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Irish Potato Famine, Network Externalities and Uncertainty: Example. Ipod: Buy To Be in Style

1. The Irish Potato Famine occurred from 1845-1849 when the price of potatoes increased, yet people consumed more potatoes. This acted as a typical Giffen good. 2. Network externalities refer to how one person's demand is influenced by other people's demands. Positive network externalities exist for products like iPods and operating systems, while negative network externalities exist for designer clothes. 3. Uncertainty can be analyzed using expected value, variability, risk, and expected utility. Expected value is the probability-weighted average outcome, while standard deviation measures risk. Expected utility incorporates people's preferences over uncertain outcomes.

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65 views5 pages

Irish Potato Famine, Network Externalities and Uncertainty: Example. Ipod: Buy To Be in Style

1. The Irish Potato Famine occurred from 1845-1849 when the price of potatoes increased, yet people consumed more potatoes. This acted as a typical Giffen good. 2. Network externalities refer to how one person's demand is influenced by other people's demands. Positive network externalities exist for products like iPods and operating systems, while negative network externalities exist for designer clothes. 3. Uncertainty can be analyzed using expected value, variability, risk, and expected utility. Expected value is the probability-weighted average outcome, while standard deviation measures risk. Expected utility incorporates people's preferences over uncertain outcomes.

Uploaded by

dijojnay
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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1

1 Irish Potato Famine

Lecture 8

Irish Potato Famine, Network Externalities and


Uncertainty

Outline
1. Chap 4: Irish Potato Famine
2. Chap 4: Network Externalities
3. Chap 5: Uncertainty
1 Irish Potato Famine
Typical Giffen good. In Year 1845-1849, people consumed more potatoes when
the price increased. (Figure 1)

2 Network Externalities
Network externality. One person’s demand depends on the demands of other
people.

• [Bandwagon effect (Figure 2)] Positive network externality. When


more people buy, you will buy more.
Example. iPod: buy to be in style.
– Market demand more elastic than real demand curve.
– Seller sets lower price.
Example. Operating system: more software available. Example.
Internet telephone.
• [Snob effect (Figure 3)] Negative network externality. When others
buy, you will not buy.
– Market demand more inelastic than real demand curve.
– Seller sets Higher price.
Example. Designer clothes: want to be special.
3 Uncertainty 2

Figure 1: Irish Potato Famine: Price Higher, Consume More

3 Uncertainty
An Outline in Uncertainty

• Preference, Decision
• Expected Value / Variability, Risk Standard Deviation
• Expected Utility

To measure risk we must know:


• All of the possible outcomes.
• The probability that each outcome will occur, the sum of the
probabilities that each outcome will occur = 1. Example. Probability of Weather
• Sunny 70%.
• Rainy 5%.
• Cloudy 25%.

The sum of all the probabilities is 100%.

Objective probability. Based on observed frequency of past events.


3 Uncertainty 3

Figure 2: Bandwagon Effect: Positive Network Externalities


3 Uncertainty 4

Figure 3: Snob Effect: Negative Network Externalities Subjective


probability. Based on perception, theory and understanding of
outcomes.
3 Uncertainty 5
Measures to characterize payoffs and degree of risk.

Example (Job).
Outcome 1 Outcome 2

Job 1 $2000 with probability 50% $1000 with probability


50%
Job 2 $1510 with probability 99% $510 with probability 1%
Table 1: Compare Two Jobs, Each has Two Outcomes

Expected value.
E(x) = p1x1 + p2x2 + ... + pnxn,

where x is a random variable, which has realizations x1,x2,...,xn with


probability p1,p2,...,pn respectively. Discuss the example. Expected values of
salary from job 1 and 2 are:

E(job1) = 0.50 × 2000 + 0.50 × 1000 = 1500.

E(job2) = 0.99 × 1510 + 0.01 × 510 = 1500.


Since
E(job1) = E(job2),

we do not know which job is better.

Standard deviation.

− − −
σ(x) = p1[x1 E(x)]2 + p2[x2 E(x)]2 + ... + pn[xn E(x)]2 .
We can consider the risks of those jobs from standard deviation:

σ1 = 0.50 × (2000 − 1500)2 + 0.50 × (1000 − 1500)2 = 500,

σ2 = 0.99 × (1510 − 1500)2 + 0.01 × (510 − 1500)2 = 99.5.


Since
σ 1 > σ 2,
for less risk, we will choose job 2.

Expected utility.

E[u(x)] = p1u(x1) + p2u(x2) + ... + pnu(xn).

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