Tag Archives: Price Elasticity of Supply

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:
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.
Source: Policonomics

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.
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.