Economic equilibrium

Economic equilibrium

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In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal. Market equilibrium, for example, refers to a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price is often called the equilibrium price or market clearing
Market clearing
In economics, market clearing refers to either# a simplifying assumption made by the new classical school that markets always go to where the quantity supplied equals the quantity demanded; or# the process of getting there via price adjustment....

 price and will tend not to change unless demand or supply change.

Properties of equilibrium


When the price is above the equifferent points of economic equilibrium.
In most simple microeconomic stories of supply and demand in a market a static equilibrium is observed in a market; however, economic equilibrium can exist in non-market relationships and can be dynamic
Dynamic equilibrium
A dynamic equilibrium exists once a reversible reaction ceases to change its ratio of reactants/products, but substances move between the chemicals at an equal rate, meaning there is no net change. It is a particular example of a system in a steady state...

. Equilibrium may also be multi-market or general
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...

, as opposed to the partial equilibrium
Partial equilibrium
Partial equilibrium is a condition of economic equilibrium which takes into consideration only a part of the market, ceteris paribus, to attain equilibrium....

 of a single market.

In economics, the term equilibrium is used to suggest a state of "balance" between supply forces and demand forces. For example, an increase in supply will disrupt the equilibrium, leading to lower prices. Eventually, a new equilibrium will be attained in most markets. Then, there will be no change in price or the amount of output bought and sold — until there is an exogenous
Exogenous
Exogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....

 shift in supply or demand (such as changes in technology
Technology
Technology is the making, usage, and knowledge of tools, machines, techniques, crafts, systems or methods of organization in order to solve a problem or perform a specific function. It can also refer to the collection of such tools, machinery, and procedures. The word technology comes ;...

 or tastes
Preference
-Definitions in different disciplines:The term “preferences” is used in a variety of related, but not identical, ways in the scientific literature. This makes it necessary to make explicit the sense in which the term is used in different social sciences....

). That is, there are no endogenous
Endogenous
Endogenous substances are those that originate from within an organism, tissue, or cell. Endogenous retroviruses are caused by ancient infections of germ cells in humans, mammals and other vertebrates...

 forces leading to the price or the quantity.

Not all economic equilibria are stable. For an equilibrium to be stable, a small deviation from equilibrium leads to economic forces that returns an economic sub-system toward the original equilibrium. For example, if a movement out of supply/demand equilibrium leads to an excess supply (surplus, or glut), that excess induces price declines which return the market to a situation where the quantity demanded equals the quantity supplied. If supply and demand curves intersect more than once, then both stable and unstable equilibria are found.

Most economists e.g., Paul Samuelson
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...

caution against attaching a normative
Normative economics
Normative economics is that part of economics that expresses value judgments about economic fairness or what the economy ought to be like or what goals of public policy ought to be....

 meaning (value judgement) to the equilibrium price. For example, food markets may be in equilibrium at the same time that people are starving (because they cannot afford to pay the high equilibrium price). Indeed, this occurred during the Great Famine in Ireland
Ireland
Ireland is an island to the northwest of continental Europe. It is the third-largest island in Europe and the twentieth-largest island on Earth...

 in 1845–52, where food was exported though people were starving, due to the greater profits in selling to the English – the equilibrium price of the Irish-British market for potatoes was above the price that Irish farmers could afford, and thus (among other reasons) they starved.

Interpretations


In most interpretations, classical economists
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....

 such as Adam Smith
Adam Smith
Adam Smith was a Scottish social philosopher and a pioneer of political economy. One of the key figures of the Scottish Enlightenment, Smith is the author of The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations...

 maintained that the free market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...

 would tend towards economic equilibrium through the price mechanism. That is, any excess supply (market surplus or glut) would lead to price cuts, which decrease the quantity supplied (by reducing the incentive to produce and sell the product) and increase the quantity demanded (by offering consumers bargains), automatically abolishing the glut. Similarly, in an unfettered market, any excess demand (or shortage) would lead to price increases, reducing the quantity demanded (as customers are priced out of the market) and increasing in the quantity supplied (as the incentive to produce and sell a product rises). As before, the disequilibrium (here, the shortage) disappears. This automatic abolition of
non-market-clearing
Market clearing
In economics, market clearing refers to either# a simplifying assumption made by the new classical school that markets always go to where the quantity supplied equals the quantity demanded; or# the process of getting there via price adjustment....

 situations distinguishes markets from central planning schemes, which often have a difficult time getting prices right and suffer from persistent shortages of goods and services.

This view came under attack from at least two viewpoints. Modern mainstream economics
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...

 points to cases where equilibrium does not correspond to market clearing (but instead to unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

), as with the efficiency wage hypothesis in labor economics. In some ways parallel is the phenomenon of credit rationing
Credit rationing
Credit rationing refers to the situation where lenders limit the supply of additional credit to borrowers who demand funds, even if the latter are willing to pay higher interest rates. It is an example of market imperfection, or market failure, as the price mechanism fails to bring about...

, in which banks hold interest rates low to create an excess demand for loans, so they can pick and choose whom to lend to. Further, economic equilibrium can correspond with monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

, where the monopolistic firm maintains an artificial shortage to prop up prices and to maximize profits. Finally, Keynesian macroeconomics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 points to underemployment equilibrium
Underemployment
Underemployment refers to an employment situation that is insufficient in some important way for the worker, relative to a standard. Examples include holding a part-time job despite desiring full-time work, and overqualification, where the employee has education, experience, or skills beyond the...

, where a surplus of labor (i.e., cyclical unemployment) co-exists for a long time with a shortage of aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

.

On the other hand, the Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

 and Joseph Schumpeter
Joseph Schumpeter
Joseph Alois Schumpeter was an Austrian-Hungarian-American economist and political scientist. He popularized the term "creative destruction" in economics.-Life:...

 maintained that in the short term equilibrium is never attained as everyone was always trying to take advantage of the pricing system and so there was always some dynamism
Dynamical system
A dynamical system is a concept in mathematics where a fixed rule describes the time dependence of a point in a geometrical space. Examples include the mathematical models that describe the swinging of a clock pendulum, the flow of water in a pipe, and the number of fish each springtime in a...

 in the system. The free market's strength was not creating a static or a general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...

 but instead in organising resources to meet individual desires and discovering the best methods to carry the economy forward.

Solving for equilibrium price


To solve for the equilibrium price, one must either plot the supply and demand curves, or solve for their equations being equal.

An example may be:




In the diagram, depicting simple set of supply and demand curves, the quantity demanded and supplied at price P are equal.

At any price above P supply exceeds demand, while at a price below P the quantity demanded exceeds that supplied. In other words, prices where demand and supply are out of balance are termed points of disequilibrium, creating shortages and oversupply. Changes in the conditions of demand or supply will shift the demand or supply curves. This will cause changes in the equilibrium price and quantity in the market.

Consider the following demand and supply schedule:
Price ($) Demand Supply
8.00 6,000 18,000
7.00 8,000 16,000
6.00 10,000 14,000
5.00 12,000 12,000
4.00 14,000 10,000
3.00 16,000 8,000
2.00 18,000 6,000
1.00 20,000 4,000

  • The equilibrium price in the market is $5.00 where demand and supply are equal at 12,000 units

  • If the current market price was $3.00 – there would be excess demand for 8,000 units, creating a shortage.

  • If the current market price was $8.00 – there would be excess supply of 12,000 units.


When there is a shortage in the market we see that, to correct this disequilibrium, the price of the good will be increased back to a price of $5.00, thus lessening the quantity demanded and increasing the quantity supplied thus that the market is in balance.

When there is an oversupply of a good, such as when price is above $6.00, then we see that producers will decrease the price to increase the quantity demanded for the good, thus eliminating the excess and taking the market back to equilibrium.

Influences changing price


A change in equilibrium price may occur through a change in either the supply or demand schedules. For instance, starting from the above supply-demand configuration, an increased level of disposable income
Disposable income
Disposable income is total personal income minus personal current taxes. In national accounts definitions, personal income, minus personal current taxes equals disposable personal income...

 may produce a new demand schedule, such as the following:
Price ($) Demand Supply
8.00 10,000 18,000
7.00 12,000 16,000
6.00 14,000 14,000
5.00 16,000 12,000
4.00 18,000 10,000
3.00 20,000 8,000
2.00 22,000 6,000
1.00 24,000 4,000


Here we see that an increase in disposable income would increase the quantity demanded of the good by 4,000 units at each price. This increase in demand would have the effect of shifting the demand curve rightward. The result is a change in the price at which quantity supplied equals quantity demanded. In this case we see that the two now equal each other at an increased price of $6.00. Note that a decrease in disposable income would have the exact opposite effect on the market equilibrium .

We will also see similar behaviour in price when there is a change in the supply schedule, occurring through technological changes, or through changes in business costs. An increase in technological usage or know-how or a decrease in costs would have the effect of increasing the quantity supplied at each price, thus reducing the equilibrium price. On the other hand, a decrease in technology or increase in business costs will decrease the quantity supplied at each price, thus increasing equilibrium price.

The process of comparing two static equilibria to each other, as in the above example, is known as comparative statics
Comparative statics
In economics, comparative statics is the comparison of two different economic outcomes, before and after a change in some underlying exogenous parameter....

. For example, since a rise in consumers' income leads to a higher price (and a decline in consumers' income leads to a fall in the price — in each case the two things change in the same direction), we say that the comparative static effect of consumer income on the price is positive. This is another way of saying that the total derivative
Total derivative
In the mathematical field of differential calculus, the term total derivative has a number of closely related meanings.The total derivative of a function f, of several variables, e.g., t, x, y, etc., with respect to one of its input variables, e.g., t, is different from the partial derivative...

 of price with respect to consumer income is greater than zero.

Dynamic equilibrium


Whereas in a static equilibrium all quantities have unchanging values, in a dynamic equilibrium various quantities may all be growing at the same rate, leaving their ratios unchanging. For example, in the neoclassical growth model
Exogenous growth model
The neoclassical growth model, also known as the Solow–Swan growth model or exogenous growth model, is a class of economic models of long-run economic growth set within the framework of neoclassical economics...

, the working population is growing at a rate which is exogenous (determined outside the model, by non-economic forces). In dynamic equilibrium, output and the physical capital
Physical capital
In economics, physical capital or just 'capital' refers to any already-manufactured asset that is applied in production, such as machinery, buildings, or vehicles. In economic theory, physical capital is one of the three primary factors of production, also known as inputs in the production function...

 stock also grow at that same rate, with output
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....

 per worker and the capital stock per worker unchanging. Similarly, in models of inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 a dynamic equilibrium would involve the price level
Price level
A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...

, the nominal money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

, nominal wage rates
Wage
A wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...

, and all other nominal values growing at a single common rate, while all real values are unchanging, as is the inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...

.

The process of comparing two dynamic equilibria to each other is known as comparative dynamics. For example, in the neoclassical growth model, starting from one dynamic equilibrium based in part on one particular saving rate, a permanent increase in the saving rate leads to a new dynamic equilibrium in which there are permanently higher capital per worker and productivity per worker, but an unchanged growth rate of output; so it is said that in this model the comparative dynamic effect of the saving rate on capital per worker is positive but the comparative dynamic effect of the saving rate on the output growth rate is zero.

See also

  • Competitive equilibrium
    Competitive equilibrium
    Competitive market equilibrium is the traditional concept of economic equilibrium, appropriate for the analysis of commodity markets with flexible prices and many traders, and serving as the benchmark of efficiency in economic analysis...

  • General equilibrium theory
  • Partial equilibrium
    Partial equilibrium
    Partial equilibrium is a condition of economic equilibrium which takes into consideration only a part of the market, ceteris paribus, to attain equilibrium....

  • Nash equilibrium
    Nash equilibrium
    In game theory, Nash equilibrium is a solution concept of a game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his own strategy unilaterally...

  • Labor theory of value
    Labor theory of value
    The labor theories of value are heterodox economic theories of value which argue that the value of a commodity is related to the labor needed to produce or obtain that commodity. The concept is most often associated with Marxian economics...

  • Price
    Price
    -Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...

  • Exchange value
    Exchange value
    In political economy and especially Marxian economics, exchange value refers to one of four major attributes of a commodity, i.e., an item or service produced for, and sold on the market...

  • Supply and demand
    Supply and demand
    Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

  • Microeconomics
    Microeconomics
    Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

  • Real prices and ideal prices
    Real prices and ideal prices
    Real prices and ideal prices refers to a distinction between actual prices paid for products, services, assets and labour , and computed prices which are not actually charged or paid in market trade, although they may facilitate trade...

  • Prices of production
    Prices of production
    Prices of production refers to a concept in Karl Marx's critique of political economy. It is introduced in the third volume of Das Kapital, where Marx considers the operation of capitalist production as the unity of a production process and a circulation process involving commodities, money and...

  • Law of value
    Law of value
    -General:The law of value is a central concept in Karl Marx's critique of political economy, first expounded in his polemic The Poverty of Philosophy against Pierre-Joseph Proudhon, with reference to David Ricardo's economics...