Expected Value and Variance

Expected Value and Variance

Have you ever wondered whether it would be "worth it" to buy a lottery ticket every week, or pondered questions such as "If I were offered a choice between a million dollars, or a 1 in 100 chance of a billion dollars, which would I choose?"

One method of deciding on the answers to these questions is to calculate the expected earnings of the enterprise, and aim for the option with the higher expected value.

This is a useful decision making tool for problems that involve repeating many trials of an experiment -- such as investing in stocks, choosing where to locate a business, or where to fish.

(For once-off decisions with high stakes, such as the choice between a sure 1 million dollars or a 1 in 100 chance of a billion dollars, it is unclear whether this is a useful tool.)

Example

John works as a tour guide in Dublin. If he has 200 people or more take his tours on a given week, he earns e1,000. If the number of tourists who take his tours is between 100 and 199, he earns e700. If the number is less than 100, he earns e500. Thus John has a variable weekly income.

From experience, John knows that he earns e1,000 fifty percent of the time, e700 thirty percent of the time and e500 twenty percent of the time. John's weekly income is a random variable with a probability distribution

Income

e1,000 e700 e500

Probability 0.5 0.3 0.2

Example

What is John's average income, over the course of a 50-week year? Over 50 weeks, we expect that John will earn

e1000 on about 25 of the weeks (50%); e700 on about 15 weeks (30%); and e500 on about 10 weeks (20%).

This suggests that his average weekly income will be

25(e1000) + 15(e700) + 10(e500) = e810. 50

Dividing through by 50, this calculation changes to

.5(e1000) + .3(e700) + .2(e500) = e810.

Expected Value of a Random Variable

The answer in the last example stays the same no matter how many weeks we average over. This suggests the following: If X is a random variable with possible values x1, x2, . . . , xn and corresponding probabilities p1, p2, . . . , pn, the expected value of X, denoted by E(X), is

E(X) = x1p1 + x2p2 + ? ? ? + xnpn.

Outcomes X x1 x2 ... xn

Probability P(X ) p1 p2 ... pn

Out. ? Prob. X P(X ) x1p1 x2p2 ... xnpn

Sum = E(X)

Expected Value of a Random Variable

We can interpret the expected value as the long term average of the outcomes of the experiment over a large number of trials. From the table, we see that the calculation of the expected value is the same as that for the average of a set of data, with relative frequencies replaced by probabilities.

Warning: The expected value really ought to be called the expected mean. It is NOT the value you most expect to see but rather the average (or mean) of the values you see over the course of many trials.

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