Basic Business Statistics

12th Edition
Chapter 5
Discrete Probability
Distributions
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-1

Chap 5-1

Learning Objectives
In this chapter, you learn:
The properties of a probability distribution
To compute the expected value and variance of a
probability distribution
To calculate the covariance and understand its use
in finance
To compute probabilities from binomial,
hypergeometric, and Poisson distributions
How to use the binomial, hypergeometric, and
Poisson distributions to solve business problems
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-2

Chap 5-2

Definitions
Random Variables

A random variable represents a possible

numerical value from an uncertain event.

Discrete random variables produce outcomes

that come from a counting process (e.g.
number of classes you are taking).

Continuous random variables produce

outcomes that come from a measurement (e.g.
your annual salary, or your weight).

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-3

Chap 5-3

Definitions Definitions
Random Variables
Random Variables
Random
Variables
Ch. 5

Discrete
Random Variable

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Continuous
Random Variable

Chap 5-4

Ch. 6

Chap 5-4

Discrete Random Variables

Can only assume a countable number of values

Examples:

Roll a die twice

Let X be the number of times 4 occurs
(then X could be 0, 1, or 2 times)

Toss a coin 5 times.

Let X be the number of heads
(then X = 0, 1, 2, 3, 4, or 5)

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-5

Chap 5-5

Probability Distribution For A

Discrete Random Variable

A probability distribution for a discrete random

variable is a mutually exclusive listing of all
possible numerical outcomes for that variable and
a probability of occurrence associated with each
outcome.

Number of Classes Taken

Probability

2
3
4
5

0.20
0.40
0.24
0.16

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-6

Chap 5-6

Example of a Discrete Random

Variable Probability Distribution
Experiment: Toss 2 Coins.

T
T
H
H

T
H
T
H

Probability Distribution
X Value

Probability

1/4 = 0.25

2/4 = 0.50

1/4 = 0.25

Probability

4 possible outcomes

Let X = # heads.

0.50
0.25

0
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

2
Chap 5-7

X
Chap 5-7

Discrete Random Variables

Expected Value (Measuring Center)

Expected Value (or mean) of a discrete

random variable (Weighted Average)
N

E(X) xi P( X xi )
i 1

Example: Toss 2 coins,

X = # of heads,
compute expected value of X:

P(X=xi)
0

0.25

0.50

0.25

E(X) = ((0)(0.25) + (1)(0.50) + (2)(0.25))

= 1.0
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-8

Chap 5-8

Discrete Random Variables

Measuring Dispersion

Variance of a discrete random variable

N

2 [x i E(X)]2 P(X x i )
i 1

Standard Deviation of a discrete random variable

2
[x

E(X)]
P(X x i )
i
i 1

where:
E(X) = Expected value of the discrete random variable X
xi = the ith outcome of X
P(X=xi) = Probability of the ith occurrence of X
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-9

Chap 5-9

Discrete Random Variables

Measuring Dispersion
(continued)

Example: Toss 2 coins, X = # heads,

compute standard deviation (recall E(X) = 1)

xi E(X)] P(X x i )
2

(0 1)2 (0.25) (1 1)2 (0.50) (2 1)2 (0.25) 0.50 0.707

Possible number of heads
= 0, 1, or 2

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-10

Chap 5-10

Covariance

The covariance measures the strength of the

linear relationship between two discrete random
variables X and Y.

A positive covariance indicates a positive

relationship.

A negative covariance indicates a negative

relationship.

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-11

Chap 5-11

The Covariance Formula

The covariance formula:

N

XY [ xi E ( X )][( yi E (Y )] P( xi yi )
i 1

where: X = discrete random variable X

Xi = the ith outcome of X
Y = discrete random variable Y
Yi = the ith outcome of Y
P(XiYi) = probability of occurrence of the
ith outcome of X and the ith outcome of Y

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-12

Chap 5-12

Investment Returns
The Mean
Consider the return per $1000 for two types of
investments.
Economic Condition
Prob.

Investment
Passive Fund X

Aggressive Fund Y

0.2

Recession

- $25

- $200

0.5

Stable Economy

+ $50

+ $60

0.3

Expanding Economy

+ $100

+ $350

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-13

Chap 5-13

Investment Returns
The Mean
E(X) = X = (-25)(.2) +(50)(.5) + (100)(.3) = 50
E(Y) = Y = (-200)(.2) +(60)(.5) + (350)(.3) = 95
Interpretation: Fund X is averaging a $50.00 return
and fund Y is averaging a $95.00 return per $1000
invested.

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-14

Chap 5-14

Investment Returns
Standard Deviation
X (-25 50) 2 (.2) (50 50) 2 (.5) (100 50) 2 (.3)
43.30
Y (-200 95) 2 (.2) (60 95) 2 (.5) (350 95) 2 (.3)
193.71

Interpretation: Even though fund Y has a higher

average return, it is subject to much more variability
and the probability of loss is higher.

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-15

Chap 5-15

Investment Returns
Covariance
XY (-25 50)(-200 95)(.2) (50 50)(60 95)(.5)
(100 50)(350 95)(.3)
8,250
Interpretation: Since the covariance is large and
positive, there is a positive relationship between the
two investment funds, meaning that they will likely
rise and fall together.

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-16

Chap 5-16

The Sum of
Two Random Variables

Expected Value of the sum of two random variables:

E(X Y) E( X) E( Y )

Variance of the sum of two random variables:

Var(X Y) 2X Y 2X 2Y 2 XY

Standard deviation of the sum of two random variables:

X Y 2X Y
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-17

Chap 5-17

Portfolio Expected Return and

Expected Risk

Investment portfolios usually contain several

different funds (random variables)

The expected return and standard deviation of

two funds together can now be calculated.

Investment Objective: Maximize return (mean)

while minimizing risk (standard deviation).

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-18

Chap 5-18

Portfolio Expected Return

and Portfolio Risk

Portfolio expected return (weighted average

return):

E(P) w E( X) (1 w ) E( Y )

Portfolio risk (weighted variability)

P w 2 2X (1 w )2 2Y 2w(1 - w) XY
Where

w = proportion of portfolio value in asset X

(1 - w) = proportion of portfolio value in asset Y

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-19

Chap 5-19

Portfolio Example
Investment X:
X = 50 X = 43.30
Investment Y:
Y = 95 Y = 193.21
XY = 8250
Suppose 40% of the portfolio is in Investment X and
60% is in Investment Y:
E(P) 0.4 (50) (0.6) (95) 77

(0.4) 2 (43.30) 2 (0.6) 2 (193.71) 2 2(0.4)(0.6)(8,250)

133.30
The portfolio return and portfolio variability are between the values
for investments X and Y considered individually
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-20

Chap 5-20

Probability Distributions
Probability
Distributions
Ch. 5

Discrete
Probability
Distributions

Continuous
Probability
Distributions

Binomial

Normal

Poisson

Uniform

Hypergeometric
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Ch. 6

Exponential
Chap 5-21

Chap 5-21

Binomial Probability Distribution

A fixed number of observations, n

e.g., 15 tosses of a coin; ten light bulbs taken from a warehouse

Each observation is categorized as to whether or not the

event of interest occurred

e.g., head or tail in each toss of a coin; defective or not defective

light bulb
Since these two categories are mutually exclusive and
collectively exhaustive

When the probability of the event of interest is represented as ,

then the probability of the event of interest not occurring is 1 -

Constant probability for the event of interest occurring

() for each observation

Probability of getting a tail is the same each time we toss the

coin

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-22

Chap 5-22

Binomial Probability Distribution

(continued)

Observations are independent

The outcome of one observation does not affect the

outcome of the other
Two sampling methods deliver independence

Infinite population without replacement

Finite population with replacement

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-23

Chap 5-23

Possible Applications for the

Binomial Distribution

A manufacturing plant labels items as

either defective or acceptable

A firm bidding for contracts will either get a

contract or not

A marketing research firm receives survey

responses of yes I will buy or no I will
not

New job applicants either accept the offer

or reject it

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-24

Chap 5-24

The Binomial Distribution

Counting Techniques

Suppose the event of interest is obtaining heads on the

toss of a fair coin. You are to toss the coin three times.
In how many ways can you get two heads?

Possible ways: HHT, HTH, THH, so there are three

ways you can getting two heads.

This situation is fairly simple. We need to be able to

count the number of ways for more complicated
situations.

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-25

Chap 5-25

Counting Techniques
Rule of Combinations

The number of combinations of selecting X

objects out of n objects is

n!
n Cx
x!(n x)!
where:
n! =(n)(n - 1)(n - 2) . . . (2)(1)
X! = (X)(X - 1)(X - 2) . . . (2)(1)
0! = 1

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(by definition)

Chap 5-26

Chap 5-26

Counting Techniques
Rule of Combinations

How many possible 3 scoop combinations could you

create at an ice cream parlor if you have 31 flavors to
select from?
The total choices is n = 31, and we select X = 3.

31!
31! 31 30 29 28!

31 5 29 4,495
31 C 3
3!(31 3)! 3!28!
3 2 1 28!

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Chap 5-27

Chap 5-27

Binomial Distribution Formula

n!
x
nx
P(X=x |n,)
(1-)
x! (n x )!
P(X=x|n,) = probability of x events of interest
in n trials, with the probability of an
event of interest being for
each trial
x = number of events of interest in sample,
(x = 0, 1, 2, ..., n)
n

= sample size (number of trials

or observations)
= probability of event of interest
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Example: Flip a coin four

times, let x = # heads:
n=4
= 0.5
1 - = (1 - 0.5) = 0.5
X = 0, 1, 2, 3, 4

Chap 5-28

Chap 5-28

Example:
Calculating a Binomial Probability
What is the probability of one success in five
observations if the probability of an event of
interest is 0.1?
x = 1, n = 5, and = 0.1

n!
P(X 1 | 5,0.1)
x (1 ) n x
x!(n x)!
5!

(0.1)1 (1 0.1) 51
1!(5 1)!
(5)(0.1)(0.9) 4
0.32805
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Chap 5-29

Chap 5-29

The Binomial Distribution

Example
Suppose the probability of purchasing a defective
computer is 0.02. What is the probability of
purchasing 2 defective computers in a group of 10?
x = 2, n = 10, and = 0.02
n!
P(X 2 | 10, 0.02)
x (1 ) n x
x!(n x)!
10!

(.02) 2 (1 .02)10 2
2!(10 2)!
(45)(.0004)(.8508)
.01531
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Chap 5-30

Chap 5-30

The Binomial Distribution

Shape
The shape of the
binomial distribution
depends on the values
of and n

Here, n = 5 and = .1

P(X=x|5, 0.1)
.6
.4
.2
0
0

P(X=x|5, 0.5)

Here, n = 5 and = .5

.6
.4
.2
0
0

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-31

Chap 5-31

The Binomial Distribution Using

Binomial Tables (Available On Line)
n = 10
x

=.20

=.25

=.30

=.35

=.40

=.45

=.50

0
1
2
3
4
5
6
7
8
9
10

0.107
4
0.268
4
0.302
0
0.201
3
0.088
1
0.026
4
0.005
5
0.000
8
0.000
1
0.000
0
0.000
0

0.056
3
0.187
7
0.281
6
0.250
3
0.146
0
0.058
4
0.016
2
0.003
1
0.000
4
0.000
0
0.000
0

0.028
2
0.1211
0.233
5
0.266
8
0.200
1
0.102
9
0.036
8
0.009
0
0.001
4
0.000
1
0.000
0

0.013
5
0.072
5
0.175
7
0.252
2
0.237
7
0.153
6
0.068
9
0.021
2
0.004
3
0.000
5
0.000
0

0.006
0
0.040
3
0.120
9
0.215
0
0.250
8
0.200
7
0.1115
0.042
5
0.010
6
0.001
6
0.000
1

0.002
5
0.020
7
0.076
3
0.166
5
0.238
4
0.234
0
0.159
6
0.074
6
0.022
9
0.004
2
0.000
3

0.0010
0.0098
0.0439
0.1172
0.2051
0.2461
0.2051
0.1172
0.0439
0.0098
0.0010

10
9
8
7
6
5
4
3
2
1
0

=.80

=.75

=.70

=.65

=.60

=.55

=.50

Examples:
n = 10, = 0.35, x = 3:

P(X = 3|10, 0.35) = 0.2522

n = 10, = 0.75, x = 8:

P(X = 2|10, 0.75) = 0.0004

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Chap 5-32

Chap 5-32

Binomial Distribution
Characteristics

Mean

Variance and Standard Deviation

E(X) n
2

n (1 - )
n (1 - )
Where n = sample size
= probability of the event of interest for any trial
(1 ) = probability of no event of interest for any trial
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-33

Chap 5-33

The Binomial Distribution

Characteristics
Examples

n (5)(.1) 0.5
n (1 - ) (5)(.1)(1 .1)
0.6708

n (5)(.5) 2.5
n (1 - ) (5)(.5)(1 .5)
1.118
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

P(X=x|5, 0.1)
.6
.4
.2
0
0

P(X=x|5, 0.5)
.6
.4
.2
0
0

Chap 5-34

Chap 5-34

Using Excel For The

Binomial Distribution (n = 4, = 0.1)

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Chap 5-35

Chap 5-35

Using Minitab For The Binomial

Distribution (n = 4, = 0.1)
2

3
5

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Chap 5-36

Chap 5-36

The Poisson Distribution

Definitions

You use the Poisson distribution when you

are interested in the number of times an event
occurs in a given area of opportunity.
An area of opportunity is a continuous unit or
interval of time, volume, or such area in which
more than one occurrence of an event can
occur.

The number of scratches in a cars paint

The number of mosquito bites on a person
The number of computer crashes in a day

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-37

Chap 5-37

The Poisson Distribution

Apply the Poisson Distribution when:

You wish to count the number of times an event

occurs in a given area of opportunity
The probability that an event occurs in one area of
opportunity is the same for all areas of opportunity
The number of events that occur in one area of
opportunity is independent of the number of events
that occur in the other areas of opportunity
The probability that two or more events occur in an
area of opportunity approaches zero as the area of
opportunity becomes smaller
The average number of events per unit is (lambda)

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-38

Chap 5-38

Poisson Distribution Formula

e
P( X x | )
x!

where:
x = number of events in an area of opportunity
= expected number of events
e = base of the natural logarithm system (2.71828...)

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Chap 5-39

Chap 5-39

Poisson Distribution
Characteristics

Mean

Variance and Standard Deviation

where = expected number of events

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Chap 5-40

Chap 5-40

Using Poisson Tables (Available

On Line)

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

0
1
2
3
4
5
6
7

0.9048
0.0905
0.0045
0.0002
0.0000
0.0000
0.0000
0.0000

0.8187
0.1637
0.0164
0.0011
0.0001
0.0000
0.0000
0.0000

0.7408
0.2222
0.0333
0.0033
0.0003
0.0000
0.0000
0.0000

0.6703
0.2681
0.0536
0.0072
0.0007
0.0001
0.0000
0.0000

0.6065
0.3033
0.0758
0.0126
0.0016
0.0002
0.0000
0.0000

0.5488
0.3293
0.0988
0.0198
0.0030
0.0004
0.0000
0.0000

0.4966
0.3476
0.1217
0.0284
0.0050
0.0007
0.0001
0.0000

0.4493
0.3595
0.1438
0.0383
0.0077
0.0012
0.0002
0.0000

0.4066
0.3659
0.1647
0.0494
0.0111
0.0020
0.0003
0.0000

Example: Find P(X = 2 | = 0.50)

e x e 0.50 (0.50) 2
P(X 2 | 0.50)

0.0758
x!
2!
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Chap 5-41

Chap 5-41

Using Excel For The

Poisson Distribution (= 3)

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Chap 5-42

Chap 5-42

Using Minitab For The Poisson

Distribution ( = 3)
2

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Chap 5-43

Chap 5-43

Graph of Poisson Probabilities

Graphically:
= 0.50
X

=
0.50

0
1
2
3
4
5
6
7

0.6065
0.3033
0.0758
0.0126
0.0016
0.0002
0.0000
0.0000

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

P(X = 2 | =0.50) = 0.0758

Chap 5-44

Chap 5-44

Poisson Distribution Shape

The shape of the Poisson Distribution

depends on the parameter :
= 3.00
= 0.50

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Chap 5-45

Chap 5-45

The Hypergeometric
Distribution

The binomial distribution is applicable when

selecting from a finite population with
replacement or from an infinite population
without replacement.

The hypergeometric distribution is applicable

when selecting from a finite population without
replacement.

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Chap 5-46

Chap 5-46

The Hypergeometric
Distribution

n trials in a sample taken from a finite

population of size N

Sample taken without replacement

Outcomes of trials are dependent

Concerned with finding the probability of X=xi

items of interest in the sample where there are
A items of interest in the population

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-47

Chap 5-47

Hypergeometric Distribution
Formula

[ A C x ][ N A C n x ]
P(X x | n, N, A)

N Cn

A

x

N A

nx
N

n

Where
N = population size
A = number of items of interest in the population
N A = number of events not of interest in the population
n = sample size
x = number of items of interest in the sample
n x = number of events not of interest in the sample
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-48

Chap 5-48

Properties of the
Hypergeometric Distribution

The mean of the hypergeometric distribution is

nA
E(X)
N

The standard deviation is

nA(N - A) N - n

2
N
N -1

Where

N - n is called the Finite Population Correction Factor

N -used
1
when sampling without replacement from a

finite population
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-49

Chap 5-49

Using the
Hypergeometric Distribution
Example: 3 different computers are selected from 10 in
the department. 4 of the 10 computers have illegal
software loaded. What is the probability that 2 of the 3
selected computers have illegal software loaded?
N = 10
A= 4

P(X 2 | 3,10,4)

A

x

n=3
x=2
N A
4 6

2 1 (6)(6) 0.3
120
N
10


n
3

The probability that 2 of the 3 selected computers have illegal

software loaded is 0.30, or 30%.
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Chap 5-50

Chap 5-50

Using Excel for the

Hypergeometric Distribution (n = 8, N = 30, A = 10)

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Chap 5-51

Chap 5-51

Using Minitab For The Hypergeometric

Distribution (n = 8, N = 30, A = 10)
2

3
5

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Chap 5-52

Chap 5-52

Chapter Summary

Addressed the probability distribution of a

discrete random variable

Defined covariance and discussed its

application in finance

Discussed the Binomial distribution

Discussed the Poisson distribution

Discussed the Hypergeometric distribution

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-53

Chap 5-53

Basic Business Statistics

12th Edition
On Line Topic
The Poisson Approximation To
The Binomial Distribution
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-54

Learning Objectives
In this topic, you learn:
When to use the Poisson distribution to
approximate the binomial distribution
How to use the Poisson distribution to approximate
the binomial distribution

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-55

The Poisson Distribution Can Be Used To

Approximate The Binomial Distribution

Most useful when n is large and is very small

The approximation gets better as n gets larger

and gets smaller

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-56

The Formula For The

Approximation
P( X )

( n )
X!

Where
P(X) = probability of X events of interest given the parameters n and
n = sample size
= probability of an event of interest
e = mathematical constant approximated by 2.71828
X = number of events of interest in the sample (X = 0, 1, 2, . . . , n)

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-57

The Mean & Standard Deviation Of

The Poisson Distribution

E ( X ) n
n
Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-58

Calculating Probabilities

Suppose = 0.08 and n = 20 then = 1.6

Can calculate by hand or can use Poisson
probability tables
e 20*0.08 ( 20 * 0.08)1
P ( X 1)
0.3230
1!
=n
X 1.1
1.2
1.3
1.4
0 .3329 .3012 .2725 .2466
l .3662 .3614 .3543 .3452
2 .2014 .2169 .2303 .2417
3 .0738 .0867 .0998 .1128
4 .0203 .0260 .0324 .0395

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

1.5
.2231
.3347
.2510
.1255
.0471

1.6
.2019
.3230
.2584
.1378
.0551

1.7
.1827
.3106
.2640
.1496
.0636

1.8
.1653
.2975
.2678
.1607
.0723

1.9
.1496
.2842
.2700
.1710
.0812

2.0
.1353
.2707
.2707
.1804
.0902

Chap 5-59

Topic Summary
In this topic, you learned:
When to use the Poisson distribution to
approximate the binomial distribution
How to use the Poisson distribution to approximate
the binomial distribution

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 5-60