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Unformatted text preview: EMSE 235 Homework 1 Solutions Business Dynamics Instructor’s Manual Problem 1. “Speculative Bubbles” Chapter 5 Expected Capital Gain + R1 Speculative Demand Delay + + Fundamental Value Recent Rate of Price Change + B3 + Demand Perceived Relative Value B1 ValueBased D emand + Moving Average Delay Price B2 Supply Recent Price B4 + Delay + Speculative Production Supply + Delay Suppliers' Expected Price Expected Profits Cost of Production + + Figure 1. Structure of a speculative bubble. Exhibit 5-15 Structure of a speculative bubble Figure 1 expands the basic negative feedback structure of markets in Figure 5‐26 to The exhibit contains the two basic negative market feedbacks from price through demand and incorporate J. S. Mill’s theory of speculative bubbles. The exhibit contains the two supply: When the price of any commodity rises relative to its fundamental value (however that basic negative market feedbacks from price through demand and supply: When the is estimated), demand falls (the Value-Based Demand loop B1). At the same time, higher prices price of any commodity rises relative to its fundamental value (however that is relative to production costs boost the expected profits of producers, expanding supply (the estimated), demand falls (the Value‐Based Demand loop B1). At the same time, Supply loop B2). higher prices relative to production costs boost the expected profits of producers, expanding supply (the Supply loop B2). In Mill’s theory, a positive feedback is created by the tendency of market participants to form expectations about the future prices of commodities at least in part by extrapolating recent price In Mill’s theory, a positive feedback is created by the tendency of market trends, and then buying for the purpose of realizing capital gains. The trend in price is judged by participants to form expectations about the future prices of commodities at least in comparing, in some fashion, the current price to the price at some time in the recent past. When part by extrapolating recent price trends, and then buying for the purpose of price rises above its recent level, the trend is upward, creating opportunities for capital gains on realizing capital gains. The trend in price is judged by comparing, in some fashion, speculative purchases (the Speculative Demand loop R1). Chapter 16 discusses how such extrapolative expectations can be modeled and gives examples. The delay in the expansion of supply in most markets means the short run supply elasticity is low (loop B2 is weak in the short run). If the short-run demand elasticity is also low (loop B1 is weak), or if market participants are highly sensitive to recent price changes and can easily raise the current price to the price at some time in the recent past. When price rises above its recent level, the trend is upward, creating opportunities for capital gains on speculative purchases (the Speculative Demand loop R1). Chapter 16 discusses how such extrapolative expectations can be modeled and gives examples. The delay in the expansion of supply in most markets means the short run supply elasticity is low (loop B2 is weak in the short run). If the short‐run demand elasticity is also low (loop B1 is weak), or if market participants are highly sensitive to recent price changes and can easily raise capital to invest in speculative purchases, then the positive loop can dominate the normal equilibrating feedbacks of the market and cause a speculative bubble to inflate (Exhibit 5‐32 adds the feedback structure for capital availability and credit standards). The faster prices rise, the greater the opportunity for capital gain and thus the higher the demand, even as those desiring the product for consumption or business purposes are driven from the market. Eventually, the price rises so high that market participants are reluctant to forecast even higher prices, or the demand loop B1 begins to cut into demand, or the product becomes so expensive that available capital begins to limit speculative purchases. Mill notes, “the price ceases to rise, and the holders, thinking it time to realize their gains, are anxious to sell. Then the price begins to decline.” Since the rate of change in price is assessed by comparing current price to recent prices, the price trend must drop when price stops rising, because the recent price catches up to the current price. The resulting Moving Average loop (B3) means that any slowdown in price escalation can cause a drop in speculative demand. As lower demand forces prices to drop, people begin to predict still lower prices in the future. Mill continues, “the holders rush into market to avoid a still greater loss, and, few being willing to buy in a falling market, the price falls much more suddenly than it rose. The exhibit also includes an additional negative loop Mill does not explicitly mention. When producers also extrapolate price trends, rising prices increase the expected price they can realize when investment in new production is realized, increasing expected profits and leading to an even larger expansion of output (the Speculative Production loop B4). Depending on the delays in expanding production, the extra supply induced by the high prices of a speculative bubble can dramatically worsen the imbalance of demand and supply when the bubble bursts, and can lead to a glut of product that depresses prices long after the bubble bursts. This diagram is intended to be simple, and omits many factors that play important roles in many speculative bubbles. For example, Mill speaks of dealers and their stocks (inventories) of product, and allows them to both buy and sell; these subtleties are glossed in the exhibit, which does not make the stock and flow structure explicit. Similarly, the diagram does not address details in the expectation formation process, the process by which capital is attracted to the market to fund speculation, credit standards, word of mouth effects that broaden participation in the boom and lower the market experience of speculators, the role of scams and frauds, and others (see Kindleberger 1978). Examples abound; typically speculative bubbles are more likely to arise for commodities in markets where the normal negative feedbacks of the market B1 and B2 are slow or weak, for example when there are substitution and production delays. Even when the demand loop B1 involves short delays, it tends to be weak in markets where the fundamental value of the commodity is difficult to assess, such as those generating no or highly uncertain cash flows (e.g. precious metals, gems, equities, real estate, art, collectibles, and race horses). Problem 2. Lynx and Rabbits ...
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