Lecture 3 Equilibrium and Government regulation of a market

1. Cobweb theorem as an illustration of stable and unstable equilibrium

Cobweb is a simple model used to illustrate the danger that time lags may introduce fluctuations into the economy. It was created by Hungarian-born economist Nicholas Kaldor (1908-1986).

This simple dynamic model of cyclical demand with time lags between the response of production and a change in price (most often seen in agricultural sectors). Cobweb theory is the process of adjustment in markets.

It traces the path of prices and outputs in different equilibrium situations. Path resembles a cobweb with the equilibrium point at the center of the cobweb.

Hypothesis:

• have a perfectly competitive market

• production period is long

• the price is determined by contemporary production

• quantity supplied is determined by contemporary price

Model can be illustrated with the help of the following graphs:

Stable cobweb

Period (day)	Current price	Quantity demanded	Quantity supplied	shortage/ surplus	Next period (day) price
I	P1	Q1	Q2	surplus	P2
II	P2	Q2	Q3	shortage	P3
III	P3	Q3	Q4	surplus	P4
IV	P4	Q4	Qn	shortage	Pn
V	…	…	…	…	…

EXPLANATION: Assume that this represents the market for X-good. The current price is P_e and quantity bought and sold Q_e.

Assume that prise rises from P_e to P₁. At the current market price of P_e there will be a surplus created – buyers cannot easily increase the demand of X-good in the short run. This would cause the price to fall (P₂). The lower price encourages consumers to buy more goods – the damand at the end of the period will increase to Q₂.

The increased demand at a price of P₂ however is met with a reduction in quantity supplied. It means that there is shortage in the market. As a result the price increases to P₃ level.

The higher price persuades produsers to increase production quantity for the next period (Q₄).

At P₃ the lower demand means a surplus is created press the price down to P₄. This will encourage buyers to expand consumption to Q_4. …

This process will continue until the price reaches equilibrium. This is termed a ‘convergent cobweb’. A convergent cobweb leads to price stability over time.

Unstable cobweb

Constant cobweb

2. Government regulation of a market

There are several main leverages of Government regulation of a market: they can be divided on direct an indirect. We’ll remind:

2.1. Price ceiling and Price floor

Price ceiling - legally mandated maximum price. It’s purpose to keep price below the market equilibrium price (as a result – shortage and then “shadow market”). Examples: rent controls, price controls during wartime, gas price rationing, etc.

Price floor - legally mandated minimum price. Designed to maintain a price above the equilibrium level (first result - surplus). Examples: agricultural price supports, minimum wage laws.

P_max

Price ceiling effect Price floor effect