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Markov Process

1. An example

1.1 Urban and rural populations are 48 million and 116 million respectively. Historical data

reveals that 5 per cent of urban population migrates to rural area and 20 per cent rural

population migrates to urban area. Determine urban-rural population after one year.

(Assuming zero per cent growth)

1.2 Simple arithmetic:

Urban: 48*0.95 + 116*0.3 = 68 million. Rural: 116*0.80 + 48*.05 = 92

1.3 Above example with percentage

Present urban-rural population is 30/70 and next year it would be:

Urban: 30*0.95 + 70*0.3 = 42.50%. Rural: 70*0.80 + 30*.05 = 57.50%

2. Generalization:

2.1

2.2

Aij i = from and j = to

2.4 S1 = S0T Where S = present share and T is transition matrix

Sn = S0TTTTTT…T {number of Ts are n and T remains constant}

Sn = SoTn

3. Markov Process

Above example is of markov process. This technique has numerous applications in

business; market share analysis, brand switching, consumer purchasing brand A in period

one will purchase brand B in next period, bad debt prediction, determining whether a

machine will have breakdown in the future, in HRM people changing companies etc.

4. Assumptions

4.1 There is a limited number or finite number of possible state. [State: Brands (A, B, C),

conditions (Breakdown, no breakdown), Companies, etc}.

4.2 The probability of changing state remains the same over the time. This means transition

matrix will remain same.

4.3 We can predict any future state from the previous state and the matrix of transition

probabilities.

4.4 The size and makeup of the system (for example, the total number of manufacturers and

customers) do not change during the analysis.

4.5 The states are mutually exclusive and collectively exhaustive. Statistically

Markov 2

We have two stores M (Murphy) and A (Ashley). A market research study was conducted

and data collected from 100 from 100 customers. Analysis of data reveals that 90% of

M’s customer will shop at M and remaining 10 % will switch to A in the following week.

Study further reveals that 20% of A will switch to M and 80% will remain with A.

6. Transition matrix P =

7. We have two states and sum of each row = 1 as it is mutually exclusive and completely

exhaustive.

8. Probabilities of states is a row vector

n is period and k number of companies.

9. Π(1) = Π(0)P

Π(2) = Π(1)P

Π(3) = Π(2)P

.

.

.

Π(n + 1) = Π(n)P

Π(1) = Π(0) P = [0.90 0.10]

Π(2) = Π(1) P = [0.83 0.17]

11. Results of the process for 15 weeks are given in the following tables:

State 1 State 2 State 1 State 2

Period 0 1.000 0.000 Period 0 0.000 1.000

Period 1 0.900 0.100 Period 1 0.200 0.800

Period 2 0.830 0.170 Period 2 0.340 0.660

Period 3 0.781 0.219 Period 3 0.438 0.562

Period 4 0.747 0.253 Period 4 0.507 0.493

Period 5 0.723 0.277 Period 5 0.555 0.445

Period 6 0.706 0.294 Period 6 0.588 0.412

Period 7 0.694 0.306 Period 7 0.612 0.388

Period 8 0.686 0.314 Period 8 0.628 0.372

Period 9 0.680 0.320 Period 9 0.640 0.360

Period 10 0.676 0.324 Period 10 0.648 0.352

Above results were obtained through QM. Show on QM

12. If we had 1000 customer, who shopped last at M; our analysis indicates that during 5th

week 723 customers will shop at M and 277 at A.

13. If we had 1000 customer, who shopped last at A; our analysis indicates that during 5th

week 555 customers will shop at M and 445A.

Markov 3

14.1 Analyzes of tables indicate that as n gets larger, the difference between the state

probabilities for the nth and (n + 1)th period becomes smaller and smaller. We conclude

that when n gets larger, Π(n + 1) and Π(n) becomes equal (almost).

14.2 Its means probabilities will become independent of beginning state when is large.

14.3 The probabilities that we approach after a large number of transitions are referred to as

the steady-state probabilities. It is also called equilibrium condition.

15. Interpretation of Steady-State Probabilities.

15.1 Π(n + 1) = Π(n)P and since difference between Π(n + 1) and Π(n) is very small we may

write Π = ΠP (remove the period as it does not matter)

Π2 = 0.1 Π1 + 0.8 Π2 -----------------2

Π1 + Π2 = 1 ----------------- 3

Put (3) in (1) and solve; SS{2/3 and 1/3}

15.3 If we have 1000 customers, markov process model tells us that in the long run, M will get

667 customers and A will get 333 customers.

15.4 Steady-state probabilities can be interpreted as the market share for two stores.

16. Use of Markov

16.1 Store A launch an advertisement campaign instead of getting 10% of M’s share get 15%.

The revised steady-state probabilities would be

Π1 = 0.85 Π1 + 0.2 Π2 ----------------- 1

Π2 = 0.15 Π1 + 0.8 Π2 -----------------2

Π1 + Π2 = 1 ----------------- 3

Put (3) in (1) and solve; SS{0.57, 0.43}. The share of A have been increase

16.2 Suppose market size is 6000 customer, ad campaign will increase customers from 2000

(6000x1/3) to 2580, increase by 580.

16.3 We can do the cost benefit analysis.

17. Account Receivable Analysis

17.1 We have four states (categories); 1. Paid, 2. Bad debt, 3. 0 – 30 days (aging – oldest

unpaid bill is not more than 30 days) and 4. 31 – 90. If any portion of an account balance

exceeds 90 days, that portion is written off as bad debt.

17.2 Suppose that one customer’s account balance on September 30 is as follows:

Aug. 15 Sep. 18 Sep. 28 Total

$ 25 $ 10 $ 50 85

Markov 4

category because oldest unpaid bill of August 15. On October 7 customer pays $25 (of

August 15). Remaining $60 will be placed in 0 – 30 category. This means transition from

one state to another state.

18. Viewing AR operations as Markov Process

18.1 We will consider each week as a trail of a Markov process with a dollar existing in one of

the following states of the system:

State – 1 Paid category Four states can be placed in

State – 2 Bad debt category any order. However, we are

State – 3 0 – 30 days category using this order to facilitate

State – 4 31 – 90 days category some matrix manipulations.

18.2 We can track the week-by-week status of one dollar by using Markov analysis.

18.3 Based on historical transitions of AR, the following matrix of transition probabilities has

been developed:

18.4 Note that the probability of a dollar in the 0 – 30 days category moving to the paid

category in the next period is 40%. Note also that a dollar in a 0 – 30 days category

cannot make the transition to a bad debt state in one week.

19. Absorbing States

We saw (Sec 17.3) that a dollar can change state from 2 to 3 and vice versa. However,

once a dollar makes a transaction to state – 1, the paid category, the probability of making

a transition to other state is zero. Similarly, once a dollar is in state – 2 (bad debt),

probability of transition to any other state is zero. Thus, once a dollar reaches state 1 or 2,

the system will remain in that state indefinitely. We conclude that all AR eventually be

absorbed into state – 1 or state – 2, hence the name absorbing state.

20. Whenever a Markov process has absorbing states, we do not compute steady-state

probabilities because each unit ultimately ends up in one of the absorbing states.

21. Now we want to know what percentage of 0 – 30 state will go to paid state and what goes

to bad debt and similarly for 31 – 90 state.

22. The Fundamental Matrix

22.1 Computation of absorbing state probabilities requires the determination of a fundamental

matrix. We begin the partitioning the matrix of transition probabilities into the following

four parts:

Markov 5

22.4

22.5 Interpretation: 89% of 0 – 30 days category will eventually be paid and 11% will become

bad debt. 74% of 31 – 90 days category will eventually being paid and 26% will remain

unpaid.

23. Establishing the Allowance for Doubtful Accounts – An Example

Suppose that 31 December balance sheet shows that AR in 0 – 30 days category is $1000

and 31 – 90 days category is $2000. In matrix form B = [1000 2000]. Multiply B with

NR i.e. BNR = [2370 630]. Thus out of $3,000, 2370 will be collected and 630

uncollected. Therefore, an allowance for bad debt should be $630.

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