fig

Suppose we have a crop which takes a year to grow and is grown only once

year,

DA

P1

Q1

P

Q O

a

SAe.g. Hops for Beer

Suppose now that demand were to rise but supply cannot respond immediately

fig

What will happen to Price?

Suppose we have a crop which takes a year to grow and is grown only once

year,

DA

P1

Q1

P

Q O

a

SAe.g. Hops for Beer

Suppose now that demand were to rise but supply cannot respond immediately

fig

So price rises to P2

Since supply is fixed, the price is determined by the available supply at Q1.

DA

P1

Q1

P

Q O

a

DB

P2

SA

• But next period farmers observe that the price of hops was very high

• So now they all want to grow hops

• At P2, what will the supply be?

fig

DA

P1

Q1

P

Q O

a

DB

P2

At P2, the following year supply increases to Q3

Q3

SA

fig

DA

P1

Q1

P

Q O

a

DB

P2

But now Supply exceeds demand so price must fall to P3

Q3

P3

SA

fig

DA

P1

Q1

P

Q O

a

DB

P2

Q3

P3

Q4

But next period farmers see lower price and decide to supply less: Q4

SA

fig

DA

P1

Q1

P

Q O

a

DB

P2

Q3

P3

Q4

Notice here that we are spiraling through time to an equilibrium

This is a stable Cobweb

SA

fig

Suppose instead that the supply curve was very flat.

DA

P1

Q1

P

Q O

a

SA

Now what will happen to Price?

fig

Suppose instead that the supply curve was very flat.

DA

P1

Q1

P

Q O

a

SA

Now what will happen to Price?

fig

Since supply is fixed, again the price must rise to P2

P1

Q1

P

Q O

a

DA

DB

SA

fig

Since supply is still fixed at Q1, again the price must rise to P2

P1

Q1

P

Q O

a

DA

DB

SAP2

But next period farmers observe that the price of hops was very high

So now they all want to grow hops

fig

DA

P1

Q1

P

Q O

a

DB

P2

Now Supply Increases to Q5

Q5

SA

At P2, what will the supply be in this case?

fig

DA

P1

Q1

P

Q O

a

DB

P2

Q5

SA

But again Supply exceeds demand so price must fall to P5

P5

fig

DA

P1

Q1

P

Q O

a

DB

P2

Q5

SA

But at P5 next period farmers decide to supply Q6

P5

Q6

fig

DA

P1

Q1

P6

Q O

a

DB

P2

Q5

SA

But if only Q6 is supplied demand will exceed supply and price will rise to P6

P5

Q6

fig

DA

P1

Q1

P6

Q O

a

DB

P2

Q5

SA

P5

Q6

But Now the price and quantity are gradually spiraling away from equilibrium. This is an unstable cobweb.

Summary of Cobweb Effects

• With a demand SHIFT and supply fixed yearly, a sudden rise in demand will see a big increase in income.

• The lagged response next year can generate cyclical fluctuations in prices over the next few years.

• When Q goes up and P fall, income PxQ can also fluctuate.

• Not all cobwebs are stable

fig

Supply Side Shock

D

PE

QE

P

Q O

e

LRS

LRS is the long-run supply curve.

SRSE is the expected supply this year.

SRSE

PA

QA

SRSA

SRSA is the actual supply this year. e.g. Bad harvest

fig

Supply Side Shock

D

PE

QE

P

Q O

LRS

So price rises, what about income?

PEeQEO=ab is expected income

SRSE

PA

QA

SRSA

ac= actual income

Overall depends on size of c relative to b

e

a

b

c

fig

Supply Side Shock

D

PE

QE

P

Q O

LRS

If demand is more inelastic, c>b and income rises.

SRSEPA

QA

SRSA

ac= actual income

Overall depends on size of c relative to b

e

a

b

c

fig

Supply Side Shock

D

PE

QE

P

Q O

LRS

But if it is a good crop and demand is inelastic,

SRSE

PA

QA

SRSA

c < b and income falls

So variability in incomes leads to pressure for government intervention

e

a

b

c