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Inst r uct or Dr Rehana Naz M at hemat i cal Economi cs I

Lecture 24

Section 17.4 from
Fundamental methods of Mathematical Economics, McGraw Hill 2005, 4
th
Edition.
By A. C. Chiang & Kevin Wainwright is covered.
The Cobweb model

Read details from book.

Question: The cobweb model is essentially based on the static market model in which

d
=
s
. What economic assumption is the dynamizing agent in the present case?
Explain.
Answer:
In the cobweb model, the supply and demand functions are of the form

dt
= [P
t
( o, [ > 0) (1)

st
= y + oP
t-1
( y, o > 0) (2)
To get first-order difference equation representing the cobweb model, we assume that in
each time period the market price is always set at a level which clears the market i.e

dt
=
st
(3)
Now
dt
=
st
, assumption is same as we do in static analysis. The dynamizing agent is
the lag in the supply function. This introduces P
t-1
term into the model, which together
with P
t
, forms a pattern of change.

Interpret the solution of cobweb model given as follows:
P
t
= ( P
0
P

) _
o
[
]
t
+ P

Note that b =
6
[
< 0 implies that the time path is oscillatory. Since
| b| = _
o
[
_ =
o
[

There can be three types of oscillations, explosive, uniform and damped depending on
| b| 1.
(i) If | b| =
6
[
> 1 o > [, then time path is divergent and oscillations are
explosive.
(ii) If | b| =
6
[
= 1 o = [, then time path is divergent and oscillations are uniform.
(iii) If | b| =
6
[
< 1 o < [, then time path is convergent and oscillations are
damped.
Example 1: Given demand and supply for the cobweb model as follows,
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Inst r uct or Dr Rehana Naz M at hemat i cal Economi cs I

dt
= 18 3P
t
(4)

st
= 3 + 4P
t-1
(5)

(a) Assuming that in each time period the market price is always set at a level which clears
the market find the time path P
t
. At t=0 P
0
.
(b) Find the intertemporal equilibrium price.
(c) Determine whether the equilibrium is stable.
(d) Find the time path of Q and analyze the condition for its convergence.
Solution:
(a) Assuming that in each time period the market price is always set at a level which clears
the market yields

dt
=
st
(6)
Usi ng ( 4) and ( 5) i n equat i on ( 6) , we have
18 3P
t
= 3 + 4P
t-1


3P
t
+ 4P
t-1
= 21 ( 7)
Letting t t + 1 in (7), we have

3P
t+1
+ 4P
t
= 21
Or
P
t+1
+
4
3
P
t
= 7 ( 8)
This is first-order linear difference equation with o =
4
3
, c=7, its solution is
P
t
= A( o)
t
+
c
1 + o

[You can use above formula directly. If you want to do all steps in finding
complementary and particular solutions you can solve by general solution method]
P
t
= A(
4
3
)
t
+ 3 ( 9)
At t=0 P
0
, (9) yields
P
0
= A + 3 A = P
0
3 ( 10)
Using (10) in (9), we have
P
t
= ( P
0
3) (
4
3
)
t
+ 3 ( 11)
(b) To find intertemporal equilibrium price set P
t
= P
t-1
= P

in the demand and supply

functions and equate them i.e
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Inst r uct or Dr Rehana Naz M at hemat i cal Economi cs I
18 3P

= 3 + 4P

= 3
P

= 3 is the intertemporal equilibrium price.

(c) We need to check whether the equilibrium is stable.
From (11) b =
4
3
<0, the time path is oscillatory. But since
| b| = _
4
3
_ =
4
3
> 1
The time path is divergent and oscillations are explosive.
(d) Substitution of the time path (11) into the demand equation (4) leads to the time path of

dt
, which we can simply write as
t
(since
dt
=
st
by the equilibrium condition):

t
= 18 3 _( P
0
3) (
4
3
)
t
+ 3 _

t
= 18 3( P
0
3) (
4
3
)
t
3( 3)
or

t
= 9 3( P
0
3) (
4
3
)
t
( 12)
Convergence of
t
depends on the (
4
3
)
t
term, which determines the convergence of
P
t
os wcll. Thus P
t
and
t
must be either both convergent or both divergent.
As for this case the time path P
t
is divergent so
t
is also divergent and oscillations are
explosive.
Example 2: Given demand and supply for the cobweb model as follows,

dt
= 22 3P
t
( 13)

st
= 2 + P
t-1
( 14)
(a) Assuming that in each time period the market price is always set at a level which clears
the market find the time path P
t
.
(b) Find the intertemporal equilibrium price.
(c) Determine whether the equilibrium is stable.
(d) Find the time path of Q and analyze the condition for its convergence.

Solution:
(a) Assuming that in each time period the market price is always set at a level which
clears the market yields

dt
=
st
(15)
Usi ng ( 13) and ( 14) i n equat i on ( 15) , we have
22 3P
t
= 2 + P
t-1


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Inst r uct or Dr Rehana Naz M at hemat i cal Economi cs I
3P
t
+ P
t-1
= 24 ( 16)
Letting t t + 1 in (16), we have

3P
t+1
+ P
t
= 24
Or
P
t+1
+
1
3
P
t
= 8 ( 17)
This is first-order linear difference equation with o =
1
3
, c=8, its solution is
P
t
= A( o)
t
+
c
1 + o

P
t
= A(
1
3
)
t
+ 6 ( 18)
At t=0 P
0
, (18) yields
P
0
= A + 6 A = P
0
6 ( 19)
Using (19) in (18), we have
P
t
= ( P
0
6) (
1
3
)
t
+ 6 ( 20)
(b) To find intertemporal equilibrium price set P
t
= P
t-1
= P

in the demand and

supply functions and equate them i.e
22 3P

= 2 + P

= 6
P

= 6 is the intertemporal equilibrium price.

(c) We need to check whether the equilibrium is stable.
From (20) b =
1
3
<0, the time path is oscillatory. But since
| b| = _
1
3
_ =
1
3
< 1
The time path is convergent and oscillations are damped.
(d) Substitution of the time path (20) into the demand equation (13) leads to the time path
of
dt
, which we can simply write as
t
(since
dt
=
st
by the equilibrium
condition):

t
= 22 3 _( P
0
6) (
1
3
)
t
+ 6 _

t
= 4 3( P
0
6) (
1
3
)
t
( 21)
Convergence of
t
depends on the (
1
3
)
t
term, which determines the convergence of
P
t
os wcll. Thus P
t
and
t
must be either both convergent or both divergent.
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Inst r uct or Dr Rehana Naz M at hemat i cal Economi cs I
As for this case the time path P
t
is convergent so
t
is also convergent and oscillations are
damped.

Example 3: Given demand and supply for the cobweb model as follows,

dt
= 19 6P
t
( 22)

st
= 6P
t-1
5 ( 23)
(a) Assuming that in each time period the market price is always set at a level which clears
the market find the time path P
t
.
(b) Find the intertemporal equilibrium price.
(c) Determine whether the equilibrium is stable.
(d) Find the time path of Q and analyze the condition for its convergence.

Solution:
(e) Assuming that in each time period the market price is always set at a level which clears
the market yields

dt
=
st
(24)
Usi ng ( 22) and ( 23) i n equat i on ( 24) , we have
19 6P
t
= 5 + 6P
t-1


P
t
+ P
t-1
= 4 ( 25)
Letting t t + 1 in (25), we have

P
t+1
+ P
t
= 4 ( 26)
This is first-order linear difference equation with o = 1, c=4, its solution is
P
t
= A( o)
t
+
c
1 + o

P
t
= A( 1)
t
+ 2 ( 27)
At t=0 P
0
, (27) yields
P
0
= A + 2 A = P
0
2 ( 28)
Using (28) in (27), we have
P
t
= ( P
0
2) ( 1)
t
+ 2 ( 29)
(b) To find intertemporal equilibrium price set P
t
= P
t-1
= P

in the demand and supply

functions and equate them i.e
19 6P

= 5 + 6P

= 2
P

= 2 is the intertemporal equilibrium price.

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Inst r uct or Dr Rehana Naz M at hemat i cal Economi cs I
(c) We need to check whether the equilibrium is stable.
From (29) b = 1<0, the time path is oscillatory. But since
| b| = | 1| = 1
The time path is divergent and oscillations are uniform.
(d) Substitution of the time path (29) into the demand equation (22) leads to the time path of

dt
, which we can simply write as
t
(since
dt
=
st
by the equilibrium condition):

t
= 19 6[ ( P
0
2) ( 1)
t
+ 2 ]

t
= 7 6( P
0
2) ( 1)
t
( 30)
As for this case the time path P
t
is divergent so
t
is also divergent.
Example 4: If

dt
= [P
t
( o, [ > 0) (31)

st
= y + oP
t

( y, o > 0) (32)
w her e
P
t

= P
t-1

+ p( P
t-1
P
t-1

) , 0 < p 1 (33)

dt
=
st
(34)
What happens if p takes its maximum value? Can we consider the cobweb model as a
special case of the present model?
Solution: Maximum value of p i s 1. Taking p = 1 in (33), we have
P
t

= P
t-1

+ 1( P
t-1
P
t-1

) P
t

= P
t-1

and t he model r educes t o t he cobw eb model . Thus the present model includes the
cobweb model as a special case.