Equilibrium refers to a state in which the market supply and demand balance each other, leading to stable prices. An oversupply of goods or services typically drives prices down, increasing demand, while a shortage drives prices up, reducing demand. This balancing effect of supply and demand results in a state of equilibrium.
Key Takeaways
- A market reaches equilibrium price when the supply of goods matches demand.
- An equilibrium market shows three characteristics: consistent agent behavior, lack of incentives for behavior change, and a dynamic equilibrium process.
- Multiple forms of economic equilibrium exist.
- Disequilibrium signifies changes in market conditions, disrupting equilibrium.
- Markets rarely achieve perfect equilibrium, though prices tend to move towards it.
Understanding Equilibrium
The equilibrium price is where the supply of goods matches demand. During periods of consolidation, such as when a major index experiences sideways momentum, supply and demand forces are relatively balanced, indicating market equilibrium.
Economists observe that prices tend to hover around equilibrium levels. If prices rise too high, market forces incentivize increased production by sellers. Conversely, if prices are too low, additional buyers will drive the price back up, maintaining a balanced equilibrium over time.
Special Considerations
Economic philosophers like Adam Smith posited that a free market naturally leans toward equilibrium. For example, a scarcity of a good tends to increase its price, reducing demand and incentivizing higher supply. Conversely, excess of a good would decrease its price and increase its demand.
However, modern economists note that cartels or monopolies can artificially maintain high prices to maximize profits. The diamond industry exemplifies this scenario: firms keep diamond supply limited to maintain high prices despite substantial underlying demand.
As argued by Paul Samuelson in Foundations of Economic Analysis, market equilibrium is not always beneficial from all perspectives. For instance, during the Irish potato famine in the mid-1800s, food markets were at equilibrium, but at prices unaffordable for the Irish, leading to widespread starvation.
Equilibrium vs. Disequilibrium
Markets not in equilibrium are said to be in disequilibrium. This can happen suddenly in otherwise stable markets or persist as a systemic characteristic. Occasionally, disequilibrium in one market can spill over to others; for example, a shortage of transport companies might reduce coffee supply internationally, disrupting coffee market equilibrium.
Many labor markets are typically in disequilibrium due to regulatory policies and public sentiment influencing job protection and wages.
Types of Equilibrium
Economic Equilibrium
Economic equilibrium broadly refers to any balanced state in the economy, representing stasis not only in prices but employment levels, interest rates, and more.
Competitive Equilibrium
Competitive equilibrium emerges when equilibrium prices are reached through market dynamics such as sellers striving to produce at low costs and buyers seeking the best deals.
General Equilibrium
General equilibrium revolves around aggregate macroeconomic forces rather than individual markets, being essential to Walrasian economics.
Underemployment Equilibrium
This type of equilibrium predicts structural unemployment persistence even in aggregate economic stability, something illustrated by Keynesian economic theory.
Lindahl Equilibrium
Lindahl equilibrium is a theoretical state where the optimal provision of public goods is matched by fair cost distribution among beneficiaries. While rarely achieved, the concept informs tax policy and welfare economics.
Intertemporal Equilibrium
Intertemporal equilibrium reflects price fluctuations over time rather than at single moments, considering the long-term adjustments consumers and firms make in budgeting and spending.
Nash Equilibrium
In game theory, Nash equilibrium dictates that the optimal strategy accounts for the opponent’s best possible action, showcased by the prisoner’s dilemma scenario.
Example of Equilibrium
Consider a store producing 1,000 spinning tops priced at $10 each but finding no buyers. Upon reducing the price to $8, they sell 250 units. A subsequent cut to $5 attracts 500 buyers. Finally, at $2, they sell all 1,000 tops, marking $2 as the equilibrium price where supply meets demand.
What Happens During Market Equilibrium?
In an equilibrium market, prices align precisely between buyer demand and seller supply. While this state is rare in the short term, equilibrium represents a long-term market average.
How Do You Calculate Equilibrium Price?
Economists calculate the equilibrium price by setting the supply function equal to the demand function and solving for the price.
What Is Equilibrium Quantity?
Equilibrium quantity is the supplied amount that exactly meets demand, eliminating both oversupply and shortage scenarios.
Related Terms: disequilibrium, economic theory, Nash equilibrium, Keynesian economics, public goods.
References
- Paul A. Samuelson. Foundations of Economic Analysis. Harvard University Press, 1983.
