Bayes Theorem

Special Type of Conditional Probability

Recall- Conditional Probability
P(Y T C|S) will be used to calculate
P(S|Y T C)
P(Y T C|F) will be used to calculate
P(F|Y T C)
HOW?????
We will learn in the next lesson?
BAYES THEOREM

Definition of Partition
Let the events B
1
, B
2
, ., B
n
be non-empty subsets
of a sample space S for an experiment. The B
i
s
are a partition of S if the intersection of any two of
them is empty, and if their union is S. This may be
stated symbolically in the following way.
1. B
i
B
j
= C, unless i = j.
2. B
1
B
2
. B
n
= S.

Partition Example
S
B
1

B
2
B
3

Example 1

Your retail business is considering holding
a sidewalk sale promotion next Saturday.
Past experience indicates that the
probability of a successful sale is 60%, if it
does not rain. This drops to 30% if it does
rain on Saturday. A phone call to the
weather bureau finds an estimated
probability of 20% for rain. What is the
probability that you have a successful
sale?
Example 1
Events
R- rains next Saturday
N -does not rain next Saturday.
A -sale is successful
U- sale is unsuccessful.
Given
P(A|N) = 0.6 and P(A|R) = 0.3.
P(R) = 0.2.
In addition we know R and N are complementary events
P(N)=1-P(R)=0.8
Our goal is to compute P(A).

) R N (
c
=
Using Venn diagram Method1
Event A is the
disjoint union of
event R A
&
event N A
S=RN
R
N
A
P(A) = P(R A) + P(N A)

P(A)- Probability that you have a
Successful Sale
We need P(R A) and P(N A)
Recall from conditional probability
P(R A)= P(R )* P(A|R)=0.2*0.3=0.06

Similarly
P(N A)= P(N )* P(A|N)=0.8*0.6=0.48

Using P(A) = P(R A) + P(N A)
=0.06+0.48=0.54


Let us examine P(A|R)

Consider P(A|R)
The conditional
probability that sale is
successful given that it
rains
Using conditional
probability formula


) R ( P
) A R ( P
) R | A ( P

=
S=RN
R
N
A
Tree Diagram-Method 2
Bayes, Partitions
Saturday
R
N
A R A 0.20.3 = 0.06
A N A 0.80.6 = 0.48
U R U 0.20.7 = 0.14
U N U 0.80.4 = 0.32
0.2
0.8
0.7
0.3
0.6
0.4
Probability
Conditional
Probability
Probability Event
*Each Branch of the tree represents the intersection of two events
*The four branches represent Mutually Exclusive events
P(R ) P(A|R)
P(N ) P(A|N)
Method 2-Tree Diagram
Using P(A) = P(R A) + P(N A)
=0.06+0.48=0.54

Extension of Example1
Consider P(R|A)
The conditional probability that it rains given
that sale is successful
the How do we calculate?
Using conditional probability formula

) N ( P ) N | A ( P ) R ( P ) R | A ( P
) R ( P ) R | A ( P
) A ( P
) A R ( P
) A | R ( P
+

=

=
8 0 6 0 2 0 3 0
2 0 3 0
. . . .
. .
+

=
= 0.1111
*show slide 7
Example 2
In a recent New York Times article, it was
reported that light trucks, which include
SUVs, pick-up trucks and minivans,
accounted for 40% of all personal vehicles on
the road in 2002. Assume the rest are cars.
Of every 100,000 car accidents, 20 involve a
fatality; of every 100,000 light truck accidents,
25 involve a fatality. If a fatal accident is
chosen at random, what is the probability the
accident involved a light truck?
Example 2
Events
C- Cars
T Light truck
F Fatal Accident
N- Not a Fatal Accident
Given
P(F|C) = 20/10000 and P(F|T) = 25/100000
P(T) = 0.4
In addition we know C and T are complementary events
P(C)=1-P(T)=0.6
Our goal is to compute the conditional probability of a Light truck
accident given that it is fatal P(T|F).

) T C (
c
=
Goal P(T|F)

Consider P(T|F)

Conditional probability
of a Light truck accident
given that it is fatal

Using conditional
probability formula


) F ( P
) F T ( P
) F | T ( P

=
S=CT
C
T
F
P(T|F)-Method1
Consider P(T|F)
Conditional probability of a Light truck
accident given that it is fatal
How do we calculate?
Using conditional probability formula

) C ( P ) C | F ( P ) T ( P ) T | F ( P
) T ( P ) T | F ( P
) F ( P
) F T ( P
) F | T ( P
+

=

=
) . )( . ( ) . )( . (
) . )( . (
6 0 0002 0 4 0 00025 0
4 0 00025 0
+
=
= 0.4545
Tree Diagram- Method2
Vehicle
C
T
F C F 0.6 0.0002 = .00012
F T F 0.40.00025= 0.0001
N C N 0.6 0.9998 = 0.59988
N T N 0.40.99975= .3999
0.6
0.4
0.9998
0.0002
0.00025
0.99975
Probability
Conditional
Probability
Probability Event
Tree Diagram- Method2
) F C ( P ) F T ( P
) F T ( P
) F ( P
) F T ( P
) F | T ( P
+

=

=
) . )( . ( ) . )( . (
) . )( . (
6 0 0002 0 4 0 00025 0
4 0 00025 0
+
=
= 0.4545
Partition
S
B
1

B
2
B
3

A
) ( ) | ( ) ( ) | ( ) ( ) | ( ) (
3 3 2 2 1 1
B P B A P B P B A P B P B A P A P + + =
Law of Total Probability
)) ( ) ( ) ((
)) ( (
) ( ) (
2 1
2 1
n
n
B A B A B A P
B B B A P
S A P A P
=
=
=

Let the events B

1
, B
2
, ., B
n
partition the finite discrete sample
space S for an experiment and let A be an event defined on S.
Law of Total Probability

=
=
+ + + =
+ + + =

n
i
i i
n n
n
n
B P B A P
B P B A P B P B A P B P B A P
B A P B A P B A P
B A B A B A P
1
2 2 1 1
2 1
2 1
) ( ) | (
) ( ) | ( ) ( ) | ( ) ( ) | (
) ( ) ( ) (
)) ( ) ( ) ((

. ) ( ) | ( ) (
1 =
=
n
i
i i
B P B A P A P
Bayes Theorem
Suppose that the events B
1,
B
2,
B
3, . . . ,
B
n

partition the sample space S for some
experiment and that A is an event defined on
S. For any integer, k, such that
we have
n k s s 1
( )
( ) ( )
( ) ( )

=
=
n
j
j j
k k
k
B P B A P
B P B A P
A B P
1
|
|
|
Focus on the Project
Recall

P(Y T C|S) will be used to calculate
P(S|Y T C)
P(Y T C|F) will be used to calculate
P(F|Y T C)

How can Bayes Theorem help us with the
decision on whether or not to attempt a loan work
out?

Partitions
1. Event S
2. Event F
Given
P(Y T C|S)
P(Y T C|F)
Need
P(S|Y T C)
P(F|Y T C)



Using Bayes Theorem



P(S|Y T C) ~ 0.477
( )
) 536 . 0 ( ) 021 . 0 ( ) 464 . 0 ( ) 022 . 0 (
) 464 . 0 ( ) 022 . 0 (
) ( ) | ( ) ( ) | (
) ( ) | (
|
+

~
+

=
F P F C T Y P S P S C T Y P
S P S C T Y P
C T Y S P
( )
.
) 536 . 0 ( ) 021 . 0 ( ) 464 . 0 ( ) 022 . 0 (
) 536 . 0 ( ) 021 . 0 (
) ( ) | ( ) ( ) | (
) ( ) | (
|
+

~
+

=
F P F C T Y P S P S C T Y P
F P F C T Y P
C T Y F P
LOAN FOCUS EXCEL-BAYES
P(F|Y T C) ~ 0.523
RECALL
Z is the random variable giving the amount of money,
in dollars, that Acadia Bank receives from a future
loan work out attempt to borrowers with the same
characteristics as Mr. Sanders, in normal times.






) 523 . 0 ( 000 , 250 $ ) 477 . 0 ( 000 , 000 , 4 $
) | ( 000 , 250 $ ) | ( 000 , 000 , 4 $
) 000 , 250 $ ( 000 , 250 $ ) 000 , 000 , 4 $ ( 000 , 000 , 4 $ ) (
+ ~
+ =
= + = =
C T Y F P C T Y S P
Z P Z P Z E
E(Z) ~ $2,040,000.

Decision
EXPECTED VALUE OF A WORKOUT=E(Z) ~ $2,040,000

FORECLOSURE VALUE- $2,100,000

RECALL
FORECLOSURE VALUE> EXPECTED VALUE OF A WORKOUT

DECISION
FORECLOSURE

Further Investigation I
let Y ' be the event that a borrower has 6, 7, or 8 years of
experience in the business.


Using the range


Let Z' be the random variable giving the amount of
money, in dollars, that Acadia Bank receives from a
future loan work out attempt to borrowers with Y

' and a
Bachelors Degree, in normal times. When all of the
calculations are redone, with Y

' replacing Y, we find that P(Y

'
T C|S) ~ 0.073 and P(Y

' T C|F) ~ 0.050.
Former Bank
Years In
Business
Years In
Business
Education
Level
State Of
Economy
Loan Paid
Back
BR >=6 <=8 yes
Calculations
P(Y ' T C|S) ~ 0.073
P(Y ' T C|F) ~ 0.050
P(S|Y ' T C) ~ 0.558
P(F|Y ' T C) ~ 0.442

The expected value of Z' is E(Z' ) ~ $2,341,000.

Since this is above the foreclosure value of
$2,100,000, a loan work out attempt is
indicated.

Further Investigation II
Let Y" be the event that a borrower has 5, 6,
7, 8, or 9 years of experience in the business
Let Z" be the random variable giving the
amount of money, in dollars, that Acadia
Bank receives from a future loan work out
attempt to borrowers with 5, 6, 7, 8, or 9
years experience and a Bachelor's Degree, in
normal times. Redoing our work yields the
follow results.
Similarly can calculate E(Z' ' )
Make at a decision- Foreclose vs. Workout
Data indicates Loan work out

Close call for Acadia Bank loan officers
Based upon all of our calculations, we
recommend that Acadia Bank enter into a
work out arrangement with Mr. Sanders.