15.

481x – FINANCIAL MARKET

DYNAMICS AND HUMAN
BEHAVIOR

The Hog Cycle

 HOG CYCLE – SCENARIO 1: CONVERGENCE

Supply
Price Price Dynamics
(Q1, P1)
(Q2, P1) • t = 0:
• Observe a price P0 (Q1, P0)
• Decide to supply Q1…
(Q3, P2) (Q2, P2) • Actual price is P1! (Q1, P1)
Demand • t = 1:
(Q1, P0) (Q*, P*)
• Observe price P1 (Q2, P1)
• Moves future supply to Q2 …
Quantity • Actual price is P2!
• Iterate… (Q2, P2)

• … Until you converge! (Q*, P*)

Do we always converge?
 HOG CYCLE – SCENARIO 2: DIVERGENCE

Price Price Dynamics

Supply
(Q1, P1) • t = 0:
(Q2, P1)
• Observe a price P0 (Q1, P0)
(Q1, P0) • Decide to supply Q1 …
(Q3, P2) (Q2, P2) • Actual price is P1! (Q1, P1)
Demand • t = 1:
• Observe price P1 (Q2, P1)
• Moves future supply to Q2 …
Quantity • Actual price is P2!
• Iterate… (Q2, P2)

• … But no convergence!
Any other possibility?
 HOG CYCLE – SCENARIO 3: LOOP

Price Price Dynamics

Supply
(Q1, P1)
(Q2, P1) • t = 0:
• Observe a price P0 (Q1, P0)
• Decide to supply Q1 …
(Q1, P0) (Q2, P2) • Actual price is P1! (Q1, P1)
Demand • t = 1:
• Observe price P1 (Q2, P1)
• Moves future supply to Q2 …
Quantity • Actual price is P2!
• Iterate… (Q2, P2)

• … But (Q3, P2) = (Q1, P0)!

 PRICE DYNAMICS

Supply
Price Market Dynamics:

(Q1, P1)
(Q2, P1)
𝑄!" = 𝑑# × 𝑃! + 𝑑$ (Demand line)
𝑄!% = 𝑠# × 𝑃!& + 𝑠$ (Supply line)

Adaptive Expectation:
(Q3, P2) (Q2, P2)

Demand Where 𝑃!& = 𝑃!'# (expected price)

(Q1, P0) (Q*, P*)

Equilibrium:
Quantity 𝑄!" = 𝑄!% = 𝑄∗
𝑃!& = 𝑃! = 𝑃∗
 PRICE DYNAMICS - EXAMPLE

Supply Market Dynamics:

Price
(Q1, P1) 𝑄!" = 𝑑# × 𝑃! + 𝑑$ (Demand line)
(Q2, P1)
𝑄!% = 𝑠# × 𝑃!'# + 𝑠$ (Supply line)

Example:
(Q3, P2) (Q2, P2) • Observe a price P0.
Demand • Decide to supply a quantity Q1.
(Q1, P0) (Q*, P*)
# ""
• Get price 𝑃# = × 𝑄# − .
"! "!
• Adjust quantity 𝑄$ = 𝑠# × 𝑃# + 𝑠$ .
Quantity # "
• Get price 𝑃$ = " × 𝑄$ − "" .
! !

• Adjust quantity 𝑄) = 𝑠# × 𝑃$ + 𝑠$ .
# ""
• Get price 𝑃) = × 𝑄) − .
"! "!
 COBWEB THEOREM

Supply
Price
(Q1, P1)
Market Dynamics:
(Q2, P1)
𝑄!" = 𝑑# × 𝑃! + 𝑑$ (Demand line)
𝑄!% = 𝑠# × 𝑃!'# + 𝑠$ (Supply line)

(Q3, P2) (Q2, P2)

Cobweb Theorem:
Demand
(Q1, P0) (Q*, P*)
• The Hog Cycle converges when:
𝑠# < 𝑑#
• The Hog Cycle will loop when:
Quantity
At convergence: 𝑠# = 𝑑#
𝑑" − 𝑠" • The Hog Cycle diverges when:
∗
𝑃 = 𝑠# > 𝑑#
𝑠# − 𝑑#
∗
𝑠# 𝑑" − 𝑠" 𝑑#
𝑄 =
𝑠# − 𝑑#
 At convergence:
𝑑$ − 𝑠$
𝑃∗ =
COBWEB THEOREM – PROOF 𝑠# − 𝑑#
𝑠#𝑑$ − 𝑠$𝑑#
𝑄∗ =
𝑠# − 𝑑#

Market Dynamics: Cobweb Theorem:

• The Hog Cycle converges when: 𝑠# < 𝑑#

𝑄!" = 𝑑# × 𝑃! + 𝑑$ (Demand line)
• The Hog Cycle will loop when: 𝑠# = 𝑑#
𝑄!% = 𝑠# × 𝑃!'# + 𝑠$ (Supply line) • The Hog Cycle diverges when: 𝑠# > 𝑑#

Recurrence:

𝑄! = 𝑠# × 𝑃!'# + 𝑠$ 𝑠# 𝑠# 𝑑$ − 𝑠$ 𝑑#
+ # " 𝑄! = × 𝑄!'# −
𝑃! = " × 𝑄! − "" 𝑑# 𝑑#
⟹
! !
𝑠# 𝑠$ − 𝑑$
𝑃! = × 𝑃!'# +
𝑑# 𝑑#
 At convergence:
𝑑$ − 𝑠$
𝑃∗ =
COBWEB THEOREM – PROOF 𝑠# − 𝑑#
𝑠#𝑑$ − 𝑠$𝑑#
𝑄∗ =
𝑠# − 𝑑#

Market Dynamics: Cobweb Theorem:

𝑠# 𝑠# 𝑑$ − 𝑠$ 𝑑# • The Hog Cycle converges when: 𝑠# < 𝑑#

𝑄! = × 𝑄!'# −
𝑑# 𝑑# • The Hog Cycle will loop when: 𝑠# = 𝑑#
𝑠# 𝑠$ − 𝑑$ • The Hog Cycle diverges when: 𝑠# > 𝑑#
𝑃! = × 𝑃!'# +
𝑑# 𝑑#

Consider Prices First:

% %" ' "" "" ' %"
𝑃! − 𝑃∗ = "! × 𝑃!'# + "!
− %! '"!
!

% %" ' "" %! ' "! ' "! "" ' %"
= "! × 𝑃!'# + "! %! ' "!
!

% %! %" ' %! "" ' %" "! * "! "" ' "! "" ' %" "!
= "! × 𝑃!'# + "! %! ' "!
!
% % %" ' %! ""
= "! × 𝑃!'# + "! %! ' "!
! !

%! %" ' "" 𝑠#

= " × 𝑃!'# + ⟹ 𝑃! − 𝑃∗ = × 𝑃!'# − 𝑃∗
! %! ' "! 𝑑#
 At convergence:
𝑑$ − 𝑠$
𝑃∗ =
COBWEB THEOREM – PROOF 𝑠# − 𝑑#
𝑠#𝑑$ − 𝑠$𝑑#
𝑄∗ =
𝑠# − 𝑑#

Market Dynamics: Cobweb Theorem:

𝑠# 𝑠# 𝑑$ − 𝑠$ 𝑑# • The Hog Cycle converges when: 𝑠# < 𝑑#

𝑄! = × 𝑄!'# −
𝑑# 𝑑# • The Hog Cycle will loop when: 𝑠# = 𝑑#
𝑠# 𝑠$ − 𝑑$ • The Hog Cycle diverges when: 𝑠# > 𝑑#
𝑃! = × 𝑃!'# +
𝑑# 𝑑#

Consider Prices First:

%!
𝑃! − 𝑃∗ = × 𝑃!'# − 𝑃∗
"!
𝑠# !
%! $ ∗
𝑃! = 𝑃 + × 𝑃+ − 𝑃∗
= × 𝑃!'$ − 𝑃∗ 𝑑#
"!

%! )
= × 𝑃!') − 𝑃∗ %! !
"! Convergence depends on :
"!
=⋯
• The Hog Cycle converges when: 𝑠# < 𝑑#
%! ! • The Hog Cycle will loop when: 𝑠# = 𝑑#
= × 𝑃+ − 𝑃∗
"! • The Hog Cycle diverges when: 𝑠# > 𝑑#
 At convergence:
𝑑$ − 𝑠$
𝑃∗ =
COBWEB THEOREM – PROOF 𝑠# − 𝑑#
𝑠#𝑑$ − 𝑠$𝑑#
𝑄∗ =
𝑠# − 𝑑#

Market Dynamics: Cobweb Theorem:

𝑠# 𝑠# 𝑑$ − 𝑠$ 𝑑# • The Hog Cycle converges when: 𝑠# < 𝑑#

𝑄! = × 𝑄!'# −
𝑑# 𝑑# • The Hog Cycle will loop when: 𝑠# = 𝑑#
𝑠# 𝑠$ − 𝑑$ • The Hog Cycle diverges when: 𝑠# > 𝑑#
𝑃! = × 𝑃!'# +
𝑑# 𝑑#

Now Consider Quantity:

% %! "" '%" "! %! "" '%" "!
𝑄! − 𝑄∗ = "! × 𝑄!'# − "!
− %! '"!
!

% %! "" '%" "! %! ' "! * "! %! "" '%" "!

= "! × 𝑄!'# − "! %! ' "!
!

%! %!" "" ' %! "! "" '%! %" "! *%" "!" * %! "! "" ' %" "!"
= × 𝑄!'# −
"! "! %! ' "!

%! %!" "" '%! %" "!

= " × 𝑄!'# − "! %! ' "!
!
𝑠#
%! %! "" ' %" "! ⟹ 𝑄! − 𝑄∗ = × 𝑄!'# − 𝑄∗
= " × 𝑄!'# − %! ' "!
𝑑#
!
 At convergence:
𝑑$ − 𝑠$
𝑃∗ =
COBWEB THEOREM – PROOF 𝑠# − 𝑑#
𝑠#𝑑$ − 𝑠$𝑑#
𝑄∗ =
𝑠# − 𝑑#

Market Dynamics: Cobweb Theorem:

𝑠# 𝑠# 𝑑$ − 𝑠$ 𝑑# • The Hog Cycle converges when: 𝑠# < 𝑑#

𝑄! = × 𝑄!'# −
𝑑# 𝑑# • The Hog Cycle will loop when: 𝑠# = 𝑑#
𝑠# 𝑠$ − 𝑑$ • The Hog Cycle diverges when: 𝑠# > 𝑑#
𝑃! = × 𝑃!'# +
𝑑# 𝑑#

Now Consider Quantity:

%!
𝑄! − 𝑄∗ = × 𝑄!'# − 𝑄∗
"!
𝑠# !
%! $ ∗
𝑄! = 𝑄 + × 𝑄+ − 𝑄∗
= × 𝑄!'$ − 𝑄∗ 𝑑#
"!

%! )
= × 𝑄!') − 𝑄∗ %! !
"! Again, convergence depends on :
"!
=⋯
• The Hog Cycle converges when: 𝑠# < 𝑑#
%! ! • The Hog Cycle will loop when: 𝑠# = 𝑑#
= × 𝑄+ − 𝑄∗
"! • The Hog Cycle diverges when: 𝑠# > 𝑑#