What Is Equilibrium?
Equilibrium is the state in which market supply and demand balance each other, and as a result, prices become stable. Generally, an over-supply of goods or services causes prices to go down, which results in higher demand—while an under-supply or shortage causes prices to go up, resulting in less demand.
The balancing effect of supply and demand results in a state of equilibrium.
KEY TAKEAWAYS
- A market is said to have reached an equilibrium price when the supply of goods matches demand.
- A market in equilibrium demonstrates three characteristics: agents’ behavior is consistent, there are no incentives for agents to change behavior, and a dynamic process governs equilibrium outcomes.
- There are several types of equilibrium used in economics.
- Disequilibrium is the opposite of equilibrium, characterized by changes in conditions that affect market equilibrium.
- In reality, markets are never in perfect equilibrium, although prices tend toward it.
Understanding Equilibrium
The equilibrium price is where the supply of goods matches the demand. When a significant index experiences a period of consolidation or sideways momentum, it can be said that the forces of supply and demand are relatively equal and the market is in a state of equilibrium.
Economists find that prices tend to fluctuate around the equilibrium levels. If the price rises too high, market forces will incentivize sellers to come in and produce more. If the price is too low, additional buyers will bid. These activities keep the equilibrium level in relative balance over time.
Special Considerations
Economists like Adam Smith believed that a free market would trend toward equilibrium. For example, a shortage of any one good would create a higher price generally, reducing demand, leading to an increase in supply provided the right incentive. The same would occur in reverse order, provided there was excess in any one market.
Modern economists point out that cartels or monopolistic companies can artificially hold prices higher and keep them there to reap higher profits. The diamond industry is a classic example of a market where demand is high. Still, supply is made artificially scarce by companies selling fewer diamonds to keep prices high.
As noted by Paul Samuelson in his 1983 work Foundations of Economic Analysis, the term equilibrium concerning a market is not necessarily a good thing from a normative perspective, and making that value judgment could be a misstep.1
Markets can be in equilibrium, but it may not mean all is well. For example, the food markets in Ireland were at peace during the great potato famine in the mid-1800s. Higher profits from selling to the British made it so the Irish and British market was at an equilibrium price higher than what consumers could pay, and consequently, many people starved.
Equilibrium vs. Disequilibrium
When markets aren’t in equilibrium, they are said to be disequilibrium. Disequilibrium can happen quickly in a more stable market or can be a systematic characteristic of specific markets.
At times disequilibrium can spill over from one market to another—for instance, if there aren’t enough transport companies or resources to ship coffee internationally. The coffee supply for certain regions could be reduced, affecting the equilibrium of coffee markets. Economists view many labor markets as being in disequilibrium due to how legislation and public policy protect people and their jobs or the amount they are compensated for their labor.
Types of Equilibrium
Economic Equilibrium
Economic equilibrium refers broadly to any state in the economy where forces are balanced. This can be related to prices in a market where supply is equal to demand, but it can also represent the level of employment, interest rates, etc.
Competitive Equilibrium
The process by which equilibrium prices are reached is through a process of competition. Among sellers is the low-cost producer to grab the largest market share and among buyers to snatch up the best deals.
General Equilibrium
General equilibrium considers the aggregation of forces occurring at the macro-economic level, not individual markets’ micro forces. It is a cornerstone of Walrasian economics.
Underemployment Equilibrium
Economists have found that there is a level of persistent unemployment that is observed when there is general equilibrium in an economy. This is known as underemployment equilibrium and is predicted by Keynesian economic theory.
Lindahl Equilibrium
Lindahl equilibrium is a special case where, in theory, the optimal amount of public goods is produced, and the cost of public goods is fairly shared among everyone. It describes an ideal state rarely if ever, achieved in reality but is used to help craft tax policy and is an important concept in welfare economics.
Intertemporal Equilibrium
Because prices may swing above or below the equilibrium level due to proximate changes in supply or demand at a given moment, it is best to look at this effect over time, known as intertemporal equilibrium. The concept is also used in understanding how firms and households budget and smooth spending over longer time horizons.
Nash Equilibrium
In game theory, Nash equilibrium is a state of play whereby the optimal strategy involves considering the optimal strategy of the other player or opponent.
Fast Fact
The prisoner’s dilemma is a common situation in game theory that exemplifies the Nash equilibrium.
Example of Equilibrium
A store manufactures 1,000 spinning tops and retails them at $10 per piece. But no one is willing to buy them at that price. To pump up demand, the store reduces its price to $8. There are 250 buyers at that price point. In response, the store further slashes the retail cost to $5 and garners five hundred buyers in total. Upon further reduction of the price to $2, one thousand buyers of the spinning top materialize. At this price point, supply equals demand. Hence $2 is the equilibrium price for the spinning tops.
What Happens During Market Equilibrium?
When a market is in equilibrium, prices reflect an exact balance between buyers (demand) and sellers (supply). While elegant in theory, markets are rarely in equilibrium at a given moment. Rather, equilibrium should be thought of as a long-term average level.
How Do You Calculate Equilibrium Price?
In economics, the equilibrium price is calculated by setting the supply function and demand function equal to one another and solving for the price.
What Is Equilibrium Quantity?
The amount supplied that exactly equals demand is the equilibrium quantity. In such a case, there will neither be an oversupply nor a shortage.
Paul A. Samuelson. “Foundations of Economic Analysis.” Harvard University Press, 1983.