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EC114 Introduction to Quantitative Economics


4. Continuous Probability Distributions
Department of Economics
University of Essex
1/3 November 2011
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
2/26
Outline
1
Continuous Random Variables
2
The Normal Distribution
3
The Standard Normal Distribution
4
Using the N(0, 1) Distribution
5
The Uniform Distribution
Reference: R. L. Thomas, Using Statistics in Economics,
McGraw-Hill, 2005, sections 2.12.3.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Continuous Random Variables 3/26
A continuous random variable is one that can take any
value in a given range.
Examples of continuous variables include weights, heights,
hours of sunshine etc.
In practical terms the values we observe are limited by the
accuracy of our measurements.
In principle, a persons weight could be 62.365982. . . kg
but we might measure this as 62.37kg.
Note that the range itself could be to +.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Continuous Random Variables 4/26
Suppose we obtain the heights (in cm) of all male
professors in UK universities.
A histogram might look something like:

The widths of the classes is 5cm eg the middle one is
172.5177.5cm.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Continuous Random Variables 5/26
Now suppose we use class widths of 2.5cm eg
175177.5cm:

Recall that it is the area of the class blocks that reects the
probability (or relative frequency).
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Continuous Random Variables 6/26
Suppose we continue making the class widths smaller and
smaller we would end up with a continuous curve:

This is the familiar bell shape of the normal distribution,
probably the most important distribution in statistics.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Normal Distribution 7/26
Recall that it is areas, not heights, that represent
probabilities.
The probability of any single value is zero because the
variable is continuous e.g. Pr(X = 175) = 0.
But we can nd probabilities such as Pr(174 < X < 175) by
calculating the area under the curve between these points.
We can do this by integration if we know the equation for
the curve.
If X is normally distributed with mean and variance
2

written X N(,
2
) then the equation we need is
p(X) =
1
(2
2
)
1/2
exp

(X )
2
2
2

, < X < .
Fortunately we dont actually need to do the integration . . .
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Normal Distribution 8/26
The following diagram depicts two normal distributions:
N(10, 2) and N(10, 10).

Both have the same mean (10) but the one with the
smallest variance is more concentrated around the mean.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Standard Normal Distribution 9/26
In practice we only ever need to know the properties of the
standard normal distribution, N(0, 1):

The distribution is centred at 0 and has unit variance.
The properties of a general N(,
2
) distribution can be
derived from tables of the N(0, 1), even though there is an
innite number of combinations of and
2
.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Standard Normal Distribution 10/26
Consider the area under the curve between 0 and z

:

Table A.1 in Thomas contains areas under the standard
normal curve; if Z N(0, 1), this is
p(z) = (2)
1/2
exp

z
2
/2

, < z < .
The numbers in the table are Pr(0 < Z < z

) i.e. the
probability that Z lies between 0 and z

.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Standard Normal Distribution 11/26
z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359
0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753
0.2 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517
0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879
0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.7 0.2580 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389
1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
... ... ... ... ... ...
3.0 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Standard Normal Distribution 12/26
For example, the entry in bold is Pr(0 < Z < 1.24) = 0.3925.
The value of z

is given to two decimal places; going down


the rst column gives the rst decimal place, the numbers
in the top row then give the second decimal place.
So our highlighted entry (z

= 1.24) corresponds to the row


marked 1.2 and the column headed 0.04.
Note that the area under the curve to the left of zero is
equal to 1/2 the distribution is symmetric around zero
and the total area is 1.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Standard Normal Distribution 13/26
Hence we nd that
Pr(< Z < 1.24) = Pr(Z < 1.24)
= Pr(Z 0) + Pr(0 < Z < 1.24)
= 0.5 + 0.3925 = 0.8925.
It also follows that
Pr(Z > 1.24) = 1 Pr(Z < 1.24) = 1 0.8925 = 0.1075.
The symmetry of the N(0, 1) distribution can be used to
calculate probabilities involving negative values of z

.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Standard Normal Distribution 14/26
The following diagram is useful:

By symmetry around zero we can see that
Pr(Z < z

) = A = Pr(Z > +z

),
Pr(z

< Z < 0) = B = Pr(0 < Z < z

).
Recall it is the area B reported in the Table.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Standard Normal Distribution 15/26
We know that A +B = 0.5 and so
A = Pr(Z < z

) = 0.5 B = 0.5 Pr(0 < Z < z

).
For example, suppose z

= 1.24 and we want to calculate


Pr(Z < 1.24).
We know that B = Pr(0 < Z < 1.24) = 0.3925 and so
Pr(Z < 1.24) = 0.5 Pr(0 < Z < 1.24)
= 0.5 0.3925 = 0.1075.
Also, it should be clear that
Pr(Z > 1.24) = 1 A = 1 0.1075 = 0.8925.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Using the N(0, 1) Distribution 16/26
The N(0, 1) distribution is a special case of the N(,
2
) but
can be used to make probability statements about this
more general distribution.
This can be done using standardisation.
Suppose X N(,
2
) what is the distribution of
Y = X ?
Recall, from Lecture 3, that if Y = a +bX, then
E(Y) = a +bE(X) and V(Y) = b
2
V(X).
Here, a = and b = 1, so E(Y) = + = 0 and
V(Y) = V(X).
Hence Y N(0,
2
).
NB: Linear combinations of normal variables are also
normal.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Using the N(0, 1) Distribution 17/26
Now suppose we divide Y by , to form
Z =
Y

=
X

.
What is the distribution of Z?
Here we are constructing a variable of the form Z = a +bY
where a = 0 and b = 1/.
Using the rules, we nd
E(Z) = 0 +

E(Y) = 0
and
V(Z) =

2
V(Y) = 1.
Hence Z N(0, 1).
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Using the N(0, 1) Distribution 18/26
This means that any N(,
2
) variable can be transformed
into a N(0, 1) variable by standardisation.
So, if X N(,
2
) then
Z =
X

N(0, 1).
How is this result used in practice?
Lets return to our example of male professors heights and
assume X N(175, 9).
What is the probability that a randomly selected professor
is taller than 180cm?
We need to nd Pr(X > 180).
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Using the N(0, 1) Distribution 19/26
Note that Z = (X 175)/3 N(0, 1).
Hence
Pr(X > 180) = Pr

X 175
3
>
180 175
3

= Pr(Z > 1.67)


= 0.5 Pr(0 < Z < 1.67)
= 0.5 A :

EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Using the N(0, 1) Distribution 20/26
Using the Table we nd that A = 0.4525 and so
Pr(X > 180) = 0.5 0.4525 = 0.0475.
Lets try something more complicated nd the probability
that a randomly selected professors height is between 171
and 181cm.
We need Pr(171 < X < 181).
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Using the N(0, 1) Distribution 21/26
Applying the same process as before:
Pr(171 < X < 181) = Pr

171 175
3
< Z <
181 175
3

= Pr(1.33 < Z < 2)


= 1 Pr(Z < 1.33) Pr(Z > 2)
= 1 A B :

EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Using the N(0, 1) Distribution 22/26
Now
A = Pr(Z < 1.33) = Pr(Z > 1.33)
= 0.5 Pr(0 < Z < 1.33)
= 0.5 0.4082 = 0.0918,
B = Pr(Z > 2) = 0.5 Pr(0 < Z < 2)
= 0.5 0.4772 = 0.0228.
Hence Pr(171 < X < 181) = 1 0.0918 0.0228 = 0.8854.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Uniform Distribution 23/26
The (continuous) uniform distribution is one in which all
outcomes are equally likely.
Suppose X is uniformly distributed and a < X < b; then
p(X) =

1
(b a)
, a < X < b;
0, otherwise.

EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Uniform Distribution 24/26
The mean and variance are
E(X) =
a +b
2
, V(X) =
(b a)
2
12
.
As an example, suppose that the time to carry out a certain
task is uniformly distributed between 10 and 30 minutes.
Here, a = 10 and b = 30; it is easy to calculate
E(X) =
10 + 30
2
= 20, V(X) =
(30 10)
2
12
=
400
12
= 33.33.
But what is Pr(X < 15)?
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
The Uniform Distribution 25/26
We require the area under the distribution between a = 10
and 15.

5 10 15 20 25 30 X
0.05
p(X)
This is the area of a rectangle of width 5 and height
p(X) = 1/(b a) = 1/20.
Hence Pr(X < 15) = 5 0.05 = 0.25.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions
Summary 26/26
Summary
Continuous random variables
The normal and standard normal distributions.
The uniform distribution.
Next week:
Basic statistical inference.
EC114 Introduction to Quantitative Economics 4. Continuous Probability Distributions