FUNDAMENTALS OF

QUANTITATIVE MODELING
Richard Waterman
Module 1: Introduction and core modeling math

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Course goals

Goals
Exposure to the language of modeling
See a variety of quantitative business models and
applications
Learn the process of modeling and how to critique
models
Associate business process characteristics with
appropriate models
Understand the value and limitations of quantitative
models
Provide the foundational material for the other three
courses in the Specialization

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Resources

Software used in this Specialization

Excel ([Link]
Google sheets ([Link]
R an open source modeling platform
([Link]
Math review
E-book: Business Math for MBAs
([Link] - essential mathematics for
business modeling

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Module 1 content
Examples and uses of models
Keys steps in the modeling process
A vocabulary for modeling
Mathematical functions
Linear
Power
Exponential
Log

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What is a model?

A formal description of a business process

It typically involves mathematical equations and/or
random variables
It is almost always a simplification of a more complex
structure
It typically relies upon a set of assumptions
It is usually implemented in a computer program or using a
spreadsheet

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Examples of models

The price of a diamond as a function of its weight

The spread of an epidemic over time
The relationship between demand for, and price of, a
product
The uptake of a new product in a market

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Diamonds and weight

Model: Expected price 260 3721 Weight

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Spread of an epidemic

Model: Cases 6.69 .

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Demand models

Model: Quantity 60,000 Price .

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The uptake of a new product

.
Model: Prop .

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How models are used in practice
Prediction: calculating a single output
Whats the expected price of a diamond ring that weighs
0.2 carats?
Forecasting
How many people are expected to be infected in 6 weeks?
Scheduling who is likely to turn up for their outpatient
appointment?
Optimization
What price maximizes profit?
Ranking and targeting
Given limited resources, which potential diamonds for sale
should be targeted first for potential purchase?

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How models are used in practice

Exploring what-if scenarios

If the growth rate of the epidemic increased to 20% each week,
then how many infections would we expect in the next 10
weeks?
Interpreting coefficients in model
What do we learn from the coefficient -2.5 in the price/demand
model?
Assessing how sensitive the model is to key assumptions

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Benefits of modeling

Identify gaps in current understanding

Make assumptions explicit
Have a well-defined description of the business process
Create an institutional memory
Used as a decision support tool
Serendipitous insight generator

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Key steps in the modeling process
ModelingProcessWorkflow

Identify
Perform
anddefine
sensitivity
inputsand
analysis
outputs Fitfor
Formulate purpose Implement
YES
model model
Validate
?
Define model
scope forecasts
NO

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What if the model doesnt always work?

When the observed outcome differs greatly from the

models prediction, then there is the possibility of learning
from this event if we can understand why the difference
occurs
Modeling is a continuous and evolutionary process
We identify the weaknesses and limitations and iterate the
modeling process to overcome them

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A modeling lexicon

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 Data driven v. theory driven
Empirical Theoretical
Theory: given a set of assumptions and relationships, then
what are the logical consequences?
Example: if we assume that markets are efficient then
what should the price of a stock option be?
Data: given a set of observations, how can we
approximate the underlying process that generated them?
Example: Ive separated out my profitable customers
from the unprofitable ones. Now, what features are
able to differentiate them?

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 Deterministic v. probabilistic/stochastic

Deterministic: given a fixed set of inputs, the model always

gives the same output
Example: Invest $1000 at 4% annual compound interest
for 2 years. After 2 years the initial $1000 will always be
worth $1081.60.
Probabilistic: Even with identical inputs, the model output
can vary from instance to instance
Example: A person spends $1000 on lottery tickets.
After the lottery is drawn how much they are worth
depends on a random variable, whether or not they won
the lottery.

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Discrete v. continuous variables

Watches can be digital or analog

Likewise models can involve discrete or continuous

variables
Discrete: characterized by jumps and distinct values
Continuous: a smooth process with an infinite number of
potential values in any fixed interval

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Static v. dynamic

Static: the model captures a single snapshot of the

business process
Given a websites installed software base, what are the
chances that it is compromised today?
Dynamic: the evolution of the process itself is of interest.
The model describes the movement from state to state
Given a persons participation in a job training program,
how long will it take until he/she finds a job and then, if
they find one, for how long will they keep it?

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Key mathematical functions

Math: the language of modeling

Four key mathematical functions provide the
foundations for quantitative modeling
1. Linear
2. Power
3. Exponential
4. Log

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The linear function

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The linear function

x is the input, y is the output
b is the intercept
m is the slope
Essential characteristic: the slope is constant
A one-unit change in x corresponds to an m-unit change
in y.

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The power function for various powers of x

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The power function

x is the base
m is the exponent
Essential characteristic:
A one percent (proportionate) change in x corresponds
to an approximate m percent (proportionate) change in
y.
Facts
1. =
2. =
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The exponential function for various values of m

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The exponential function

e is the mathematical constant: 2.71828
Notice that as compared to a power function, x is in the
exponent of the function and not the base

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The exponential function

Essential characteristic:
the rate of change of y is proportional to y itself
Interpretation of m for small values of m (say -0.2 m 0.2):
For every one-unit change in x, there is an approximate
100m% (proportionate) change in y
Example: if m = 0.05, then a one-unit increase in x is
associated with an approximate 5% increase in y

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The log function

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The log function

The log function is very useful for modeling processes that exhibit
diminishing returns to scale
These are processes that increase but at a decreasing rate
Essential characteristic:
A constant proportionate change in x is associated with the
same absolute change in y

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The log function

Proportionate change in x is associated with constant change in y

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The log function

log
b is called the base of the logarithm
The most frequently used base is the number e and the
logarithm is called the natural log
The log undoes (is the inverse of) the exponential function:
log

log log log
In this course we will always use the natural log and write
it simply as log(x)
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The four functions

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Module summary

Uses for models

Steps in the modeling process
It is an iterative process and model validation is key
Discussed various types of models, discrete v. continuous
etc.
Reviewed essential mathematical functions that form the
foundation of quantitative models

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