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EC114 Introduction to Quantitative Economics

3. Discrete Probability Distributions
Department of Economics
University of Essex
25/27 October 2011
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
2/23
Outline
1
Sample Spaces
2
Probability distributions
3
Expectations
4
Pictorial Representations
5
The Binomial Distribution
Reference: R. L. Thomas, Using Statistics in Economics,
McGraw-Hill, 2005, sections 1.11.6.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Sample Spaces 3/23
In analysing the properties of random variables and the
associated probabilities it is important to know the
complete set of possible outcomes of the experiment this
is the sample space.
Suppose a fair coin is ipped three times; the sample
space can be represented by a tree diagram:

EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Sample Spaces 4/23
There are 8(=2
3
) possible outcomes, each of which is
equally likely with probability 1/8.
The outcomes in the sample space can also be listed in a
table:
HHH HHT HTH HTT
THH THT TTH TTT
Note that the outcomes in a sample space are mutually
exclusive.
Hence the sum of the probabilities for all the outcomes is
one.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Probability distributions 5/23
In the previous experiment let X be a random variable
equal to the number of tails obtained.
The variable X can take the values 0, 1, 2 or 3:
HHH (0) HHT (1) HTH (1) HTT (2)
THH (1) THT (2) TTH (2) TTT (3)
The variable X is an example of a discrete random variable
because it can only take integer values.
However, a variable Y that can take on the values 0.5, 1.0,
1.5, 2.0 2.5 and 3 is also discrete.
The point is that the variable cant take any value in a
given range e.g. 2.376543.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Probability distributions 6/23
The probability distribution of X is:
x 0 1 2 3
p(x) 0.125 0.375 0.375 0.125
We will often use the notation p(x) to denote Pr(X = x)
e.g. p(2) = Pr(X = 2).
For example,
p(1) = Pr(X = 1) = Pr(HHT) + Pr(HTH) + Pr(THH)
=
1
8
+
1
8
+
1
8
=
3
8
= 0.375.
We can also write

p(x) = 1 to denote that the sum of all
probabilities is one.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Probability distributions 7/23
Associated with the probability distribution is the
cumulative distribution.
For the random variable X we can dene
C(x) = Pr(xor fewer tails) = Pr(X x).
From the probability distribution we therefore obtain:
x 0 1 2 3
C(x) 0.125 0.500 0.875 1.000
For example,
C(2) = Pr(X 2) = Pr(X = 0) + Pr(X = 1) + Pr(X = 2)
= p(0) +p(1) +p(2)
= 0.125 + 0.375 + 0.375 = 0.875.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Expectations 8/23
Suppose we repeat our coin experiment a large number of
times.
We might ask the question: how many tails would we
obtain on average in the three ips of the coin?
It is (hopefully!) obvious that the answer is 1.5 tails
because the most likely outcomes are 1 and 2, each with
probability 0.375.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Expectations 9/23
But we need to be able to calculate such an average value
in more general cases (such as where the distribution is
not symmetric).
The expected value, or expectation, or mean of the
distribution is often denoted by the Greek letter (mu).
It is dened as follows:
= E(X) =

xp(x),
i.e. the sum of all possible outcomes weighted by their
probabilities.
In our example we have
E(X) = 0p(0) + 1p(1) + 2p(2) + 3p(3)
= 0(0.125) + 1(0.375) + 2(0.375) + 3(0.125)
= 0 + 0.375 + 0.75 + 0.375 = 1.5.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Expectations 10/23
We can also nd expectations of functions of X.
For example, the expectation of X
2
is
E(X
2
) =

x
2
p(x),
i.e. the sum of the squared values of X weighted by their
probabilities.
In our example we have
E(X
2
) = 0p(0) + 1p(1) + 4p(2) + 9p(3)
= 0(0.125) + 1(0.375) + 4(0.375) + 9(0.125)
= 0 + 0.375 + 1.50 + 1.125 = 3.
Important: E(X
2
) = [E(X)]
2
.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Expectations 11/23
In general, if we have a function f (X) of X (e.g. f (X) = X
2
),
E[f (X)] =

f (x)p(x)
and E[f (X)] = f (E(X)).
Why might we be interested in the mean of functions of X?
The variance of X, denoted V(X) or
2
(the Greek letter
sigma), is the mean squared deviation of X around :

2
= V(X) = E(X )
2
=

(x )
2
p(x).
In our example we know that = 1.5, so it is easy to
compute
2
.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Expectations 12/23
Extending the earlier table:
x 0 1 2 3
p(x) 0.125 0.375 0.375 0.125
x 1.5 1.5 0.5 0.5 1.5
(x 1.5)
2
2.25 0.25 0.25 2.25
(x 1.5)
2
p(x) 0.28125 0.09375 0.09375 0.28125
Hence
2
= 0.75 (the sum of the last row above).
It is usually easier to calculate
2
a different way:

2
= E(X
2
)
2
.
To check:
2
= 3 1.5
2
= 3 2.25 = 0.75.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Expectations 13/23
Expectations play a large role in statistics.
Often we are interested in a linear function of a random
variable X of the form Z = a +bX, where a and b are
constants (non-random).
The mean and variance of Z are
E(Z) = a +bE(X), V(Z) = b
2
V(X).
Example: demand, Q, for a good is given by Q = 10 P,
where P denotes the price (a random variable) with
E(P) = 2 and V(p) = 0.5. Find E(Q) and V(Q).
Here we have a = 10 and b = 1 and so
E(Q) = 10 + (1) E(P) = 10 2 = 8,
V(Q) = (1)
2
0.5 = 0.5.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Pictorial Representations 14/23
Discrete probability distributions can be represented using
a histogram.
The vertical axis represents the probability; the horizontal
axis represents the values that X can take.
For our coin example:

0 1 2 3 X
0.5


0.375


0.25


0.125


0
Recall (from lecture 2) that it is the area of the bars that is
important, not the heights.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Pictorial Representations 15/23
Consider the following probability distribution:

0.5

0.375

0.25

0.125

0
9 10 11 12 13 14 15 16 X
P
r
o
b
a
b
i
l
i
t
y

D
e
n
s
i
t
y

We can use it to nd probabilities of certain events.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Pictorial Representations 16/23
For example:
P(X = 12) = 0.0625;
P(X = 10 or 11) = P(X = 10) +P(X = 11)
= 0.125 + 0.5 = 0.625;
P(9 X < 11) = P(X = 9) +P(X = 10)
= 0.125 + 0.125 = 0.25.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
The Binomial Distribution 17/23
An important example of a discrete distribution is the
Binomial distribution.
Consider an experiment where each trial has two possible
outcomes, success (S) or failure (F), and each trial is
independent of all others.
An example is ipping a coin.
If the probabilities of success or failure remain the same
across all trials, they are said to be binomial (or sometimes
Bernoulli) trials.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
The Binomial Distribution 18/23
Let n denote the number of trials, X the number of
successes (which is a discrete random variable taking
values 0, 1, 2, . . . , n), and the probability of success.
Suppose there are x successes followed by n x failures:
SSS . . . S

x
FFF . . . F

nx
Because the outcomes are independent, the probability P
of this sequence occuring is the product of the individual
probabilities:
P = . . .

x
(1 )(1 )(1 ) . . . (1 )

nx
=
x
(1 )
nx
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
The Binomial Distribution 19/23
However, this sequence is only one of all possible
sequences that can occur.
The total number of sequences yielding x successes in n
trials is
n
C
x
=
n!
(n x)!x!
where n! = n (n 1) (n 2) . . . 2 1 (n factorial).
Each sequence is mutually exclusive and so the probability
of x successes is
Pr(X = x) =
n!
(n x)!x!

x
(1 )
nx
, x = 0, 1, 2, . . . , n,
which denes the binomial distribution.
For given n and , this formula tells us the probability of x
successes.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
The Binomial Distribution 20/23
The mean and variance of the binomial distribution are
= E(X) = n,
2
= V(X) = n(1 ).
Example: a researcher applies for a grant to a funding
agency each year over a six year period. Each years
application is independent of all others, and there is a 25%
chance of success. What are the probabilities of x
successes, where x = 0, 1, 2, . . . , 6?
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
The Binomial Distribution 21/23
Here we have n = 6 and = 0.25 so that 1 = 0.75. Also
note that 0! = 1. Hence
p(0) =
6!
6!0!
(0.25)
0
(0.75)
6
= 0.177;
p(1) =
6!
5!1!
(0.25)
1
(0.75)
5
= 0.355;
p(2) =
6!
4!2!
(0.25)
2
(0.75)
4
= 0.297;
p(3) =
6!
3!3!
(0.25)
3
(0.75)
3
= 0.132;
p(4) =
6!
2!4!
(0.25)
4
(0.75)
2
= 0.033;
p(5) =
6!
1!5!
(0.25)
5
(0.75)
1
= 0.004;
p(6) =
6!
0!6!
(0.25)
6
(0.75)
0
= 0.002.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
The Binomial Distribution 22/23
The probability distribution is:
x 0 1 2 3 4 5 6
p(x) 0.177 0.355 0.297 0.132 0.033 0.004 0.002
The mean and variance are
= E(X) = 6 0.25 = 1.5,

2
= V(X) = 6 0.25 0.75 = 1.125.
The researcher can expect to obtain 1.5 grants in a six
year period we would interpret this as being between 1
and 2 grants as half grants arent awarded!
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions
Summary 23/23
Summary
Discrete random variables; probability distributions.
Expectations mean, variance, linear functions.
The binomial distribution.
Next week:
Continuous random variables and probability distributions.
EC114 Introduction to Quantitative Economics 3. Discrete Probability Distributions