What is Disequilibrium?
Disequilibrium represents a state where market equilibrium is disrupted due to internal or external forces, leading to an imbalance between supply and demand. This can either be a short-term result of shifting variables or a manifestation of long-term structural issues.
Key Insights
- Disequilibrium occurs when supply and demand are mismatched due to various external forces.
- Causes range from government interventions and market inefficiencies to independent actions by market players.
- Markets generally self-correct, returning to a new state of balance over time.
- For example, overpriced goods incentivize increased production, raising supply and ultimately lowering prices back to equilibrium.
- Instances include short-term scenarios like market crashes to long-term events like economic recessions.
Comprehending Disequilibrium
Market imbalances arise when certain forces alter the price of commodities or services, disrupting the balance between supplied and demanded quantities. Economist John Maynard Keynes postulated that true equilibrium is seldom achieved due to numerous variable factors impacting financial markets.
An efficient market in equilibrium features corresponding quantities supplied and demanded at a stable price. Disequilibrium occurs when the balance of supply and demand does not adjust as expected, often leading to either a surplus or a shortage. Market forces generally work to restore equilibrium through arbitrage, where players profit from undervalued assets and sell overvalued ones.
Illustrating Disequilibrium
Consider the wheat market represented hypothetically below. The equilibrium price (P~e~) is the sweet spot where farmers are comfortable supplying wheat, and consumers are willing to purchase it.
At a higher price (P~2~), suppliers are incentivized to supply more wheat, while consumers buy less, leading to a surplus and thus a market disequilibrium where supply exceeds demand. Conversely, a price lower than P~e~ (P~1~) would cut supply due to low profitability, leading to a shortage as demand surpasses supply.
Economic theory asserts that, in a free market, the price will eventually return to equilibrium (P~e~) if there are no external interferences.
Causes of Disequilibrium
Market disequilibrium originates from various sources:
- Price Stickiness: A fixed price period for goods or services may lead to shortages if demand increases.
- Government Interventions: Policies such as price floors or ceilings disturb the natural balance of supply and demand.
- Labor Market Imbalances: A minimum wage set above the market equilibrium can cause excess labor supply.
- Trade Deficits and Surpluses: A disproportionate balance of imports and exports disturbs equilibrium at the national level.
- Exchange Rate Fluctuations: Currency revaluation or devaluation influences market balance.
Resolving Disequilibrium
The resolution of disequilibrium involves market adjustments or government intervention. For instance, price imbalances in labor markets can be corrected through policy amendments or investment in workforce retraining. Technological innovation and efficiency improvements in production can also help regain market share and balance.
Practical Example
Disequilibrium can emerge swiftly in stable markets, as seen in flash crashes. The most notable incidence occurred on May 6, 2010, when the Dow Jones Industrial Average plunged over 1,000 points within minutes. This rapid devaluation, exacerbated by automated trading, highlighted the volatile nature of market disequilibrium.
Frequently Asked Questions (FAQs)
What Happens When Disequilibrium Occurs?
Prolonged market unbalance results in abnormally high or low prices, undercutting future market fitness. Consumers and investors act to restore balance by adjusting demand and supply respectively.
What Causes Disequilibrium?
It stems from supply-demand mismatches or market-induced frictions elsewhere. Policy protections and compensation discrepancies can keep labor markets in persistent disequilibrium.
How Can Disequilibrium Be Prevented?
Optimization measures include eliminating trade barriers, enhancing market fluidity, and improving information dissemination to avert persistent disequilibria.
Related Terms: market equilibrium, balance of payments, current account deficit, price stickiness.
References
- U.S. Securities & Exchange Commission. “Findings regarding the market events of May 6, 2010”.
