SummaryFirms in a perfectly competitive market may encounter some problems that can decrease their competitiveness and may even force them out of the market. The way they deal with problems will determine whether they can stay in the market. In this Learning Path we learn about these problems, how firms’ cost structures change, and how an equilibrium is reached in the market.
- Supply and demand
- Market clearing
- Cobweb model
Cobweb models explain irregular fluctuations in prices and quantities that may appear in some markets. The key issue in these models is time, since the way in which expectations of prices adapt determines the fluctuations in prices and quantities. Cobweb models have been analysed by economists such as Ronald H. Coase, Wassily Leontief or Nicholas Kaldor. It was in Kaldor’s paper on the subject, “A Classificatory Note on the Determinateness of Equilibrium”, 1934, where the analysis of these models became of great interest, and where the phenomenon took the name of Cobweb theorem. Four years later, in 1938, economist Mordecai Ezekiel wrote the paper “The Cobweb Theorem”, which gave the phenomenon and its particular diagrams popularity.
Cobweb models are easily explained using the example used by Kaldor in 1934: agricultural markets. Let’s say weather conditions aren’t optimal during a year, which causes the quantity supplied of a certain crop to be quite small (Qt, see figure below, first diagram). This excessive demand, or shortage, causes prices to be unusually high (Pt). When farmers realise how high prices are, they’ll plant more in order to supply more the following year. However, supply is so high the following year (Qt+1) that prices decrease to meet consumers’ demand (Pt+1). Since prices are low, farmers decide to lower their supply the following year (Qt+2), resulting in high prices again (Pt+2). This process will go on until an equilibrium is reached after a few fluctuations. This unique equilibrium is reached because in this first scenario, the elasticity of the demand curve, in absolute terms, is higher than the elasticity of the supply curve, which implies a convergent fluctuation.
The second diagram shows that a continuous fluctuation between two equilibriums will take place when both elasticities are equal to each other. The third diagram shows a divergent fluctuation, given by the fact that the demand curve is steeper than the supply curve. Even though these three diagrams show very different results, the example explained above can result in any of these scenarios, depending on each curve’s elasticity.
There is another possible scenario, which is given by changes in the steepness of curves: if near the point where the supply and demand curves cross demand is steeper than supply, but when we move far away from this point the supply curve gets steeper than the demand curve, we get a cobweb as the one in the figure below. At first, prices and quantities act as in a divergent fluctuation. However, as supply gets steeper than demand, a limit cycle may be reached, turning this divergent fluctuation into a continuous fluctuation.