Download Using this module:

Using this module:
This module covers two forms of adjustment for a competitive market. When a shock to
either demand or supply occurs the move to the new equilibrium is described either by a
Walrasian auction mechanism or by a Cobweb model. The market used to illustrate
shifts and adjustment methods is the market for newly constructed housing. This market
has aspects that make both types of adjustment potentially useful in explaining market
phenomena.
When using the module the first screen you see offers merely the SimEcon logo. If you
don’t want to wait while it displays, left click anywhere on the blackboard image and you
will immediately move to the next screen. This will save you a few seconds. The next
screen contains a brief explanation of the contents of the module, which you can access
by left clicking on the piece of chalk labeled Markets 3. Alternatively, you can click on
the word Instructions on the top tool bar and get access to the contents of this manual. If
you just want to begin using the module you can either click on the word Continue on the
tool bar or click on the graph at the center of the blackboard.
The next screen shows you the original values for four variables that affect the demand
for housing, and four that affect the supply of housing. These are the things that you will
subsequently be able to change and by doing so influence the behavior of this market.
After examining these values, click on Continue on the tool bar. The next screen shows
the supply and demand graph with the original values for all eight variables, including the
equilibrium values for price and quantity of new built housing. After examining this
graph and the numerical values on it, click on Shock Market on the tool bar.
The next screen lists the eight variables which can shift demand or supply and therefore
cause a shock to the market. Click on any one of these before proceeding. (One is
already selected by default so if you do nothing except proceed to the next screen you
have selected the default variable.) Click on Continue to proceed.
The next screen shows the original value of the variable you have selected. In order to
change the value and shock the market click on the white box in which the value is
displayed and enter a new value. You can proceed using the old value but you will not
get any interesting results if you do. Click Continue to proceed.
The next screen shows the old supply and demand information in white and the new
information in a different color. You will see either a new demand line or a new supply
line (depending on which kind of variable you changed) and the new equilibrium price
and quantity. In some cases you will also see a short explanation of some aspect of the
results. After examining the results click on Adjustment to proceed. If instead of
continuing on you wish to try a new value for the same variable, click on New Value on
the tool bar. If you want to switch to changing a different variable, click on New
Disturbance on the tool bar.
The next screen offers you the choice between two different ways for the market to adjust
to the disturbance you have caused Walrasian auction and Cobweb. Full descriptions of
these adjustment processes can be found elsewhere in this manual/instructions. If you
select the Walrasian auction option you can immediately proceed by clicking Continue.
If you select the Cobweb option you must then decide whether or not you will allow
speculators to operate in this market. A definition of speculator will be found elsewhere
in this manual/instruction. If you click on No (no speculators allowed to operate) you can
immediately proceed to get results by clicking Continue.
If you select the Cobweb option and then click on Yes (allow speculation) you have more
decisions to make before proceeding. First, you must determine how much speculation
there will be. The default level is zero, but that gets you the same results as if you had
not allowed speculation. The maximum is 100%, i.e., the amount of speculation will be
as much as the model permits—with limits set to prevent weird and unreasonable results.
Once you determine how much speculation there will be you need to determine whether
the speculators will be smart or foolish. Smart speculators are good at predicting how
prices will change in the market as a result of any shock, foolish ones are bad at that
endeavor.
Limits on and meaning of Market Shocks:
For each of the eight variables listed as sources for market shocks there are upper and
lower limits for the values you can set. The table below shows each variable, the lower
limit on its value, the base (default) value, and the upper limit on the value you can set.
Variable
House rentals
Price of furniture
Income
Demand tax rate
Commercial building price
Number of firms
Construction material cost
Supply tax rate (or subsidy)
Lower limit Base value
Upper limit
$1
$10
$20
$0.10
$4
$14
$0.10
$10
$30
0%
0%
30%
$3
$10
$17
500
1000
2000
%3
$1
$40
-80%
0%
30%
House rentals represent the price of a good that is a substitute for buying a new built
house. People buy furniture to fill a new house so the price of furniture is the price of a
good that is a complement to new built houses. Income has the usual impact on the
demand for a normal good. When the government puts on a tax to be paid by those who
buy a new house the total price paid by the buyer is the price received by the seller
(builder) plus the amount of the tax. The module reports the price received by the seller –
as seen by the module it looks like the demand line shifted, though from the perspective
of the buyers they still buy the same amount at each given price. In other words, if before
the tax is put on buyers would buy 100 houses when the price they pay is $100 they still
will. But if you put on a 10% tax then when the price received by a seller is $100 the
buyers are paying $110. Consequently they buy fewer than 100 houses when the price
(to the seller) is $100.
On the supply side, the price of commercial building represents an opportunity cost to
home builders. They could use the same resources to build either homes of commercial
buildings, so the higher the prices in the market for commercial buildings, the fewer
houses will be built as resources are moved to the commercial market. The number of
firms in the market has the usual effects on the supply of this product, the more firms, the
larger the number of homes offered on the market. The more costly it is to buy
construction materials, the higher the price builders would have to receive to make it
worthwhile to build a given number of homes. When the government puts on a tax that
must be paid by sellers of a home, then at the same price sellers actually get to keep less
to cover their costs and profits. As a result, at the same price (as seen by the buyers)
sellers will build and offer fewer homes for sale. (This is not a statement about the
incidence of the tax, but about the way the tax affects the supply line in the module.
Similarly the discussion of the demand tax did not mean that all the burden of the tax was
on the buyers, it was about the way that tax affected the demand line in the module.) If
the tax rate is set as a negative number that means the government is subsidizing the
housing market not collecting a tax.
The essential elements of the Walrasian auction:
No actual transactions take place until the price reaches the market equilibrium (quantity
supplied equals quantity demanded). Goods - in this case new single family homes-are
produced at the same time as they are sold. Assume the market is currently in
equilibrium and there is a shock - a shift in either demand or supply-so that the original
price is no longer an equilibrium price (supply no longer equals demand). At that
moment an auctioneer steps up and calls together everyone who might be interested in
either buying or selling at some price.
The auctioneer begins to call out prices, starting at the original equilibrium value. Those
willing to buy hold up signs indicating their willingness to buy at that price, those willing
to sell do the same. If the auctioneer sees more signs offering to buy than signs offering
to sell the shock has caused excess demand at the original equilibrium price. The rule in
this auction is that when this happens the auctioneer "calls out" a higher price. If at this
price quantity demanded is still larger than quantity supplied, a new higher price is called
in the next round. Again: No actual transactions take place at these disequilibrium prices,
the price adjustments continue until the excess demand disappears. When the quantity
demanded equals the quantity supplied the new equilibrium has been reached and all
deals are closed (houses are bought and sold).
The same applies if the shock causes excess supply, with ongoing price declines until the
new equilibrium price is reached. In both cases all transactions after the shock occur at
the new equilibrium price. While in principle the price adjustments could be continuous,
in the module all adjustments are completed in three discrete steps. At the third the new
equilibrium is reached.
Cobweb model:
There are two assumptions underlying the cobweb model of adjustment. One is that
output (quantity supplied) changes happen at discrete intervals so that if, for example,
there is a demand shock, there is an initial "market period" in which output does not
change. There is also an assumption that suppliers plan output based on an expected
price for the next period. In the basic model, the expected price for the next period is the
actual price in the current period.
In the diagram above there is an initial demand shift from D to D' and with output fixed
in the first period price rises to the new demand line as indicated by arrow "a." In effect
this means that during the "market period" something like the Walrasian auction process
is taking place. Producers assume the price will stay at the higher level and increase
output to the level indicated by the supply line (arrow b).
When the new output comes on the market, price drops to the demand line (arrow c).
Since producers assume the price will stay at this low level, they reduce output to the
supply line in the next period (arrow d). As a result price will increase again. In the
example shown the market is stable in that the price and output fluctuations keep
decreasing and, in the limit, the new equilibrium P and Q will be reached.
If the initial shock was from an increase in supply then the adjustment process would
begin with a change in the quantity supplied at the original price. When this new output
comes on the market the price drops to the level where buyers are willing to buy the full
amount produced. Subsequently the same kind of pattern will emerge, as it will with
decreased in demand or supply.
This adjustment process is defined as being stable if the price fluctuations get smaller and
smaller over time (and so do the quantity variations. This model is stable (with no
speculation) if that the slope of the demand line is less than steep than the slope of the
supply line. If this is true the price does not rise much in the above graph, and the higher
price does not lead to much increase in output in the next period. As a result there is a
price decrease smaller than the previous increase and a subsequent drop in production
also smaller than the previous increase. While it would take an infinite sequence of
fluctuations before the market actually reached the new equilibrium, over time both price
and quantity get closer and closer to that new equilibrium.
In the case of an unstable market (with no speculation) the demand line is steeper. As a
result the initial price rise is greater while a flatter supply line brings on a larger rise in
output. Instead of a spiraling in cobweb pattern as shown in the graph, the result is an
outward spiral, with ever larger fluctuations in P and Q, at least until the limits P = 0 and
Q = 0 (the D and S intercepts) are reached.
Speculation:
Speculation is defined as buying or selling in the current period not based on a demand
for the product at the current price or willingness to produce and sell at the current price,
but on the expectation that the price is going to change at a future date. Someone who
looks at the current price, believes that the price is going to go up, and as a result buys
now is acting as a speculator. Usually the term is not applied to those who buy now
because they expect to use the product themselves in the future (and want to get it before
it gets more expensive). Instead it is applied to those who buy now, hold onto the
product and expect to re-sell it when the price goes up, making a profit on the deal.
This module only uses the simplest form of speculation and does not get into contracts to
sell at a future date products you do not own (expecting to be able to buy them later when
the price drops and make a profit that way). It also does not cover forms of speculation
involving more complex methods of profiting from a predicted price fluctuation, hedging
possible price fluctuations, etc. The speculator in this module can buy a house “today”
and hold it till the next period, then sell it. If the price went up in the meantime the
speculator made a profit. In the real world holding the house for one period would have a
cost, so the speculator would only make a profit from a price increase large enough to
cover this holding cost. The holding cost in this module is assumed to be zero so any
expected price increase offers the possibility of gaining from speculation.
A smart speculator would look at the market shock, understand what is going to happen
to the price as a result, and can make profitable deals. If there were a demand increase,
leading to an immediate price increase the smart speculator would not be buying at that
time. However, in the next period when the naïve (or not so smart) producers expand
production since they expect the price to stay high they are going to cause a price decline.
When the price drops the smart speculator buys—and as a result the price does not
decline as much as it would have if there were no smart speculators. The price does not
decline as much because the quantity demanded now consists of those who want to buy
for themselves plus the quantity the speculators want to buy. The quantity demanded
therefore equals the amount produced at a price higher than you would see if only the
first group were buying.
Not all speculators are smart. There are many ways of being a not-smart speculator, but a
common way is to look at the way prices are changing now and assume that will
continue. In other words, when prices are going up, believe that they will just continue to
go up, when they are going down believe they will keep going down. A speculator who
thinks this way will buy when the price is rising and sell when the price is falling. Such a
speculator is likely to wind up buying at a high price and selling at a low price. This is
not profitable. Also, if speculators are buying when prices are high (even without them)
they will drive prices even higher. If they sell when prices will be low (even without
them) then prices will go even lower. Instead of getting prices to vary less, as smart
speculators would, they cause prices to vary more. The same is true for quantity
variations.
Adding smart speculators to a market that is stable anyway can cause prices and
quantities to converge toward the equilibrium more rapidly. Adding them to an unstable
market could (if there are enough of them) make an unstable market stable. On the other
hand, adding foolish speculators to an otherwise stable market could cause prices and
quantities to converge to the new equilibrium more slowly, and could even make a stable
market unstable (at least until the foolish speculators all went broke and were unable to
interfere anymore).
On the graph the presence of speculators would mean the prices and quantities could turn
out to be at values that were not on either the demand curve (which does not include
speculative demand) or the supply curve (which does not include amounts speculators
bought up in a previous period and are trying to sell in the current period.