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Cobweb Model

The cobweb model explains periodic price fluctuations in markets where supply must be determined before prices are observed. It analyzes how producers' expectations of past prices can lead to cyclical overshooting and undershooting of market equilibrium as supply alternates between being too high or low. The model shows how prices and quantities may converge toward equilibrium over time (the stable case) or diverge further from it (the unstable case), depending on whether supply or demand is more responsive to price changes. While the model provides insights into expectation formation and market dynamics, it relies on the unrealistic assumption of purely backward-looking expectations.

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472 views

Cobweb Model

The cobweb model explains periodic price fluctuations in markets where supply must be determined before prices are observed. It analyzes how producers' expectations of past prices can lead to cyclical overshooting and undershooting of market equilibrium as supply alternates between being too high or low. The model shows how prices and quantities may converge toward equilibrium over time (the stable case) or diverge further from it (the unstable case), depending on whether supply or demand is more responsive to price changes. While the model provides insights into expectation formation and market dynamics, it relies on the unrealistic assumption of purely backward-looking expectations.

Uploaded by

shoaib
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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cobweb model

The cobweb model or cobweb theory is an economic model that explains why prices might be
subject to periodic fluctuations in certain types of markets. It describes cyclical supply and
demand in a market where the amount produced must be chosen before prices are observed.
Producers' expectations about prices are assumed to be based on observations of previous
prices. Nicholas Kaldor analyzed the model in 1934, coining the term "cobweb theorem".

The Model:

The convergent case: each new outcome is successively closer to the intersection of supply and demand.

The divergent case: each new outcome is successively further from the intersection of supply and demand.

The cobweb model is based on a time lag between supply and demand decisions. Agricultural
markets are a context where the cobweb model might apply, since there is a lag between planting
and harvesting (Kaldor, 1934, p. 133-134 gives two agricultural examples: rubber and corn).
Suppose for example that as a result of unexpectedly bad weather, farmers go to market with an
unusually small crop of strawberries. This shortage, equivalent to a leftward shift in the
market's supply curve, results in high prices. If farmers expect these high price conditions to
continue, then in the following year, they will raise their production of strawberries relative to other
crops. Therefore when they go to market the supply will be high, resulting in low prices. If they then
expect low prices to continue, they will decrease their production of strawberries for the next year,
resulting in high prices again.

This process is illustrated by the diagrams on the right. The equilibrium price is at the intersection of
the supply and demand curves. A poor harvest in period 1 means supply falls to Q1, so that prices
rise to P1. If producers plan their period 2 productions under the expectation that this high price will
continue, then the period 2 supply will be higher, at Q2. Prices therefore fall to P2 when they try to sell
all their output. As this process repeats itself, oscillating between periods of low supply with high
prices and then high supply with low prices, the price and quantity trace out a spiral. They may spiral
inwards, as in the top figure, in which case the economy converges to the equilibrium where supply
and demand cross; or they may spiral outwards, with the fluctuations increasing in magnitude.
The cobweb model can have two types of outcomes:

If the supply curve is steeper than the demand curve, then the fluctuations decrease in
magnitude with each cycle, so a plot of the prices and quantities over time would look like an
inward spiral, as shown in the first diagram. This is called the stable or convergent case.

If the slope of the supply curve is less than the absolute value of the slope of the demand
curve, then the fluctuations increase in magnitude with each cycle, so that prices and quantities
spiral outwards. This is called the unstable or divergent case.

Two other possibilities are:

Fluctuations may also remain of constant magnitude, so a plot of the outcomes would
produce a simple rectangle, if the supply and demand curves have exactly the same slope (in
absolute value).

If the supply curve is less steep than the demand curve near the point where the two curves
cross, but more steep when we move sufficiently far away, then prices and quantities will spiral
away from the equilibrium price but will not diverge indefinitely; instead, they may converge to
a limit cycle.

In either of the first two scenarios, the combination of the spiral and the supply and demand curves
often looks like a cobweb, hence the name of the theory.

Elasticities versus slopes [edit]


The outcomes of the cobweb model are stated above in terms of slopes, but they are more
commonly described in terms of Elasticities. In terms of slopes, the convergent case requires that
the slope of the supply curve be greater than the absolute value of the slope of the demand curve:

In standard microeconomics terminology, define the elasticity of supply as

the elasticity of demand as


point, that is
the convergent case requires

, and

. If we evaluate these two Elasticities at the equilibrium


and

, then we see that

whereas the divergent case requires

In words, the convergent case occurs when the demand curve is more elastic than the
supply curve, at the equilibrium point. The divergent case occurs when the supply curve
is more elastic than the demand curve, at the equilibrium point (see Kaldor, 1934, page
135, propositions (i) and (ii).)

Role of expectations [edit]


One reason to be skeptical of this model's predictions is that it assumes producers are
extremely shortsighted. Assuming that farmers look back at the most recent prices in
order to forecast future prices might seem very reasonable, but this backward-looking
forecasting (which is called adaptive expectations) turns out to be crucial for the model's
fluctuations. When farmers expect high prices to continue, they produce too much and
therefore end up with low prices, and vice versa.
In the stable case, this may not be an unbelievable outcome, since the farmers'
prediction errors (the difference between the price they expect and the price that
actually occurs) become smaller every period. In this case, after several periods prices
and quantities will come close to the point where supply and demand cross, and
predicted prices will be very close to actual prices. But in the unstable case, the farmers'
errors get larger every period. This seems to indicate that adaptive expectations is a
misleading assumptionhow could farmers fail to notice that last period's price is not a
good predictor of this period's price?
The fact that agents with adaptive expectations may make ever-increasing errors over
time has led many economists to conclude that it is better to assume rational, that is,
expectations consistent with the actual structure of the economy. However, the rational
expectations assumption is controversial since it may exaggerate agents' understanding
of the economy. The cobweb model serves as one of the best examples to illustrate why
understanding expectation formation is so important for understanding economic
dynamics, and also why expectations are so controversial in recent economic theory.

Evidence[edit]
Livestock herds [edit]
The cobweb model has been interpreted as an explanation of fluctuations in
various livestock markets, like those documented by Arthur Hanau in German hog
markets; see Pork cycle. However, Rosen et al. (1994) proposed an alternative model
which showed that because of the three-year life cycle of beef cattle, cattle populations
would fluctuate over time even if ranchers had perfectly rational expectations.[1]

Human experimental data [edit]


In 1989, Wellford conducted twelve experimental sessions each conducted with five
participants over thirty periods simulating the stable and unstable cases. Her results
show that the unstable case did not result in the divergent behavior we see with cobweb

expectations but rather the participants converged toward the rational


expectations equilibrium. However, the price path variance in the unstable case was
greater than that in the stable case (and the difference was shown to be statistically
significant).
One way of interpreting these results is to say that in the long run, the participants
behaved as if they had rational expectations, but that in the short run they made
mistakes. These mistakes caused larger fluctuations in the unstable case than in the
stable case.

Housing sector in Israel [edit]


The residential construction sector of Israel was, primarily as a result of waves of
immigration, and still is, a principal factor in the structure of the business cycles in Israel.
The increasing population, financing methods, higher income, and investment needs
converged and came to be reflected through the skyrocketing demand for housing. On
the other hand, technology, private and public entrepreneurship, the housing inventory
and the availability of workforce have converged on the supply side. The position and
direction of the housing sector in the business cycle can be identified by using a cobweb
model (see Tamari, 1981).

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