## Cobweb Theory and Price Elasticity

I have blogged on this topic before and although not in the NCEA or CIE syllabus’ I find it useful theory to mention when doing supply, demand and elasticity. Agricultural markets are particularly vulnerable to price fluctuations. many agricultural products have inelastic demand and inelastic supply. This means that any change in demand or supply has more of an impact on price than on quantity. Price fluctuations can also arise due to the time lag between planning agricultural production and selling the produce. The cobweb theory (so-called because of the appearance of the diagram) suggests that price can fluctuate around the equilibrium for some time, or even move away from the equilibrium. Dairy farmers base their production decisions on the price prevailing in the previous time period.

The supply of dairy products in New Zealand fits this assumption – farmers make their production decisions today, but the dairy cooperatives (Fonterra, Westland, etc.) don’t make a final decision on the price farmers will receive until close to the end of the season.

Cobweb scenarios:
Convergent
At the equilibrium point, if the demand curve is more elastic than the supply curve, we get the price volatility falling, and the price will converge on the equilibrium. For example:

• Adverse weather conditions means their is a poor crop – Qt
• The excess demand causes the price to rise – Pt
• Because of the higher price famers plant more crops and therefore greater supply – Qt+1
• With supply so high prices drop to meet demand – Pt+1
• Lower prices mean that famers supply less to the following year – Qt+2
• This results in higher prices again – Pt+2
• Because of the higher price famers plant more crops and therefore greater supply – Qt+3 etc.
• This process continues until you get to an equilibrium as the PED is greater than the PES – supply curve is steeper than the demand curve.

Continuous
This is occurs where there is a continuous fluctuation between two equilibriums – Pt and Pt+1. The PED and the PES are equal to each other.
Divergent
Prices will diverge from the equilibrium when the PES greater than the PED at the equilibrium point – i.e.the demand curve is steeper than the supply – price changes could increase and the market becomes more changeable.

Even though these three diagrams show very different results they are dependent on the PES and the PED of the market.

## Cobweb Theory – The New Zealand dairy market

Agricultural markets are particularly vulnerable to price fluctuations. many agricultural products have inelastic demand and inelastic supply. This means that any change in demand or supply has more of an impact on price than on quantity. Price fluctuations can also arise due to the time lag between planning agricultural production and selling the produce. The cobweb theory (so-called because of the appearance of the diagram) suggests that price can fluctuate around the equilibrium for some time, or even move away from the equilibrium. Dairy farmers base their production decisions on the price prevailing in the previous time period.

The supply of dairy products in New Zealand fits this assumption – farmers make their production decisions today, but the dairy cooperatives (Fonterra, Westland, etc.) don’t make a final decision on the price farmers will receive until close to the end of the season. However the New Zealand dairy industry faces a severe test over the next year. World price for dairy products have reached their lowest levels since late 2002. Last seasons low milk price \$4.40/kg is to be followed by a payment of \$3.70/kg.

So, what has happened? At the start of the milking season, farmers’ expected price was \$7.00 per kg of milk solids (unless they had prescience), so they based their production plans on that price. In the diagram below, say that D0 and S0 are the initial demand and supply curves, respectively, with demand for dairy products relatively high. Farmers, who expect the price P0 (\$7.00), produce Q0 units of dairy products (this is the quantity supplied on the supply curve S0, with the price P0). By the end of the season though, demand has fallen to D1. When the farmer cooperative tries to sell Q0 dairy products, the price falls to P1 (\$4.50; this is the price where the quantity demanded, from the demand curve D1, is exactly equal to Q0).

Now, going into the next season farmers observe the low price P1 (\$4.50) and expecting that low price to persist, they produce Q1 units of dairy products (this is the quantity supplied on the supply curve S1, with the price P1). Come the end of the season, the farmer cooperative finds that they can sell the Q1 dairy products for the much higher price P2 (this is the price where the quantity demanded, from the demand curve D2, is exactly equal to Q1). Now the price is high, farmers produce more but at the end of the season, the price falls… and so on. Essentially, the market follows the red line (which makes it look like a cobweb – hence the name of the model), and eventually the market gets back to long-run equilibrium (price P*, quantity Q*).

Source: Michael Cameron University of Waikato.

Price fluctuations can drive some dairy farmers who would make a profit in the long run form the industry and discourage other farmers from entering the industry. Farmers may also leave the industry as a result of the tendency for the price of dairy products to fall. This is because demand does not tend to increase at the same rate as supply. Demand for most agricultural products is income inelastic, so that demand rises relatively slowly.