Notes

A brief introduction to economics

Part III Tyler Moore
Computer Science & Engineering Department, SMU, Dallas, TX

September 11, 2012

Markets Exercises

Outline

Notes

Markets From individual to aggregate Equilibrium Eciency Exercises Exercise 1: antivirus software Exercise 2: DDoS protection

2 / 26 From individual to aggregate Equilibrium Eciency

Markets Exercises

Making an optimal choice under budget constraint

Budget constraint: o1 p1 + o2 p2 m o2

Notes

m p2
e dg bu t lin e

p2 Indierence curves p1
m p1

o1

Diagrams adapted from Varians Intermediate Microeconomics

4 / 26 From individual to aggregate Equilibrium Eciency

Markets Exercises

Making an optimal choice under budget constraint

We just saw one example of an optimal choice for prices p1 and p2 given a budget m What happens when prices change? The optimal choice does too We can systematically vary prices and obtain the optimal demand Denition (Demand function) A demand function for outcomes o1 and o2 and budget m returns the optimal choice of outcomes demanded do1 (p1 , p2 , m) for given prices and budget.

Notes

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Markets Exercises

From individual to aggregate Equilibrium Eciency

What about other agents?

Notes

We can measure overall market demand by adding up all individual market demand functions Denition (Market demand function) A market demand function for outcome o1 for n agents is given by
n

Do1 (p1 , p2 , m1 , m2 , . . . , mn ) =
i=1

do1 (p1 , p2 , mi )

(1)

6 / 26 From individual to aggregate Equilibrium Eciency

Markets Exercises

What about supply?

Notes

Thus far we have focused on consumer preferences But production also matters (the supply side) Suppliers of goods are individually willing to produce goods at dierent prices We can construct a market supply function S(p1 ) similar to the market demand function D(p1 )

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Markets Exercises

Market equilibrium

Notes

Denition (Market equilibrium) Market equilibrium is achieved at the price p where D(p ) = S(p ). The market price is in equilibrium because agents are individually optimizing their demand functions d based on the prices they observe

8 / 26 From individual to aggregate Equilibrium Eciency

Markets Exercises

Market equilibrium
price

Notes

constant supply

p
de m an

cu

rv

quantity

Diagrams adapted from Varians Intermediate Microeconomics

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Markets Exercises

From individual to aggregate Equilibrium Eciency

Market equilibrium
price

Notes

constant price

p
de m an d cu rv

quantity

Diagrams adapted from Varians Intermediate Microeconomics

9 / 26 From individual to aggregate Equilibrium Eciency

Markets Exercises

Market equilibrium
price

Notes

supply curve

pd = ps
de m an

cu

rv

quantity

Diagrams adapted from Varians Intermediate Microeconomics

9 / 26 From individual to aggregate Equilibrium Eciency

Markets Exercises

Market equilibrium
price

Notes

supply curve

Willing to buy pd pd = ps Willing to sell ps

de m an d cu rv

quantity

Diagrams adapted from Varians Intermediate Microeconomics

9 / 26 From individual to aggregate Equilibrium Eciency

Markets Exercises

Equilibrium in the stock market

Stock-market pricing

Notes

price

shares issued

21 p 20 19
de m an d cu rv e

quantity
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Markets Exercises

From individual to aggregate Equilibrium Eciency

Equilibrium in the stock market

Stock-market pricing: increase

Notes

price

shares issued

p 21 p 20 19

ask=bid: $21

ol

ne de m

w d

an

de

cu

an

rv e

cu

rv e

quantity
10 / 26

Markets Exercises

From individual to aggregate Equilibrium Eciency

Equilibrium in the stock market

Stock-market pricing: decrease

Notes

price

shares issued

21 p 20 p 19

ne

ask=bid: $19
w ol de m d de d an m an

cu

rv e

cu

rv e

quantity
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Markets Exercises

From individual to aggregate Equilibrium Eciency

Properties of the stock market

Notes

Stock market value = p q Stock market value: present value of expected future prots While the expected future prots can be highly uncertain, the stock price is very certain Stockholders want rms to adopt strategies that maximize future prots Firms can adopt strategies that maximize stock market value, and by doing so act in the best interest of stockholders

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Markets Exercises

Pareto eciency

Notes

Informally: a situation is Pareto ecient if no agent can be made better o without making another agent worse o. Denition (Pareto eciency) Suppose n agents have selected outcomes oi O for all i = 1..n. A system is Pareto ecient if there is no feasible outcome oi for an agent i where oi oi such that oj oj for j = 1..n, j = i.

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Markets Exercises

From individual to aggregate Equilibrium Eciency

Is market equilibrium Pareto ecient? Yes!

price

Notes

supply curve

Willing to buy pd pd = ps Willing to sell ps

de m an d cu rv

quantity

Diagrams adapted from Varians Intermediate Microeconomics

13 / 26 From individual to aggregate Equilibrium Eciency

Markets Exercises

Pareto ecient or not?

Notes

Pareto eciency makes no judgment about what constitutes a fair distribution of outcomes Can totalitarian dictatorship be Pareto ecient? Can complete socialism be Pareto ecient? What about waiting in line to buy tickets?

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Markets Exercises

First Fundamental Theorem of Welfare Economics

Denition (First Fundamental Theorem of Welfare Economics) Any competitive equilibrium leads to a Pareto ecient allocation of resources. This denition begs the question: under what circumstances do we get competitive equilibrium?
Assume complete markets (perfect information, no transaction costs) Assume price-taking behavior (innite buyers and sellers, no barriers to entry)

Notes

Next time we will discuss market failures, and explain why information security suers from many of them
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Markets Exercises

Exercise 1: antivirus software Exercise 2: DDoS protection

Risk attitude example (take 2): antivirus software

Suppose you have $10,000 in wealth. You have the option to buy antivirus software for $x. Outcomes available: O ={hacked (decreases wealth by $2,000), not hacked (no change in wealth)} Without AV software, probability of being hacked is 0.1 (P(hacked|no antivirus) = 0.1) With AV software, probability of being hacked is 0 (P(hacked|antivirus) = 0) Exercise 1: How much would you pay for antivirus software if you were risk-neutral and the probability of getting hacked is 0.1 if you dont have AV installed?
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Notes

Markets Exercises

Exercise 1: antivirus software Exercise 2: DDoS protection

Risk attitude example (take 2): antivirus software

Notes

First question: what is the constraint that makes buying AV aordable? Recommended approach: draw out the table of outcomes and actions, along with probabilities Solve for x

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Markets Exercises

Exercise 1: antivirus software Exercise 2: DDoS protection

Another example

Notes

Modeling real-world situations using rational choice theory is a fundamental skill There usually is no single correct model; instead you must justify your choices for approximating reality This includes a statement of the limitations of the model, so that we are clear on its shortcomings Lets practice together on a newsworthy topic

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Markets Exercises

Exercise 1: antivirus software Exercise 2: DDoS protection

GoDaddy, worlds largest web hosting provider, hacked?

Notes

Source: http://www.zdnet.com/anonymous-hacker-claims-godaddy-attack-outage-hits-millions-7000003925/ 20 / 26

Markets Exercises

Exercise 1: antivirus software Exercise 2: DDoS protection

Turns out GoDaddy experienced a non-malicious outage

Notes

Source: http://www.cnn.com/2012/09/11/tech/mobile/godaddy-response-outage/index.html 21 / 26

Markets Exercises

Exercise 1: antivirus software Exercise 2: DDoS protection

Exercise 2: lets model a security investment decision

Notes

Suppose GoDaddy is approached by a security rm XYZSec oering a DDoS protection product XYZSec claims to be able to eradicate DDoS threats using a shared-bandwidth pool, will sell for $100,000. Your task: model GoDaddys security investment choice using rational choice theory
1 2

What are the outcomes? What are the actions?

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Markets Exercises

Exercise 1: antivirus software Exercise 2: DDoS protection

Exercise 2: Actions-outcomes table

Notes

1 2

Fill in the following table Note which items are missing from the description and cant be lled in
Action action a1 action a2 outcome o1 U(o1 ) P(o1 |action) ? ? ? ? outcome o2 U(o2 ) P(o2 |action) ? ? ? ? E [U(action)] ? ?

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Markets Exercises

Exercise 1: antivirus software Exercise 2: DDoS protection

Exercise 2: Actions-outcomes table

Notes

Action a1 a2

U(o1 )

outcome o1 P(o1 |action)

outcome o2 U(o2 )

P(o2 |action)

E [U(action)]

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Markets Exercises

Exercise 1: antivirus software Exercise 2: DDoS protection

Exercise 2: Calculate the eectiveness of DDoS prevention

Notes

Suppose that GoDaddy expects an outage would cost them $10 million to deal with. How well must XYZSecuritys DDoS prevention system work in order to be worth the cost? (Hint: use the action-outcome table from the last slide) State the assumptions that you must make for the model to work, and qualitatively assess whether or not they are reasonable

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Markets Exercises

Exercise 1: antivirus software Exercise 2: DDoS protection

Exercise 2: Calculate the eectiveness of DDoS prevention

Notes

My answer: P(DDoS) .001 Solution details: see whiteboard My assumptions

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