Lecture 5 Behavioral Finance

Teaching Goals
Epidemiological Models
Network-Models with Direct Neighbor Effects
Network-Models with Global Network Effects
Behavioral Finance
Lecture 5 - Herd Behavior:

Epidemics and Network-Externalities
Dr. Markus Demary
Ulm University
Summer Term 2021
Dr. Markus Demary Behavioral Finance

Teaching Goals
1 Teaching Goals
1 Epidemiological Models
The Basic Idea
The SIR Epidemic Model
Applications of the SIR Model
1 Network-Models with Direct Neighbor Effects

Assumptions
Decision rule
Cascading behavior
Stopping cascades
1 Network-Models with Global Network Effects

The economy without network effects
The economy with network effects
Stability, instability and tipping points

Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
Payoff- and network-externalities
Teaching Goals: Students should learn
∙ how changes in behavior cascade through a network

∙ how cascading behavior can stop
Epidemiological model
∙ what the spread of infecticious deseases and the spread of information can have in common
∙ how the dynamics of epidemics work
Models with direct neighbour effects
∙ the network effects are of a local nature

∙ important for your decisions are the decisions of the agents you are connected with
Models with global network effects
∙ the network effects are of a global nature

∙ important for your decisions are the decisions of the majority of the agents

Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
Epidemics
Basic idea
∙ epidemics (pathogens, ideas, computer viruses) spread through a
population
∙ properties of the pathogen: contagiousness, length of infection period and
its severity
∙ properties of the social network (who knows whom or travel patterns)
Social network structure

∙ pathogens: network structure depends on the deseases mode of
transmission (e.g. HIV or Corona-virus)
∙ computer viruses: internet has a broader network compared to short-range
wireless communication
∙ ideas: different transmission for seminars, television, newspapers or social
networks

Teaching Goals
Epidemics
Biological versus social contagion
∙ biological contagion: lack of decision making (if we abstract from

preventative behavior), modelled probabilistically
∙ social contagion: people are making decisions to adopt a new idea or
innovation, modelled by utility maximization
Simple model: branching process
∙ a persion carrying a new desease enters a population and transmits it to

other persons with probability p
∙ infectious person meets k people while contagious (these k people are the
first wave of the epidemic)

Teaching Goals
Epidemics: A Simple Model
First wave
∙ k people are at risk of being infected, each with probability p
Second wave
∙ each person in the first wave meets k different people
∙ second wave: k × k = k 2 people
∙ each infected people in the first wave passes the desease to each of the k
second-wave people with probability p
Subsequent waves
∙ each person in the current wave meets k people and passes the desease
with probability p
∙ the contact network has the shape of a tree: single node at the top, every
node is connected to a set of nodes in the level below

Teaching Goals
Epidemics: the branching process
3-1
2-1 3-2
3-3
3-4
1-0 2-2 3-5
3-6
3-7
2-3
3-8
3-9
Source: Similar figures can be found in Easley/Kleinberg (2010), Networks, Crowds and Markets, Chapter 21
Teaching Goals
Epidemics: A Simple Model
The Basic Reproductive Number
∙ k people are at risk of being infected, each with probability p

∙ the basic reproductive number is the expected number of new cases caused
by a single individual
∙ in the branching process the basic reproductive number is R0 = p × k
∙ the outcome is determined, whether the basic reproductive number is
smaller or larger than one
Interpretation
∙ R0 < 1: each infected person produces less than one new case in
expectation =⇒ the size of the outbreak is trending downward
∙ R0 > 1: each infected person produces more than one new infection in
expectation =⇒ the size of the outbreak is trending upward
∙ even when R0 > 1, whenever p < 1 there is a chance that none of the first
infected people will succeed in infecting anyone else

Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
Assumption: three states
∙ Susceptible S(t) ≥ 0: before a node has caught the desease, it is

susceptible to infection from its neighbors
∙ Infectious I(t) ≥ 0: once the node has caught the desease, it has some
probability of infecting its susceptible neighbors
∙ Removed or Recovered R(t) ≥ 0: after an infectitous period the node is
removed from consideration (e.g. recovered because of immunity)
∙ Population N (t) = S(t) + I(t) + R(t) ≥ 0: can be stationary, growing or
shrinking by assumption
S(t) I(t) R(t)
∙ Normalization: N (t)
+ N (t)
+ N (t)
= 1 or often N (t) = 1
Initial conditions
∙ S(t0 ) = N (t0 ) = 1: before a patient zero appears, the whole population is
susceptible to infection
∙ I(t0 ) = R(t0 ) = 0: no infectious and recovered individuals

Teaching Goals
Dynamics of the susceptible
dS S·I
=v·N −β − µS (1)
dt N
∙ v: birth rate of the population, new born vN are susceptible

∙ β = κ · q: infection rate, κ: contact rate and q: infection rate per contact
I
∙ λ = βN : probability of infection
∙ λS: newly infected individuals
∙ µ: death rate of the population (independent of infection)

Teaching Goals
Dynamics of the infected
dI S·I
=β − γI − µI (2)
dt N
∙ β = κ · q: infection rate, κ: contact rate and q: infection rate per contact

I
∙ λ = βN : probability of infection
∙ λS: newly infected individuals
∙ γ: recovery rate, γI: individuals who have recovered, who are no more
susceptible to infection
∙ µI: infected individuals who have died

Teaching Goals
Dynamics of the recovered
dR
= γI − µR (3)
dt
∙ γI: recovered individuals

∙ µR: recovered individuals who have died

Teaching Goals
Assumption: stationary population: µ = v = 0 and N = 1
dS
= −βS · I (4)
dt
dI
= βS · I − γI (5)
dt
dR
= γI (6)
dt
The epidemic starts
dI

= βS · I − γI = I βS − γ (7)
dt
∙ I(t) > 0
∙ βS > γ or R0 · S > 1 with R0 = β/γ as the basic reproductive number

Teaching Goals
Assumption: growing population: µ > 0 and v > 0 and N = 1
dS
= v − βS · I − µS (8)
dt
dI
= βS · I − γI − µI (9)
dt
dR
= γI − µR (10)
dt
The epidemic starts
dI

= βS · I − γI = I βS − γ − µ (11)
dt
∙ I(t) > 0
∙ βS > γ + µ or R0 · S > 1 with R0 = β/(γ + µ) as the basic reproductive
number
Teaching Goals

Equilibrium points
Equilibrium condition:
dI S·I
=β − γI = 0 (12)
dt N
Desease-free equilibrium
I ∗ = 0 leads to
∗ ∗ ∗ ∗
E1 = (S1 , I1 , R1 ) = (1, 0, 0) (13)
Endemic equilibrium
βS/N = γ, which means S ∗ = N/R0 which leads to
∗ ∗ ∗ ∗
E2 = (S2 , I2 , R2 ) = (1/R0 , µ/(R0 − 1)β, 1 − 1/R0 − µ(R0 − 1)/β) (14)
∙ case R0 = 1 leads to E2∗ = (1, 0, 0) = E1∗

∙ case R0 < 1 each infected individual produces on average less than one infected individual,
which leads to a convergence to E1∗ = (1, 0, 0)
∙ case R0 > 1 the infection is able to invade the susceptible population and the infections
becomes endemic

Teaching Goals

Examples for the endemic equilibrium
R0 = 8.3
∙ 2 percent of the population die naturally: µ = 0.02

∙ 10 contacts and 10 percent chance of infection leads to a mean
transmission rate of β = 10 · 0.1 = 1
∙ 10 percent recover per unit time γ = 0.1
1
∙ infectious period γ
= 10 days
β 1
∙ this leads to a basic reproductive number of R0 = γ+µ
= 0.1+0.02
= 8.3
∙ Infections stabilize at S ∗ = 1/R0 = 1/8, i.e. one eight of the population
are still suceptible

Teaching Goals

Examples for the endemic equilibrium
R0 = 4.8
∙ 2 percent of the population die naturally: µ = 0.02

∙ 50 contacts and 0.5 percent chance of infection leads to a mean
transmission rate of β = 100 · 0.005 = 2.5
∙ 50 percent recover per unit time γ = 0.5
1
∙ infectious period γ
= 5 days
β 2.5
∙ this leads to a basic reproductive number of R0 = γ+µ
= 0.5+0.02
= 4.8
∙ Infections stabilize at S ∗ = 1/R0 = 1/5, i.e. 20 percent of the population
are still suceptible

Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
Application: influenza in a British boarding school
∙ estimated active infectious period: 1/γ = 2.2 days

∙ mean transmission rate: β = 1.66 per day
∙ basic reproductive number: R0 = 3.652
∙ estimated curve of the infected reaches peak of 5 weeks
Application: online social networks
∙ Cannarella and Sprechler: information diffusion on Twitter

∙ Wang and Wang: rumor spreading on social networks

Teaching Goals
Application: viral marketing
∙ encourages people on social networks to share product information with

their friends
∙ more impact because information was recommended by friends and peer
networks
∙ spread of information is comparable to epidemic
Application: audience applause
∙ Crowd psychology: individuals change their behavior in response to others

∙ Mann et al.: individuals’ probability of starting clapping increased in
proportion to the number of other audience members already affected by
social contagion

Teaching Goals
Application: diffusion of ideas
∙ the diffusion of ideas holds many similarities to the spread of infections

∙ Bettencourt et al.: spreading of Feynaman diagrams in theoretic physics
communities
∙ Funk: diffusion of public campains
Application: spread of computer viruses
∙ spread of computer viruses through the interconnected computers is similar

to the transmission of an infectious desease

Teaching Goals
Application: rational expectations epidemiological models
∙ connection between epidemiological models and rational decision making

∙ fighting pandemics is not only in the hands of policymakers but also in the
hands of rational decision makers who change their behavior in response to
a pandemic
∙ there are behavioral implications of public health policies
Application: financial network contagion
∙ macroprudential risks: bank-specific risks contribute to financial stability

∙ losses can spread through the interbank market, e.g. after the failure of
Lehman Brothers
∙ losses in mortgage-backed securities were transmitted to banks which hold
similar assets after the burst of the US housing bubble

Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
Payoff- and network-externalities
Basic idea
∙ an individual’s choices depend on what other people do
∙ new ideas and innovations are adopted by a population
Economic structure
∙ interactions at a local level: social network structure is important
∙ individuals often do not care as much about the full population’s decisions
as about the decisions made by friends and collegues
∙ in a work setting: choice of technology such that it is compatible with
collegues’ technology

Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
Assumptions
Decisions
∙ individuals make decisions based on the choices of their neighbors
∙ the benefits of adipting the new behavior increases as more and more of
the neighbors adopt it
Coordination game
∙ each network node has a choice between two alternatives: A or B

∙ If nodes v amd w are linked, then there is an incentive to have their
behaviors match
Payoffs
∙ if v and w both adopt A: they each get a payoff of a > 0

∙ if v and w both adopt B: they each get a payoff of b > 0
∙ if they adopt oppositve behaviors, they each get a payoff of 0

Teaching Goals
Assumptions
Multiple games
∙ individuals are playing this game with all of their neighbors

∙ v’s choice of strategy will be based on the choices made by all of its
neighbors, taken together
Basic question
∙ initially, v and all neightbors are using B

∙ suppose that some of the neighbors adopt A
∙ what should v do in order to maximize its payoff?
Payoff depends on
∙ the relative number of neighbors using A or B

∙ the relation between the payoff values a and b

Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
Decision rule
Decision rule
∙ Suppose that a p fraction of v’s neightbors are using A
∙ and a 1 − p fraction of v’s neighbors are using B
∙ if v has d neighbors: pd adopt A and (1 − p)d adopt B
Payoffs
∙ Payoff of choosing A: pda

∙ Payoff of choosing B: (1 − p)db
A is better than B if
pda ≥ (1 − p)db (15)

b
p ≥ (16)
a+b

Teaching Goals
Decision rule
Interpretation
∙ if a fraction of at least q = b/(a + b) of your neighbors use A, then you

should, too
∙ when q is small: A is the more enticing behavior, and it only takes a small
fraction of your neighbors engaging in A for you to do so as well
∙ if q is large, then B is the attractive behavior, and you need a lot of your
friends to engage in A before you switch to A

Teaching Goals
Decision rule
Example
∙ Payoff of using A: a = 3 and payoff of using B: b = 2

∙ 3 neigbours are using A and 4 neigbours are using B
Payoffs
3
∙ Payoff of choosing A: pda = 7
·7·3=9
4
∙ Payoff of choosing B: (1 − p)db = 7
·7·2=8
A is better than B because
pda ≥ (1 − p)db (17)

b
p ≥ (18)
a+b
3 2 2
p= ≥ = (19)
7 3+2 5
Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
Cascading behavior
Multiple equilibria
∙ One equilibrium, in which everybody uses A

∙ One equilibrium, in which everybody uses B
∙ How easy is it, to tip the network from one equilibrium to the other?
∙ What are other intermediate equilibria, in which one group uses A and
another group uses B?
Assumption
∙ Initial behavior: everybody is using B

∙ Then: a small set of inital adopters / fashion leaders decide to use A
∙ Then: all other agents re-evaluate their payoffs
Questions
∙ Do all the other agents choose to follow the fashion leaders?

∙ What could cause the spread of A to stop?
Teaching Goals
Initial situation: all agents are using option B
r s
v w
t u
Source: Easley/Kleinberg (2010), Networks, Crowds and Markets, Chapter 19

Teaching Goals
Agents v and w are early adopters of option A
r s
v w
t u

Teaching Goals
Agents r and t switch to option A
r s
v w
t u

Teaching Goals
Agents s and u switch to option A
r s
v w
t u

Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
Initial situation: all agents are using option B
r s
v w
t u

Teaching Goals
Agents v and w are early adopters of option A
r s
v w
t u

Teaching Goals
Agents r and t switch to option A
r s
v w
t u

Teaching Goals
Agents s and u do not switch to option A
r s
v w
t u

Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
Assumptions
∙ market with huge number of potential purchasers

∙ each is small enough relative to the entire market, total mass is equal to 1
∙ individuals are arranged in [0, 1], ordered in decreasing reservation prices
∙ r(x) is the reservation price of consumer x, a strictly decreasing function
Market equilibrium
∙ market price p
∙ consider r(x) = p: all consumers between 0 and x buy the product, all
others don’t
∙ equilibrium quantity: r(x∗ ) = p∗
∙ result is based on the absence of network effects

Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
Assumptions
∙ potential purchasers take their reservation prices as well as the total

number of users into account
∙ a z fraction of the population is using the good
∙ reservation price of consumer x: r(x)f (z), where f (z) measures the
benefit from having others also using the good
∙ f (z) is increasing in z
Decision rules
∙ each consumer has to predict z in order to evaluate whether to purchase
∙ at market price p∗ : consumer x expects a z fraction to use the good
∙ x wants to purchase provided that r(x)f (z) ≥ p∗

Teaching Goals
Self-fulfilling expectation
∙ we assume that consumers predictions are perfect

∙ then all form a shared expectation of z
∙ if everyone expects that a z fraction of the population will purchase the
product, then this expectation is in turn fulfilled by people’s behavior
Market equilibrium
∙ if z = 0 then reservation price = r(x)f (0) = 0, which is below p∗

∙ no one wants to purchase and the shared expecation z = 0 is fulfilled
∙ 0 < z < 1: if a z fraction of the population purchases the good, to which
set of individuals does this correspond to?
∙ if x0 purchases the good, x < x0 will also purchase the good
∙ therefore 0 < x < z will purchase the good

Teaching Goals
Market equilibrium
∙ lowest reservation price has consumer z, which is r(z)f (z)

∙ for these consumers to purchase the good, we must have p∗ = r(z)f (z)
∙ if the price p∗ > 0 with the quantity 0 < z < 1 form a self-fulfilling
expectations equilibrium, then p∗ = r(z)f (z)
Example
∙ r(x) = 1 − x, decreasing in x
∙ f (z) = z, increasing in z
∙ r(z)f (z) = z(1 − z), parabolic shape

Teaching Goals
Market equilibrium for p∗ > 1/4
∙ if p∗ > 1/4 then there is no solution to p∗ = r(z)f (z) = z(1 − z)

∙ since the right-hand side has a maximum value of 1/4 at z = 1/2
∙ the only equilibrium is when z = 0
Market equilibrium for 0 < p∗ < 1/4
∙ there are two solutions z1 and z2 to p∗ = z(1 − z) where the horizontal

line y = p∗ slices through z(1 − z)
∙ if people believe a z fraction to buy the good, a z fraction between 0 and
z will buy it

Teaching Goals
1 Teaching Goals
The Basic Idea

Assumptions
Decision rule
Cascading behavior
Stopping cascades


Teaching Goals
What happens at other values of z
∙ if z is between 0 and z1 : there is downward pressure on consumption,

since r(z)f (z) < p∗
∙ if z is between z1 and z2 : there is upward pressure on consumption, since
r(z)f (z) > p∗
∙ if z is larger than z2 : there is downward pressure on consumption, since
r(z)f (z) < p∗

Teaching Goals
Market equilibria
∙ z = 0 and z = z2 are stable equilibria, demand drives z to either 0 or z2

∙ z = z1 is an unstable equilibrium, demand drives z away from z1
∙ z1 is a critical point / tipping point in the success of the good: if the
producer can get the consumers’ expectations for the number of
purchasers above z1 , they can use the upward pressure of demand to get
their market share to the stable equilibrium z2
∙ if consumers’ expectations are below z1 , then the downward pressure will
tend to drive the market share to 0

Lecture 5 Behavioral Finance

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Teaching Goals

Lecture 5 - Herd Behavior:

Dr. Markus Demary

Summer Term 2021

Dr. Markus Demary Behavioral Finance

1 Network-Models with Direct Neighbor Eﬀects

1 Network-Models with Global Network Eﬀects

Dr. Markus Demary Behavioral Finance

1 Network-Models with Direct Neighbor Eﬀects

1 Network-Models with Global Network Eﬀects

Dr. Markus Demary Behavioral Finance

Payoﬀ- and network-externalities

Teaching Goals: Students should learn

∙ how changes in behavior cascade through a network

Models with direct neighbour eﬀects

∙ the network eﬀects are of a local nature

Models with global network eﬀects

∙ the network eﬀects are of a global nature

Dr. Markus Demary Behavioral Finance

1 Network-Models with Direct Neighbor Eﬀects

1 Network-Models with Global Network Eﬀects

Dr. Markus Demary Behavioral Finance

1 Network-Models with Direct Neighbor Eﬀects

1 Network-Models with Global Network Eﬀects

Dr. Markus Demary Behavioral Finance

Social network structure

Dr. Markus Demary Behavioral Finance

Biological versus social contagion

∙ biological contagion: lack of decision making (if we abstract from

Simple model: branching process

∙ a persion carrying a new desease enters a population and transmits it to

Dr. Markus Demary Behavioral Finance

Epidemics: A Simple Model

Dr. Markus Demary Behavioral Finance

Epidemics: the branching process

Epidemics: A Simple Model

The Basic Reproductive Number

∙ k people are at risk of being infected, each with probability p

Dr. Markus Demary Behavioral Finance

1 Network-Models with Direct Neighbor Eﬀects

1 Network-Models with Global Network Eﬀects

Dr. Markus Demary Behavioral Finance

The SIR Epidemic Model

Assumption: three states

∙ Susceptible S(t) ≥ 0: before a node has caught the desease, it is

Dr. Markus Demary Behavioral Finance

The SIR Epidemic Model

Dynamics of the susceptible

∙ v: birth rate of the population, new born vN are susceptible

Dr. Markus Demary Behavioral Finance

The SIR Epidemic Model

Dynamics of the infected

∙ β = κ · q: infection rate, κ: contact rate and q: infection rate per contact

Dr. Markus Demary Behavioral Finance

The SIR Epidemic Model

Dynamics of the recovered

∙ γI: recovered individuals

Dr. Markus Demary Behavioral Finance

The SIR Epidemic Model

Assumption: stationary population: µ = v = 0 and N = 1

The epidemic starts

Dr. Markus Demary Behavioral Finance

The SIR Epidemic Model