Cobweb Model - Role of Expectations

Role of Expectations

One reason to be skeptical about this model's predictions is that it assumes producers are extremely shortsighted. Assuming that farmers look back at the most recent prices in order to forecast future prices might seem very reasonable, but this backward-looking forecasting (which is called adaptive expectations) turns out to be crucial for the model's fluctuations. When farmers expect high prices to continue, they produce too much and therefore end up with low prices, and vice versa.

In the stable case, this may not be an unbelievable outcome, since the farmers' prediction errors (the difference between the price they expect and the price that actually occurs) become smaller every period. In this case, after several periods prices and quantities will come close to the point where supply and demand cross, and predicted prices will be very close to actual prices. But in the unstable case, the farmers' errors get larger every period. This seems to indicate that adaptive expectations is a misleading assumption: how could farmers fail to notice that last period's price is not a good predictor of this period's price?

The fact that agents with adaptive expectations may make ever-increasing errors over time has led many economists to conclude that it is better to assume rational expectations, that is, expectations consistent with the actual structure of the economy. However, the rational expectations assumption is controversial since it may exaggerate agents' understanding of the economy. The cobweb model serves as one of the best examples to illustrate why understanding expectation formation is so important for understanding economic dynamics, and also why expectations are so controversial in recent economic theory.