0! = 1

 These sequences are mutually exclusive, since no two

can occur at the same time

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-18
 Binomial Probability Distribution
 A fixed number of observations, n
 e.g., 15 tosses of a coin; ten light bulbs taken from a warehouse
 Two mutually exclusive and collectively exhaustive
categories
 e.g., head or tail in each toss of a coin; defective or not defective
light bulb
 Generally called “success” and “failure”
 Probability of success is P , probability of failure is 1 – P
 Constant probability for each observation
 e.g., Probability of getting a tail is the same each time we toss
the coin
 Observations are independent
 The outcome of one observation does not affect the outcome of
the other
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-19
 Possible Binomial Distribution
Settings

 A manufacturing plant labels items as

either defective or acceptable
 A firm bidding for contracts will either get a
contract or not
 A marketing research firm receives survey
responses of “yes I will buy” or “no I will
not”
 New job applicants either accept the offer
or reject it
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-20
 Binomial Distribution Formula

n! X nX
P(x)  P (1- P)
x ! (n  x )!
P(x) = probability of x successes in n trials,
with probability of success P on each trial
Example: Flip a coin four
times, let x = # heads:
x = number of ‘successes’ in sample,
n=4
(x = 0, 1, 2, ..., n)
P = 0.5
n = sample size (number of trials
or observations) 1 - P = (1 - 0.5) = 0.5
P = probability of “success” x = 0, 1, 2, 3, 4

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-21
 Example:
Calculating a Binomial Probability
What is the probability of one success in five
observations if the probability of success is 0.1?
x = 1, n = 5, and P = 0.1

n!
P(x  1)  P X (1 P)n X
x! (n  x)!
5!
 (0.1)1(1 0.1)5 1
1! (5  1)!
 (5)(0.1)(0.9)4
 .32805
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-22
 Binomial Distribution
 The shape of the binomial distribution depends on the
values of P and n
Mean P(x) n = 5 P = 0.1
.6
 Here, n = 5 and P = 0.1 .4
.2
0 x
0 1 2 3 4 5

.6
P(x) n = 5 P = 0.5
 Here, n = 5 and P = 0.5
.4
.2
0 x
0 1 2 3 4 5
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-23
 Binomial Distribution
Mean and Variance

 Mean
μ  E(x)  nP
 Variance and Standard Deviation

σ  nP(1- P)
2

σ  nP(1- P)
Where n = sample size
P = probability of success
(1 – P) = probability of failure

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-24
 Binomial Characteristics
Examples
μ  nP  (5)(0.1)  0.5
Mean P(x) n = 5 P = 0.1
.6
.4
σ  nP(1- P)  (5)(0.1)(1  0.1) .2
 0.6708 0 x
0 1 2 3 4 5

μ  nP  (5)(0.5)  2.5 P(x) n = 5 P = 0.5

.6
.4
σ  nP(1- P)  (5)(0.5)(1  0.5) .2
 1.118 0 x
0 1 2 3 4 5

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-25
 Using Binomial Tables
N x … p=.20 p=.25 p=.30 p=.35 p=.40 p=.45 p=.50
10 0 … 0.1074 0.0563 0.0282 0.0135 0.0060 0.0025 0.0010
1 … 0.2684 0.1877 0.1211 0.0725 0.0403 0.0207 0.0098
2 … 0.3020 0.2816 0.2335 0.1757 0.1209 0.0763 0.0439
3 … 0.2013 0.2503 0.2668 0.2522 0.2150 0.1665 0.1172
4 … 0.0881 0.1460 0.2001 0.2377 0.2508 0.2384 0.2051
5 … 0.0264 0.0584 0.1029 0.1536 0.2007 0.2340 0.2461
6 … 0.0055 0.0162 0.0368 0.0689 0.1115 0.1596 0.2051
7 … 0.0008 0.0031 0.0090 0.0212 0.0425 0.0746 0.1172
8 … 0.0001 0.0004 0.0014 0.0043 0.0106 0.0229 0.0439
9 … 0.0000 0.0000 0.0001 0.0005 0.0016 0.0042 0.0098
10 … 0.0000 0.0000 0.0000 0.0000 0.0001 0.0003 0.0010

Examples:
n = 10, x = 3, P = 0.35: P(x = 3|n =10, p = 0.35) = .2522
n = 10, x = 8, P = 0.45: P(x = 8|n =10, p = 0.45) = .0229

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-26
 4.5
The Hypergeometric Distribution
Probability
Distributions

Discrete
Probability
Distributions

Binomial

Hypergeometric

Poisson

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-27
 The Hypergeometric Distribution

 “n” trials in a sample taken from a finite

population of size N
 Sample taken without replacement
 Outcomes of trials are dependent
 Concerned with finding the probability of “X”
successes in the sample where there are “S”
successes in the population

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-28
 Hypergeometric Distribution
Formula

S! (N  S)!

CSxCNnxS x! (S  x)! (n  x)! (N  S  n  x)!
P(x)  
CnN
N!
n! (N  n)!
Where
N = population size
S = number of successes in the population
N – S = number of failures in the population
n = sample size
x = number of successes in the sample
n – x = number of failures in the sample
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-29
 Using the
Hypergeometric Distribution
■ Example: 3 different computers are checked from 10 in
the department. 4 of the 10 computers have illegal
software loaded. What is the probability that 2 of the 3
selected computers have illegal software loaded?
N = 10 n=3
S=4 x=2

CSxCNnxS C24C16 (6)(6)

P(x  2)  N
 10   0.3
Cn C3 120
The probability that 2 of the 3 selected computers have illegal
software loaded is 0.30, or 30%.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-30
 4.6
The Poisson Distribution
Probability
Distributions

Discrete
Probability
Distributions

Binomial

Hypergeometric

Poisson

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-31
 The Poisson Distribution
 Apply the Poisson Distribution when:
 You wish to count the number of times an event
occurs in a given continuous interval
 The probability that an event occurs in one subinterval
is very small and is the same for all subintervals
 The number of events that occur in one subinterval is
independent of the number of events that occur in the
other subintervals
 There can be no more than one occurrence in each
subinterval
 The expected number of events per unit is  (lambda)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-32
 Poisson Distribution Formula

λ x
e λ
P(x) 
x!
where:
x = number of successes per unit
 = expected number of successes per unit
e = base of the natural logarithm system (2.71828...)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-33
 Poisson Distribution
Characteristics

 Mean
μ  E(X)  λ
 Variance and Standard Deviation

σ  E[(X  μ) ]  λ
2 2

σ λ
where  = expected number of successes per unit

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-34
 Using Poisson Tables

0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90
X

0 0.9048 0.8187 0.7408 0.6703 0.6065 0.5488 0.4966 0.4493 0.4066

1 0.0905 0.1637 0.2222 0.2681 0.3033 0.3293 0.3476 0.3595 0.3659
2 0.0045 0.0164 0.0333 0.0536 0.0758 0.0988 0.1217 0.1438 0.1647
3 0.0002 0.0011 0.0033 0.0072 0.0126 0.0198 0.0284 0.0383 0.0494
4 0.0000 0.0001 0.0003 0.0007 0.0016 0.0030 0.0050 0.0077 0.0111
5 0.0000 0.0000 0.0000 0.0001 0.0002 0.0004 0.0007 0.0012 0.0020
6 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0001 0.0002 0.0003
7 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

Example: Find P(X = 2) if  = .50

e   X e 0.50 (0.50)2
P( X  2)    .0758
X! 2!

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-35
 Graph of Poisson Probabilities
0.70

Graphically: 0.60

 = .50 0.50

= P(x) 0.40

X 0.50
0.30
0 0.6065
0.20
1 0.3033
2 0.0758 0.10

3 0.0126 0.00
0 1 2 3 4 5 6 7
4 0.0016
x
5 0.0002
6 0.0000
P(X = 2) = .0758
7 0.0000

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-36
 Poisson Distribution Shape

 The shape of the Poisson Distribution

depends on the parameter  :

0.70
 = 0.50 0.25
 = 3.00
0.60
0.20
0.50

0.15
0.40

P(x)
P(x)

0.30 0.10

0.20
0.05
0.10

0.00 0.00
0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 8 9 10 11 12

x x

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-37
 4.7
Joint Probability Functions

 A joint probability function is used to express the

probability that X takes the specific value x and
simultaneously Y takes the value y, as a function of x
and y

P(x, y)  P(X  x  Y  y)
 The marginal probabilities are

P(x)   P(x, y) P(y)   P(x, y)

y x

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-38
 Conditional Probability Functions

 The conditional probability function of the random

variable Y expresses the probability that Y takes the
value y when the value x is specified for X.

P(x, y)
P(y | x) 
P(x)
 Similarly, the conditional probability function of X, given
Y = y is:
P(x, y)
P(x | y) 
P(y)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-39
 Independence
 The jointly distributed random variables X and Y are
said to be independent if and only if their joint probability
function is the product of their marginal probability
functions:

P(x, y)  P(x)P(y)
for all possible pairs of values x and y

 A set of k random variables are independent if and only

if
P(x1, x 2 ,, x k )  P(x1 )P(x 2 )P(x k )

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-40
 Conditional Mean and Variance

 The conditional mean is

μY|X  E[Y | X]   (y | x) P(y | x)

Y

 The conditional variance is

σ 2Y|X  E[(Y  μY|X )2 | X]   [(y  μY|X )2 | x]P(y | x)

Y

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-41
 Covariance
 Let X and Y be discrete random variables with means
μX and μY
 The expected value of (X - μX)(Y - μY) is called the
covariance between X and Y
 For discrete random variables
Cov(X, Y)  E[(X  μX )(Y  μY )]   (x  μx )(y  μy )P(x, y)
x y

 An equivalent expression is
Cov(X, Y)  E(XY)  μxμy   xyP(x, y)  μxμy
x y

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-42
 Covariance and Independence

 The covariance measures the strength of the

linear relationship between two variables

 If two random variables are statistically

independent, the covariance between them
is 0
 The converse is not necessarily true

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-43
 Correlation
 The correlation between X and Y is:

Cov(X, Y)
ρ  Corr(X, Y) 
σ Xσ Y

 ρ = 0  no linear relationship between X and Y

 ρ > 0  positive linear relationship between X and Y
 when X is high (low) then Y is likely to be high (low)
 ρ = +1  perfect positive linear dependency
 ρ < 0  negative linear relationship between X and Y
 when X is high (low) then Y is likely to be low (high)
 ρ = -1  perfect negative linear dependency

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-44
 Portfolio Analysis

 Let random variable X be the price for stock A

 Let random variable Y be the price for stock B
 The market value, W, for the portfolio is given by the
linear function

W  aX  bY
(a is the number of shares of stock A,
b is the number of shares of stock B)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-45
 Portfolio Analysis
(continued)

 The mean value for W is

μW  E[W]  E[aX  bY]
 aμX  bμY
 The variance for W is

σ 2W  a 2σ 2X  b 2σ 2Y  2abCov(X, Y)
or using the correlation formula

σ 2W  a 2σ 2X  b 2σ 2Y  2abCorr(X, Y)σ Xσ Y

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-46
 Example: Investment Returns
Return per $1,000 for two types of investments

Investment
P(xiyi) Economic condition Passive Fund X Aggressive Fund Y
.2 Recession - $ 25 - $200
.5 Stable Economy + 50 + 60
.3 Expanding Economy + 100 + 350

E(x) = μx = (-25)(.2) +(50)(.5) + (100)(.3) = 50

E(y) = μy = (-200)(.2) +(60)(.5) + (350)(.3) = 95

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-47
 Computing the Standard Deviation
for Investment Returns
Investment
P(xiyi) Economic condition Passive Fund X Aggressive Fund Y
0.2 Recession - $ 25 - $200
0.5 Stable Economy + 50 + 60
0.3 Expanding Economy + 100 + 350

σ X  (-25  50) 2 (0.2)  (50  50) 2 (0.5)  (100  50) 2 (0.3)

 43.30

σ y  (-200  95)2 (0.2)  (60  95)2 (0.5)  (350  95)2 (0.3)

 193.71
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-48
 Covariance for Investment Returns
Investment
P(xiyi) Economic condition Passive Fund X Aggressive Fund Y
.2 Recession - $ 25 - $200
.5 Stable Economy + 50 + 60
.3 Expanding Economy + 100 + 350

Cov(X, Y)  (-25  50)(-200  95)(.2)  (50  50)(60  95)(.5)

 (100  50)(350  95)(.3)
 8250

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-49
 Portfolio Example
Investment X: μx = 50 σx = 43.30
Investment Y: μy = 95 σy = 193.21
σxy = 8250

Suppose 40% of the portfolio (P) is in Investment X and

60% is in Investment Y:
E(P)  .4 (50)  (.6) (95)  77

σ P  (.4)2 (43.30) 2  (.6)2 (193.21) 2  2(.4)(.6)(8250)

 133 .04

The portfolio return and portfolio variability are between the values
for investments X and Y considered individually
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-50
 Interpreting the Results for
Investment Returns
 The aggressive fund has a higher expected
return, but much more risk

μy = 95 > μx = 50
but
σy = 193.21 > σx = 43.30

 The Covariance of 8250 indicates that the two

investments are positively related and will vary
in the same direction
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-51
 Chapter Summary

 Defined discrete random variables and

probability distributions
 Discussed the Binomial distribution
 Discussed the Hypergeometric distribution
 Reviewed the Poisson distribution
 Defined covariance and the correlation between
two random variables
 Examined application to portfolio investment

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-52