What is equilibrium in Economics?
Equilibrium in Economics (also known as economic equilibrium) can be defined as a state of balance in an economy, that is, there is a balance in the economic forces. It is a concept borrowed from the physical sciences where physical-economic forces can balance themselves. We can apply it to a number of contexts.
Meaning of Economic equilibrium
In elementary microeconomics, market equilibrium is the price that is equal to demand and supply in a particular price. In other words, it is a point where the hypothetical demand and supply curves intersect. Economic variables do not change from their equilibrium values when external forces are not present. We can as well say that national income is at its equilibrium when aggregate supply equates to aggregate supply. It will be our major area of concentration in this article.
When we talk about this economic concept, the market is in this state when consumers take out of the market everything that the producers take into the market without excesses of one over the other.
If this concept refers to a market for a single good, service, or a factor of production, we can refer to it as a partial equilibrium. In general equilibrium, the market is in a state in which all final goods, services, and factors of production are in equilibrium simultaneously.
On the other hand, disequilibrium takes place when changes in the variables lead to excess demand or supply. This causes a movement to a new equilibrium point. When we talk about an economic shock, we are referring to a sudden change.
Market Equilibrium (economic equilibrium)
The general theory of equilibrium tries to show us that all markets move towards a coordinated equilibrium (Leon Walras).
We also refer to economic equilibrium as market equilibrium. It is the combination of economic variables which commonly involve price and quantity. Here, normal economic processes such as demand and supply drive the economy. The term is also applicable to variables like interest rates or aggregate consumption spending.
The equilibrium point represents a theoretical state of rest in which every economic transaction that needs to take place with the given state of all relevant economic variables has taken place. The concept is only theoretical because the market may never reach equilibrium actually. However, it is moving constantly towards equilibrium.
Buyers and sellers in the market, therefore, face the incentives through current prices and quantities. These drive them to offer either higher or lower prices and quantities that will move the economy towards equilibrium.
We can think of something with regards to market prices, demand, and supply. If a given market price is too low, the quantity that buyers are willing and able to buy will exceed the quantity that the sellers are willing to offer for sale. In this case, there will be no balance between supply and demand. Consequently in a situation of oversupply or overdemand in the market will lead to a state of disequilibrium.
If as a result of low prices, sellers are unwilling to offer more commodities for sale, buyers will need to offer higher prices. This is to trigger sellers to release more goods to the market. In this case, the market price will rise towards a point where the quantity demanded equals quantity supplied. When the market gets to this point, we call this market equilibrium.
This is the price that equates to demand and supply. It explains the third law of demand and supply which states that the equilibrium price is the price that equals demand to supply. The interaction of the forces of demand and supply determines it. In a free-market economy (capitalist economy), the equilibrium price is the market price of the commodity. It also means the price at which the number of goods buyers or consumers are willing and able to buy is equal to the number of goods the sellers are willing and are able to offer for sale. In other words, all buyers buy all the quantity of that commodity they want to buy while sellers/producers sell all the quantity they want to sell.
Anything above the equilibrium point, there will be more supply of that commodity than the demand for it. In other words, there will be an excess supply or surplus of the commodity released to the market. Below the equilibrium point, on the other hand, there will be more demand for the commodity by consumers than its supply by sellers. In other words, there will be excess Demand over Supply which will bring about a scarcity of that commodity in the market. If any of these instances occur, there will be no establishment of equilibrium price.
We can only establish an equilibrium price in the market when demand equals supply. There are usually forces that push prices towards the equilibrium point thereby making it fairly stable. It will change only if there are changes in the factors affecting changes in demand or supply.
Equilibrium quantity is a situation whereby there is no shortage or excess of a commodity in the market. This directly implies that the quantity that consumers want to buy is equal to the quantity the producers are supplying. We can say that there is a balance between the quantity demanded and the quantity supplied. In other words, the market reaches a perfect state of balance. This is because prices stabilize to suit all the parties, that is the buyers and sellers.
The basic microeconomic theory makes a model available to determine the desirable price and quantity of a product or service. The theory bases on the supply and demand model which is the general basis for capitalism. The theory assumes that the behaviors of the producers and consumers are predictable and consistent without any other factor influencing their decisions.
Looking at the supply and demand graph, there are two curves. One represents the demand while the other represents the supply.
As we have understood, the supply curve slopes upward. This is because of the direct relationship between supply and price where the producer has a higher motivation to supply more when prices are higher. The demand curve on the other hand slopes downward because of the inverse relationship between price and quantity demanded. Consumers are willing to buy more at lower prices.
Because the two curves have opposite movements, they will definitely intersect on the supply and demand graph. The point of intersection is the point of economic equilibrium which also represents the equilibrium price and the equilibrium quantity of a good or service. This should be agreeable to both the consumers and the producers. On a hypothetical basis, it is the most efficient state a market will be able to reach and to which it naturally moves. This theory does not take into consideration potential externalities which are capable of causing market failures.
Equilibrium in the real world
This is fundamentally a theoretical concept that may never occur in actual terms in an economy. This is because the factors affecting demand and supply are always dynamic. In other words, the state of all economic variables changes constantly over time. The economy pursues a state of equilibrium without attaining it, though it may get close to it. The economy may attain partial equilibrium, but it may never attain it completely.
Throughout the economy, entrepreneurs compete, making guesses based on their judgment pertaining to the best combination of goods, prices, and quantities to buy and sell. Because a free market economy (capitalism) rewards those who guess better through profits, entrepreneurs gain rewards for moving towards equilibrium.
The financial and business media, market researchers, and others provide information about relevant economic states. This is usually an economic state of demand and supplies more available to entrepreneurs over time. The combination of market incentives helps in selecting better guesses about the state of an economy. This has a chance of increasing better information regarding the economy to educate those guesses. When this happens, it advances the economy towards the equilibrium prices and quantities of every good and service bought and sold.
In economics, equilibrium is an economic state whereby there exists a balance between economic forces such as demand and supply. This is with the absence of external forces and the values of these economic variables do not change. Now, this is a reason why it is not attainable because all variables change over time.
Types of equilibrium
A) Static Equilibrium
Prof. Mehta stated that “static equilibrium is that which maintains itself outside the time period under consideration”. It is a pleasant state that every firm, industry, factor, or individual wants to attain. Once they attain this stage, they will never want to leave.
A consumer is in equilibrium when he derives maximum satisfaction from a given purchase on different commodities and services. Any shift along this part will decrease his total satisfaction rather than increasing it. A firm is in its equilibrium when it is at its maximum profit and does not have the incentive to expand or contract its output. It is a state in which adjusting firms do not have the tendency to leave the industry. New firms do not even have the tendency to enter the industry. In essence, an industry is in a state of balance when all firms are earning just normal profits.
There are three types of static equilibrium namely;
- Micro static
- Macro static
- comparative statics
It is an economic model that shows the relationship among variables where one variable appears in two or more relationships. In a price determination micro-static model, the relationship between supply and demand determines the price at a point in time. It is as well constant through time and the demand and supply functions are;
D= (P) —– I
S= (P) —-II Where;
D = demand
P = price
S = supply
The function shows that there is an inverse relationship between demand and price as the law of demand implies. That is if the price falls, the demand will rise while if the price rises, the demand will fall keeping other things equal. Equation 2 on the other hand shows that there is a direct relationship between price and supply. That is if price rises, supply will rise and if supply decreases, supply will decrease.
Macro static is a term that explains the static equilibrium state of an economy. Prof. Kurihara explained that “If the object is to show a still picture of the economy as a whole, the micro static method is the appropriate technique… The technique is one for investigating the relationship between macro variables in the final point of equilibrium without making references to the process of adjustment in the final position”. We can show the final equilibrium state by the equation;
Y = C + I Where;
Y = Total Income
C = Total consumption expenditure
I = Total Investment expenditure
In a static Keynesian model, we determine the equilibrium level by the intersection between the aggregate supply and the aggregate demand functions.
This one compares the position of one equilibrium with another, and the system finally attains another equilibrium state. It does not explain how the system gets to the final equilibrium state with a change in data.
In a comparative static analysis, equilibrium positions correspond to the different sets of data compared.
One of the limitations of the static analysis is that it does not predict the movement of the market from one equilibrium point to another. Also, it fails to predict whether a market can achieve a given equilibrium position or not.
B) Dynamic Equilibrium
Under this category, prices, quantities, technology, incomes, tastes, and other factors go through constant change. This the disturbance of the fixed period of an equilibrium state.
For example, the demand for fish increases as a result of an increase in the taste for fish. Here, the seller will increase the price and change the behavior of the old buyers. This situation will throw the market into a disequilibrium state and it will remain so until the supplier increases the supply of fish to the level of the new demand.
The word dynamic in economics means the study of economic change, it is a process of change over time. There are two types of dynamic equilibrium namely;
- Micro dynamic
- Macro dynamic
Micro dynamic equilibrium
It explains the changes in demand, supply, and price over a long period of time. The cobweb theorem/ model helps to analyze the movements of prices and outputs when prices wholly determine supply in the previous period.
As prices move up and down (in cycles), the quantities also tend to move up and down in a counter-cyclical manner. Examples are the prices of perishable products like fruits and vegetables. The demand curve and the supply curves help in understanding these movements (converging and diverging).
Macro dynamic equilibrium
To understand the macro dynamic equilibrium and the cobweb theorem, click here.
C) Stable Equilibrium
An economy is in stable equilibrium when it experiences disturbances on which it depends and it then resumes to its initial position. The disturbance is self-adjusting which restores the original equilibrium.
Marshall said, “when the demand price equals supply price, the amount produced has no tendency to either increase or decrease”.
D) Unstable Equilibrium
In this case, the economic disturbance will lead to further disturbances. It will never get the economy to its original position. According to Pigou, “If the small disturbance calls out further disturbing forces which act in a cumulative manner to drive the system from its initial position”.
E) Neutral Equilibrium
This is when economic disturbances do not bring the economy back to its original state. The economy does not move away from its original state as well, it rests where the forces have moved it to. Here when there is a disturbance in the equilibrium position, the forces bring the economy to a new position where the system comes to rest.
F) Partial Equilibrium (particular)
This analyzes an equilibrium position of a particular sector of an economy. It also applies to several partial groups of the economic unit and this corresponds to a particular set of data. Partial equilibrium analysis is also known as microeconomic analysis studies the equilibrium of an individual, a firm, an industry, or a group of industries. The analysis views these sectors in isolation. It takes notice of the changes in one or two variables, leaving other factors constant. It studies the relationship between only a few selected variables while keeping other variables unchanged. The price determination of a commodity is simplified by just looking at the price of one commodity and assuming that the prices of other commodities remain unchanged.
Examples of a partial equilibrium
- Consumer’s equilibrium: This has to do with a consumer gaining maximum aggregate satisfaction from purchasing and consuming a particular commodity at a given price and supply of that commodity. The conditions are the marginal utility of each good being equal to the price. Secondly, the consumer has to spend his entire income on purchasing goods. Here the assumption is that the consumer’s tastes, preferences, money income, and prices of the commodities he intends to buy are constant.
- Producer’s equilibrium: This is when a consumer is able to maximize his total net profit in the economic conditions under which he is working.
- Firm’s equilibrium: When a firm is able to attain profit by utilizing all the resources at its disposal, that is attaining its optimum size.
- Industry’s equilibrium: This shows that there is no driving force for new firms to enter the industry or for the existing firms to opt out. This happens when the marginal firm in the industry is making just a normal profit, not more, not less. In this instance, the firms that have incentives to change it do not have the opportunity and those that have the opportunity do not have the incentive.
- The given price of a commodity is constant for every consumer.
- The tastes and preferences of the consumers, incomes, and habits are constant.
- The prices of productive resources of a commodity and other related goods such as substitutes or complementary goods are constant.
- Factors of production are easily available to industries at a known constant price in compliance with the methods of production in use.
- The prices of these commodities that the factors of production help to produce and the price and quantity of other factors are constant and known.
- The mobility of factors of production between places and occupations is constant.
G) General Equilibrium
This is a theoretical branch of microeconomics. The analysis helps in studying the behavior of economic variables, taking into full account the relationship between the variables and the entire economy. When the prices of commodities make each of its supply equal to its demand and also factor prices make each of its supply equal to its supply. All products and factor markets are simultaneously in a state of balance and here we sat that there is a balance in the general economy
Conditions for a general equilibrium
There are two conditions that characterize this concept;
- Every consumer maximizes his satisfaction while every producer maximizes his profits.
- The total quantity demanded equals the total quantity supplied at a positive price in both the factor and the product markets. This implies that all markets are cleared.
When there is an excess supply or an excess demand, there will be no balance in the general market. On the supply and demand graph, the point of intersection shows a market balance. Anything above or below this point of intersection between the supply curve the demand curves shows a state of disequilibrium.
The market is in a state of imbalance also when consumers are not able to maximize their satisfaction and producers are not able to maximize their profit.
Equilibrium and economic efficiency
Equilibrium is useful in creating an efficient and balanced market. When a market is at a balanced state, both price and quantity, it should have no reason to move away from that point. This is because there is a balance between the quantity demanded and the quantity supplied.
If a market is not in a balanced state, economic pressure will rise to move the market towards an equilibrium price and equilibrium quantity. This comes up usually when there is an excess supply over demand, that is, there is more supply than demand. Or when there is excess demand over supply, meaning that there is more demand for the commodity than the market is supplying. This balance is a natural function of the capitalist economy (free market economy).
Another instance is a competitive market operating in a state of balance. Such a market is an efficient market.
Finding equilibrium using the four-step process
We know fully well that equilibrium is a point of intersection between the supply curve and the demand curve. We shall take a look at how to find the equilibrium using the four-step process. The steps first explain first, how to draw the demand and supply curves on a graph and find the equilibrium. The next step is to consider how economic changes affect supply and demand. Finally, make adjustments to the graph to help identify the new equilibrium point.
- Draw the supply and demand curves to show the state of the market before the economic change occurred. Think about the variables that affect the shift in both supply and demand. Find the initial equilibrium price and quantity (values) using the diagram.
- Decide if the analyzed economic changes affect demand or supply.
- Determine whether the effects of these variables on supply or demand cause the curve to move leftward or rightward. Draw a new supply or demand curve on the graph.
- Identify the new point of equilibrium and compare the initial equilibrium price and quantity to the new intersection in the price and quantity.
This clearly explains the effects of changes in demand and supply on the equilibrium which disrupts the initial state and creates a new one.
An increase in demand with a constant supply causes the equilibrium price and quantity to increase. While a decrease in demand with a constant supply causes the equilibrium price and quantity to decrease.
On the other hand, an increase in supply with a constant demand leads to a decrease in the equilibrium price with an increase in the equilibrium quantity. While a decrease in supply with a constant demand leads to an increase in the equilibrium price and a decrease in the equilibrium quantity.
Importance of equilibrium
Represents the picture of an analysis
Equilibrium analysis represents a picture of a private enterprise. This is where consumers attain a position of maximum satisfaction while the producers maximize profits. This is where there is no waste of resources but fully employed. In this case, there is maximum economic efficiency and also the maximization of economic welfare. This, therefore, helps in understanding the factors that determine an economic pattern.
Understanding how economic works
By ruling out certain irrelevant assumptions, we can easily understand how an economic system is working. We can know if the economy is working efficiently or if there are harsh factors that are altering its smooth functioning. With the help of equilibrium analysis, we can study the problems of disequilibrium and the restoration of economic balance.
Understanding the complex problems of the market
the general equilibrium analysis helps to further predict the consequences of a sovereign/independent economic event. If the demand for a commodity rises, it can cause the price of that commodity to rise. It consequently reduces the prices of its substitutes thereby raising the prices of complementary goods.
These factors may reduce demand for one commodity and the demand. It may further affect the demand for this commodity and the prices of productive resources may also rise. The general equilibrium analysis helps to understand the nature of the complex relationship chains of the market on step by step basis.
Understanding how the pricing process works
It is useful in explaining how prices function in an economy. Relative prices change three major economic decisions: what to produce, how to produce, and for whom to produce the commodities.
Individual producers and consumers make these decisions. This is because each commodity or service responds to changes in supply and demand. This analysis, therefore, helps to integrate different individual decisions that a change in price affects.
Understanding the input-output analysis
The major importance of general equilibrium analysis provides a conceptual basis for input-output analysis which Leontief pointed out that. We regard this analysis as the outstanding variable for the general equilibrium analysis. And the households and firms relate in an interdependent system of inputs and outputs of the economy.
What is disequilibrium?
This is an economic situation whereby external forces disrupt the market’s supply and demand equilibrium. As a result of this situation, the market falls into a state in which there is an imbalance or a mismatch between supply and demand. It is the opposite of equilibrium.
So many factors cause disequilibria such as government intervention, inefficiencies in the labor market, one-sided actions by either a supplier or a distributor. A market can resolve disequilibrium by entering into a new state of market balance.
For example, people get motivated to start producing more overpriced goods. In this situation, increasing the supply of these goods to meet their demands thereby lowering the prices restores the market’s state of balance.
Examples are short-term cases like slight crashes to long-term situations like recessions and economic depression.
We have seen a market or an economic equilibrium to be a state of balance in the market. This is when suppliers supply the exact quantity of goods consumers want to buy. It is also important to note that it is a theoretical concept because markets may never attain that point, though heading towards it. Though a partial equilibrium is attainable at some point.
We looked at the types of equilibrium that are categorized based on the modeling, analysis, and responses to economic pressure.
Though this is a microeconomic theory, it is a desirable point for every market because, by this, the market will be efficient. At this point, consumers can maximize their satisfaction from their purchases gives the price of a commodity while sellers maximize their profits.
The fourth law of demand and supply states that an increase in demand will lead to an increase in the equilibrium price and quantity and vice-versa. This reflects the effects of change in demand (increase or decrease) on equilibrium.
The fifth law of demand and supply as well reflects the effects of change in supply on equilibrium (increase or decrease).