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SUMMARY
The case seeks to solve the probabilities of forecasting which state of nature will occur in
the following year: a good economy or a bad economy. The chances that a state of nature will
occur are 60% and 40%, for good economy and bad economy, respectively. Predictions that a
good economy will happen are 80% correct and 20% wrong. Likewise, predictions that a bad
economy will happen is 90% correct and 10% wrong. The Bayes’ Theorem was used to get the
probabilities.
PROBLEM STATEMENT
Problem 1:
A.) Two states of nature exist for a particular situation: a good economy and a bad
economy. An economic study may be performed to obtain more information about which
of these will actually occur in the coming year. The study may forecast either a good
economy or a poor economy. Currently, there is a 60% chance that the economy will be
good and a 40% chance that it will be poor. In the past, whenever the economy was
good, the economic study predicted it would be good 80% of the time. (The other 20% of
the time, the prediction was wrong). In the past, whenever the economy was poor, the
economic study predicted it would be poor 90% of the time. (The other 10% of the time,
the prediction was wrong)
Problem 2:
B) Suppose the initial (prior) probability of a good economy is 70% (instead of 60%),
and the probability of a poor economy is 30% (instead of 40%). Find the posterior
probabilities in part A based on the new values
Problem 1
Chances of State of
Nature occurring
Problem 2
Chances of State of
Nature occurring
The model used for the problem is the Bayes’ theorem. We have applied the same formula and
steps in reaching our posterior probabilities.
However, we have presented our variables in a tabular approach since it is much easier to
comprehend and apply.
We were able to come up with the following posterior probabilities using the above model:
Problem 1:
Problem 2:
Problem 1
The above results show that given a good economy, the new probability that it
will be a correct prediction is 92.3%. This means that there is only a minimal chance that
a good economy prediction is wrong as the results shows only a 7.7% chance.
Comparing it with the probabilities of a bad economy, there is only a 75% chance that it
will be correct and only a 25% chance that it will not occur. Therefore, there is a bigger
chance that the economy in the following year will be a good economy given the
probabilities.
Problem 2
If the probability of a good economy will increase, the probability that a correct
prediction will also increase. Just like in this circumstance where in the probability of a
good economy occurring increased to 70%, the probability of a correct prediction also
increased to 93.3%. Thus, there is also a bigger chance that the economy in the
following year will be good.
CONCLUSION
APPENDICES
Problem # 1
Posterior Probabilities:
Problem # 2
PG Joint probabilities
(1) (2) (1) X (2)
Good Economy 70% 60% 42%
Poor Economy 30% 10% 3%
Marginal probability 45%
PG Joint probabilities
(1) (2) (1) X (2)
Good Economy 70% 20% 14%
Poor Economy 30% 90% 27%
Marginal probability 41%
Posterior probabilities: