1

The Cobweb Model

Consider the pigs market. Let the demand be linear. Furthermore the demand xd is hit by stochastic t shocks ut : xd = a bpt + ut t a; b > 0

that is ut causes a level shift but not a shift in the slope. The linear supply curve is also hit by a stochastic term vt xs = c + dpe + vt t t c; d > 0

where pe is the expected value of (future) pt : Market clearing: t xd = xs t t For forecasting the next periods price we have three possible ways.

1.1

Static Expectations
pe = pt1 t

Denition 1 We assume

that is we simply expect todays observed price for tomorrow and we do not use any (new) information available today. Market clearing yields: xs t c + dpt1 + vt bpt pt = xd t = a bpt + ut = a c dpt1 + ut vt ac d ut vt pt1 + = b b b

We have a rst order stochastic dierence equation. a c ut vt d + 1 + L pt = b b b 1 d ac ut vt + 1+ L pt = d b b b 1+ b 1 X d i uti vti ac + pt = b + d i=0 b b Let p denote the intersection of the deterministic parts of the demand and supply curves. p = ac b+d

The particular solution of the stochastic model is then given by: pP t

1 X d i uti vti =p + b b i=0

1 1 Since fut gt=1 and fvt gt=1 are stationary processes pP uctuates around p . The homogenous part t of the solution is given by: t d p0 pH = t b

If d < b the solution is converging to the equilibrium price p : If d > b the deviations from equilibrium are getting bigger and bigger.

1.2

Adaptive Expectations
pe = pe + h pt1 pe t t1 t1

Denition 2 We assume 0<h<1

that is agents correct their forecast by h-times the forecasting error. Market clearing yields: c + dpe + vt t bpt pt Plugging in the price forecast: pt = ut vt ac d e + pt1 + h pt1 pe t1 b b b pt1 = Multiply by h 1 yields: (h 1) pt1 = (h 1) d ac ut1 vt1 (h 1) pe + (h 1) t1 b b b (2) ac d e ut1 vt1 pt1 + b b b (1) = a bpt + ut = a c dpe + ut vt t a c d e ut vt pt + = b b b

For t 1 the market equilibrium is given by:

Adding equation (1) and equation (2) yields: pt + (h 1) pt1 = h ac h d (pt1 ) + b b pt = h ac + 1 h h d pt1 + b b
ut vt b ut vt b

+ (h 1) ut1 vt1 b

+ (h 1) ut1 vt1 b

This time the homogenous solution is given by: t d pht = 1 h h p0 b This process is stable if 1 < 1 h h d <1 b

holds. The last inequality implies: 1hh d b d h b d b < 1 < h > 1

This is obviously always true. Regarding the rst inequality 1 < 1 h h h 2 < h 2h > h | {z }
>1

d b

d b

d b

Meaning that even if d > b there are possibilities that the price converges.

1.3

Rational Expectations

see your notes