What is Cobweb Theory? Provide examples

The Cobweb Theory adds the variable of time to supply and demand. In real markets, the decision to provide a certain quantity is not made at the same time as demand decisions for that good. Goods need to be produced and then come to the market before the decision is made to purchase those goods. Supply decisions may be made based on the information at one point, but that information may no longer be applicable by the time the products come to market. In other words, expectations of price and quantity may be inaccurate and result in a quantity supplied that does not allow for attaining the equilibrium price.

This theory was first developed in the context of agricultural markets. Crop production and demand is one good example of the Cobweb Theory. Here is a hypothetical example involving the market for avocados. One year, a fire destroyed several farms that produced avocados. This drastically reduced the available quantity of avocados and increased the price per avocado. The remaining suppliers then increased their crops in the following year, expecting prices to stay high. The increased supply created an excess quantity that could not yield a higher price from the prior year. The next year, the suppliers returned to their original amount, which resulted in another gap in supply as the destroyed farms had not been replaced with new suppliers. This cycle of time lags demonstrated Cobweb Theory.

Purchasing habits in response to a crisis also demonstrate the cobweb theory. For example, people may stock up on a large amount of toilet paper or hand sanitizer. They may also be willing to pay more than what was previously an equilibrium price for those items. With a high level of demand, suppliers may ramp up production. However, with stocked supplies or the crisis calming down, the demand may drop off to lower than previous levels. People are trying to use what they have purchased, and there may now be excess goods, which require lower prices to sell. If the suppliers base future production decisions on this lower quantity or cost, the market will once again face a shortage as demand increases again after people have used their stockpiles or if another crisis hits.