The original Python notebook is on Github. Download it if you would like to follow along.

This IPython notebook solves the competitive storage model for the price of storable commodities using collocation as the numerical method. We reproduce an example from section 9.9.2 of Miranda and Fackler’s *Applied Computational Economics and Finance* using Python and independently of the authors’ CompEcon MATLAB toolbox.

### The problem

The competitive storage model is a simple model for the price of a storable commodity. It has an uneven empirical record but it provides a good illustration of the computational problems which arise in modern macroecnomics.

We consider a commodity, say wheat, which can be stored subject to the condition that a fraction $\lambda$ of the total stock at the end of a period disappears before the beginning of the next period and a cost per unit cost $c$ has to be paid for storage. In each period there is an addition to stocks due to a stochastic harvest $z$ and a reduction in stock from an outside demand given by a demand function $P(q)$.

Storage decisions are taken by competitive speculators who must form expectations about future prices. These future prices depend on both the stochastic harvest in the next period as well as the total stock carried forward by all speculators taken together. We assume that speculators have rational expectations.The speculators are assumed to be risk neutral and discount their future profits by a discount factor $\delta$.

Let $s_t$ be the stock at the beginning of period $t$ and $x_t$ be the stock at the end of period $t$ and $p_t$ be the price that prevails in period $t$. Then the equilibrium conditions are, first that outside consumers should demand the quantity $(s_t-x_t)$ that is not stored,

$p_t = P(s_t-x_t)$

that the stocks in consecutive periods be linked according to the storage technology, $s_{t+1} = (1-\lambda)x_t+z_{t+1}$

and most importantly the speculators maximize profits. $p_t \ge \delta(1-\lambda)[E_t p_{t+1}]-c,\quad \text{with equality if $x_t>0$}$

The last equation has the complementary slackness form it has becuase speculators may be at a corner solution where they do not carry forward any stocks at all. If this is the case then current prices can rise above the expected future return from carrying stocks. On the other hand current prices can never be lower than expected future revenues in equilibrium since such a condition would produce an infinite demand for wheat by speculators in the current period.

### The solution algorithm

It is known that the above system of equations has a solution of the form $p_t = \phi(s_t)$. However there is generally no analytical solution and the function $\phi(\cdot)$ must be computed numerically.

Suppose we expect that prices next period are governed by the function $f(s_{t+1})$. Then the price function this period, say $g(s_{t})$, will be a function of this expectation through our equilibrium conditions above. We express this relationship in the form

$g = Tf$

where $T$ is an abstract operator representing the working of the equilibrium conditions. It is precisely the property of a stationary rational equations solution that it is a fixed-point of this operator

$\phi = T\phi$

i.e., the expected law of prices is such as to produce behaviour which confirms the expect law of prices.

In order to find an approximate solution to this fixed-point equation we restrict our search to the finite dimensional space of Chebyshev polynomials of a given degree. The true solution may not lie in this space and thus no function in this space may satisfy the fixed-point equation at all points. In order to nonetheless get a good approximation to the true solution the collocation method we use in this notebook requires that the function come close to satising the fixed-point equation at a given finite set of points. In this notebook we take these points to be Chebyshev nodes. The task of finding the Chebyshev polynomial which satisfies this condition is carried out through successive approximation: starting from an initial guess $f_0$ we calculate $y_n = (Tf_0)(x_n)$ at our chosen Chebyshev nodes $x_n$. Then $f_1$ is then taken to be a Chebyshev polynomial that passes through the points $(x_n,y_n)$. This is continued until we reach a fixed point.

There are two more technical difficulties. The operator $T$ involves computing a conditional expectation in order to find expected profits. For arbitrary functions this cannot be done exactly and we have to make a numerical approximation. In this notebook we use Gauss-Hermite quadrature to replace the continuous distribution of the shocks $z_t$ by a discrete approximation.

Finally, we need to work with a bounded state space for our calculations. If $\lambda>0$ and $\bar z$ the maximum possible realization of the shock then the beginning-of-period stock can never exceed $\bar z/\lambda$. This however does not work when $\lambda=0$. Also using this bound is harmful even when $\lambda>0$ since this forces us to consider very large values of stock which are not reached in equilibrium, thereby wasting computational resources. We therefore follow the literature in arbitrarily assuming that there is an upper abound $x_{max}$ on end-of-period stocks. The value of this parameter is adjusted to be large enought that it is never reached in equilibrium.

See Judd, *Numerical Methods in Economics*, Chapter 11 and 17 for more details as well as alternative algorithms. Section 17.4 discusses the competitive storage model.

## Imports

```
import sys
import math as m
import numpy as np
from numpy import linalg
import scipy.optimize as spopt
from numpy.polynomial.chebyshev import Chebyshev
from numpy.polynomial.hermite import hermgauss
from scipy.stats import rv_discrete
import scipy.io as spio
import matplotlib.pyplot as plt
from collections import namedtuple
%matplotlib inline
```

## Collocation

## Collocation in general

```
def collocation_solve(T,fhat,nodes,fit,
=True,tol=1e-6,maxiter=500):
log"""
Try to solve the operator equation Tf = f.
We use successive approximations to find a function fhat in some function
space such that Tfhat = fhat at all points in `nodes`.
Inputs:
T(fhat,s): return (Tfhat)(s)
fhat: initial guess for fhat
nodes: collocation nodes
fit: a function when called as fit(x,y) with x and y
as arrays, returns an element phi of the chosen
function space such that phi(x[i]) = y[i]
log: if True prints progress messages
tol: tolerance parameter for stopping criteria
maxiter: maximum number of successive approximation
iterations to try
Returns:
Either `fhat` if success or `None` if iteration count exceeded.
"""
for i in range(maxiter):
= np.empty_like(nodes)
lhs = np.empty_like(nodes)
rhs for j,s in enumerate(nodes):
= T(fhat,s)
lhs[j] = fhat(s)
rhs[j] = linalg.norm(lhs-rhs,np.inf)
err if log and i%10==0:
print("Iteration {}: Error = {:.2g}".format(i+1,err),
file=sys.stderr)
"b-",label="Tf")
plt.plot(nodes,lhs,"r-",label="f")
plt.plot(nodes,rhs,
plt.legend()
plt.show()= fit(nodes,lhs)
fhat if err<tol:
return fhat
if log:
print("collocation_solve: iteration count exceeded",
file=sys.stderr)
return None
```

## Collocation using Chebyshev polynomials and nodes

```
def chebyshev_solve(T,guesser,degree,domain,
=True,tol=1e-6,maxiter=500):
log"""
Try to solve the operator equation Tf = f using
Chebychev collocation.
Inputs:
T(fhat,s): return (Tfhat)(s)
guesser: a function, `guesser(x)` gives a guess
for the function at point `x`.
degree: the degree of the Chebyshev series to use
domain: a list `[lower,upper]` of the domain over
which the function is to be approximated
log: if True prints progress messages
tol: tolerance to be used in stopping criteria
maxiter: maximum number of iterations for successive
approximation.
Returns:
Either `fhat` if success or `None` if iteration count
exceeded.
"""
= Chebyshev.basis(degree+1,domain).roots()
nodes
def fitter(x,y):
return Chebyshev.fit(x,y,degree,domain)
= fitter(nodes,
f0 for n in nodes]))
np.array([guesser(n)
return collocation_solve(T,f0,nodes,fitter,log,tol,maxiter)
```

## The competitive storage model

### The problem data structure

```
# A competitive storage problem
= namedtuple("StorageProb",
StorageProb "cost" # Marginal cost per-unit stored
["shrink" # Fraction of goods lost per period ($\lambda$)
,"yvol" # Log of harvest is distributed N(0,yvol)
,"xmax" # Maximum end-of-period stock
,"disc" # Time discount rate ($\delta$)
,"P" # External demand function P(q)
, ])
```

### Solution

```
# Solving the problem
class StorageSolution(object):
"""
A solution to the competitve storage model.
Constructor:
StorageSolution(prob,hgdeg=5,cdeg=50,
tol=1e-6,maxiter=500,log=True)
hgdeg: degree of Gauss-Hermite
discretization of shocks
cdeg: dgree of Chebychev polynomial to use
tol: tolerance for stopping criteria
maxiter: maximum no of iterations
log: if True print progress report
The model is solved in the process of constructing
the object, so constructor calls are expensive.
If the model cannot be solved in the give number of
iterations throws a ValueError. Computational
problems can cause an AssertionError to be thrown.
Instance variables:
Saved from constructor: prob, hgdeg, cdeg, tol
Others:
smax Maximum beginning-of-period stock
smin Minimum beginning-of-period stock
zs An array of discretized harvest shock values
ws An array of probability weights
corresponding to `ws`
phi The computed price as a function of
begining-of-period shocks
storage_revenue(phi,x)
Discounted expected revenue net of storage
costs per unit stored when the pricing
function is `phi` and end-of-period stocks
in the current period is `x`.
opti_storage(phi,s)
The optimal amount to store when the pricing
function is `phi` and beginning-of-period
stocks is `s`. Rational expectations is
built in: the expected stocks tomorrow is
consistent with storage decision taken.
T(phi) We want T(phi,s) = phi(s) for all s.
"""
def __init__(self,p,ghdeg=5,cdeg=50,
=1e-6,maxiter=500,log=True):
tol
# Store input parameters
self.prob = p
self.ghdeg = ghdeg
self.cdeg = cdeg
self.tol = tol
# Compute Gauss-Hermition integration nodes
self.ws = hermgauss(ghdeg)
ys,self.ws = self.ws/m.sqrt(m.pi)
self.zs = np.exp(ys*p.yvol)
= np.min(self.zs), np.max(self.zs)
zmin,zmax
# Bounds for beginning-of-period stocks
# Note xmax is maximum end-of-period shocks
self.smin = zmin
self.smax = zmax + (1 - p.shrink)*p.xmax
# Storage revenue computation
def storage_revenue(phi,x):
= sum(
Etom + (1 - p.shrink)*x)*w
phi(z for (z,w) in zip(self.zs,self.ws)
)return p.disc*(1 - p.shrink)*Etom - p.cost
self.storage_revenue = storage_revenue
# Optimal storage decision
def opti_storage(phi,s):
= p.P
P = p.xmax
xmax
if s>xmax and storage_revenue(phi,xmax) > P(s-xmax):
return xmax
elif storage_revenue(phi,0) < P(s-0):
return 0
else:
= min(xmax,s)
max_feas = \
x_star,r lambda x:\
spopt.brentq(-P(s-x),
storage_revenue(phi,x)0,max_feas,
=True,
full_output=1e-5)
xtolassert r.converged
return x_star
self.opti_storage = opti_storage
# Initial guess for pricing function
def init(s):
return p.P(s)
# We want T(phi) = phi
def T(phi,s):
= opti_storage(phi,s)
x_star = p.P(s-x_star)
ans assert ans>=0
return ans
self.T = T
self.phi = chebyshev_solve(T,init,cdeg,
self.smin,self.smax],
[
log,tol,maxiter)if self.phi is None:
raise ValueError("Failed to converge")
```

### Visualization and simulation

```
def illustrate(soln):
"""
Plot solution variables and diagnostics
``soln` is an instance of `StorageSolution`
"""
= plt.subplots(2,2,sharex=True)
f,((ax1,ax2),(ax3,ax4)) 10,10)
f.set_size_inches(
= np.linspace(soln.smin,soln.smax,100)
ss
= [soln.opti_storage(soln.phi,s) for s in ss]
store
ax1.plot(ss,store)"Equilibrium storage")
ax1.set_title("Supply")
ax1.set_xlabel("Storage")
ax1.set_ylabel(
= [soln.prob.P(s) for s in ss]
P = [soln.phi(s) for s in ss]
phi "r-",label="without storage")
ax2.plot(ss,P,"b-",label="with storage")
ax2.plot(ss,phi,
ax2.legend()"Equilibrium price")
ax2.set_title("Supply")
ax2.set_xlabel("Price")
ax2.set_ylabel(
def optimal_profit(s):
= soln.opti_storage(soln.phi,s)
x return soln.storage_revenue(soln.phi,x)-soln.prob.P(s-x)
= [optimal_profit(s) for s in ss]
profits
ax3.plot(ss,profits)"Arbitrage profit")
ax3.set_title("Profit")
ax3.set_ylabel("Supply")
ax3.set_xlabel(
= [soln.T(soln.phi,s)-soln.phi(s) for s in ss]
resid
ax4.plot(ss,resid)"Approximation residual")
ax4.set_title("Tf-f")
ax4.set_ylabel("Supply")
ax4.set_xlabel(
```

```
def simulate(soln,niter,burnin=1000,s0=None):
"""
Run a simulation.
soln: An instance of `Storage Solution`
niter: The number of iteration for which to return results
burnin: The number of initial iterations to discard
s0: Initial beginning-of-period stock.
None selects the middle point of the domain.
Returns: arrays x and P of end-of-period stocks and prices
"""
= np.empty(niter)
xs = np.empty(niter)
Ps
if s0 is None:
= (soln.smin+soln.smax)/2
s elif s0 > soln.smax:
= soln.smax
s elif s0 < soln.smin:
= soln.smin
s else:
= s0
s
=rv_discrete(values=(range(len(soln.ws)),soln.ws))
dist= soln.phi
phi = soln.opti_storage
opti_storage = soln.prob.shrink
shrink = soln.zs
zs = soln.prob.P
P
for i in range(niter+burnin):
= opti_storage(phi,s)
x = zs[dist.rvs(size=1)]
z if i>burnin:
-burnin] = x
xs[i-burnin] = P(s-x)
Ps[i= (1-shrink)*x+z
s return xs,Ps
```

## Example from Miranda & Fackler

```
def isoelastic_demand(gamma):
return lambda q: q**(-gamma)
```

```
# Example from section 9.9.2 of Miranda & Fackler
= StorageProb(cost = 0.1,
mirfac_p = 0,
shrink = isoelastic_demand(2.0),
P = 0.2,
yvol = 0.9,
xmax = 0.9)
disc = StorageSolution(mirfac_p,tol=1e-10) mirfac_s
```

`Iteration 1: Error = 0.14`

`Iteration 11: Error = 1.6e-08`

` illustrate(mirfac_s)`

```
= 500
sim_N = simulate(mirfac_s,sim_N)
sim_xs,sim_Ps = (1-float(np.count_nonzero(sim_xs))
sim_so /sim_N))
print("Proportion of stockouts = {}".format(sim_so)
= plt.subplots(2,1,sharex=True)
f,(ax1,ax2) 10,9)
f.set_size_inches(=0.3,color="orange")
ax1.plot(sim_xs,linewidth"End of period stocks")
ax1.set_title(=0.3,color="darkblue")
ax2.plot(sim_Ps,linewidth"Price") ax2.set_title(
```

```
Proportion of stockouts = 0.71
<matplotlib.text.Text at 0x7f475ed685c0>
```