Question

Discuss what is meant by subjective probability. Provide a business-related example in which subjective probability would likely be used. Also provide an example when to use subjective probability assessment.

Answer 1

Subjective probability is a type of probability derived from an individual's personal judgment or own experience about whether a specific outcome is likely to occur. It contains no formal calculations and only reflects the subject's opinions and past experience. Subjective probabilities differ from person to person and contain a high degree of personal bias. An example of subjective probability is a "gut instinct" when making a trade.

Subjective probability can be contrasted with objective probability, which is the computed probability that an event will occur based on an analysis in which each measure is based on a recorded observation or a long history of collected data.

> Business related example

Estimating the probability that the General Motors will loose its first ranking in the car sales .

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We often think of probability in terms of the classical probability definition, which is the number of favorable events, divided by the total number of events. However, this is one narrow case of probability and it isn’t suitable for all areas of the field, including Bayesian probability. A more philosophical approach is to realize that probabilities only have meaning to the person thinking about them (i.e for that person). Being subjective when calculating probabilities is a way of quantifying the unknown and is a necessary part of life.

Let’s say that you’ve been to your dentist twice, and have spent $125 and $150 each time. You hear through the grapevine that the dentist has upgraded his office and that his fees have “skyrocketed.” You have two choices:

1. Guesstimate (i.e. use subjective probability) that you budget $300 to cover the potential bill.
2. Go to the dentist with no idea what the cost is going to be, receive a bill for $375, and completely destroy your budget.