* Probability Theory by Example

* Often times some of the rules of probability theory can seem quite abstract.

* Hopefully simulating data will yield a clearer understanding of how these rules work.

* This is stata code

version 11

set seed 11

clear

set obs 100

* First off if A & B are independent then the expected value of A*B is equal expected value of a times that of the expected value of B.

* E(A*B)=E(A)E(B) if A and B are independent.

gen A=rnormal()+9

gen B=runiform()

gen AB = A*B

sum A

local A=r(mean)

sum B

local B=r(mean)

di "mean_A * mean_B = `=`A'*`B''"

sum ab

* Se can see that the mean of A times the mean of B is close to that of the mean of the two variables.

* They do not need to be equal because all of the measures are noisy because we are dealing with a sample.

* As the sample gets larger they should get closer.

clear

* Increase sample size to 100,000 observations

set obs 100000

gen A=rnormal()+9

gen B=runiform()

gen AB = A*B

sum A

local A=r(mean)

sum B

local B=r(mean)

di "mean_A * mean_B = `=`A'*`B''"

sum AB

* However, simply because E(AB)=E(A)*E(B) does not imply independence.

clear

* Increase sample size to 100,000 observations

set obs 100000

gen A=rnormal()

gen B=abs(A)

* B equals the absolute value of A

gen AB=A*B

sum A

local A=r(mean)

sum B

local B=r(mean)

di "mean_A * mean_B = `=`A'*`B''"

sum AB

* The means are pretty close.

* However, there closeness clearly does not imply independence since: we know the value of B if we know what A is.

* Another way of thinking about independence is "does knowing A tell us anything about B or does knowing B tell us anything about A?"

* Clearly A tells us a lot about B

* Let's look at Bayes Theorem briefly

* Bayes Theorem states

* P(A|B)=P(B|A)P(A)/P(B)

* If A and B are independent then P(B|A)=P(B) and P(A|B)=P(A)

* Let's try simulating an example:

clear

* Increase sample size to 100,000 observations

set obs 100000

gen A=rbinomial(1,.6)

* The probability of A. P(A=1)=.6 or in our sample

sum A

di r(mean)

gen B=rbinomial(1,.1+A*.7)

* The probability of B given A [P(B=1|A=1)] = .1+A*.7 = .1+.7=.8

* Therefore P(B=1)= .1+E(A)*.7=.1+.6*.7=.1+.42=.52

* So P(A=1|B=1)= P(B=1|A=1)*P(A=1)/P(B=1)

di "P(A=1|B=1)=".8*.6/.52

* Lets see if the data confirms

sum A if B == 1

* This gives us the probability of A == 1 given B==1 (because A is a dummy variable)

* The mean which is what we are looking at is pretty close

* Likewise:

di "P(A=1|B=0)="(1-.8)*.6/.52

sum A if B == 0

* Thus Bayes rule seems to work pretty well in our generated data.

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