A cobweb model with elements from prospect theory
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We present a cobweb model to explain price adjustment in a competitive market with homogeneous firms based on assumptions from Prospect Theory. Price changes are evaluated with respect to a psychological reference price which enters directly into the demand function. Accordingly, firms face a downward-sloping demand curve that is kinked at the consumers’ reference price. Differently from the traditional cobweb model, the economy is described by a discontinuous map. Without assuming specific non-linearities and keeping the essential underlying mechanics of the model intact, we find that the implementation of several features from Prospect Theory into our simple cobweb model may significantly influence the market dynamics. Behavioral parameters play an important role for the market stability by reducing fluctuations and by directly affecting consumers’ demand as well as production decisions.
KeywordsCobweb model Reference price Transaction utility Behavioral economics Discontinuous maps Complex dynamics
JEL ClassificationD03 E32
Work developed in the framework of the research project on Dynamic models for behavioural economics, financed by DESP-University of Urbino.
We wish to thank two anonymous reviewers for their valuable comments and suggestions. The usual caveats apply.
Compliance with Ethical Standards
The authors declare that they have no conflict of interest.