| Economic equilibrium | |
|---|---|
| A solution concept in game theory | |
| Relationship | |
| Subset of | Equilibrium, Free market |
| Superset of | Competitive equilibrium, Nash equilibrium, Intertemporal equilibrium, Recursive competitive equilibrium |
| Significance | |
| Used for | mostly Perfect competition, but also some Imperfect competition |
In economics, economic equilibrium is a situation in which economic forces such as supply and demand are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change. For example, in the standard text perfect competition, equilibrium occurs at the point at which quantity demanded and quantity supplied are equal. Market equilibrium in this case is 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 competitive price or market clearing price and will tend not to change unless demand or supply changes, and quantity is called the "competitive quantity" or market clearing quantity. But the concept of equilibrium in economics also applies to imperfectly competitive markets, where it takes the form of a Nash equilibrium.
Properties of equilibrium
Three basic properties of equilibrium in general have been proposed by Huw Dixon. These are:
Equilibrium property P1: The behavior of agents is consistent.
Equilibrium property P2: No agent has an incentive to change its behavior.
Equilibrium property P3: Equilibrium is the outcome of some dynamic process (stability).
Example: competitive equilibrium
Competitive Equilibrium: Price equates supply and demand.
- P – price
- Q – quantity demanded and supplied
- S – supply curve
- D – demand curve
- P0 – equilibrium price
- A – excess demand – when P0
In a competitive equilibrium,
supply equals demand. Property P1 is satisfied, because at the
equilibrium price the amount supplied is equal to the amount demanded.
Property P2 is also satisfied. Demand is chosen to maximize utility
given the market price: no one on the demand side has any incentive to
demand more or less at the prevailing price. Likewise supply is
determined by firms maximizing their profits at the market price: no
firm will want to supply any more or less at the equilibrium price.
Hence, agents on neither the demand side nor the supply side will have
any incentive to alter their actions.
To see whether Property P3 is satisfied, consider what happens
when the price is above the equilibrium. In this case there is an excess
supply, with the quantity supplied exceeding that demanded. This will
tend to put downward pressure on the price to make it return to
equilibrium. Likewise where the price is below the equilibrium point
there is a shortage in supply leading to an increase in prices back to
equilibrium. Not all equilibria are "stable" in the sense of equilibrium
property P3. It is possible to have competitive equilibria that are
unstable. However, if an equilibrium is unstable, it raises the question
of reaching it. Even if it satisfies properties P1 and P2, the absence
of P3 means that the market can only be in the unstable equilibrium if
it starts off there.
In most simple microeconomic stories of supply and demand a static equilibrium is observed in a market; however, economic equilibrium can be also dynamic. Equilibrium may also be economy-wide or general, as opposed to the partial equilibrium
of a single market. Equilibrium can change if there is a change in
demand or supply conditions. 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 shift in supply or demand (such as changes in technology or tastes). That is, there are no endogenous forces leading to the price or the quantity.
Example: Nash equilibrium
Equilibrium
quantities as a solution to two reaction functions in Cournot duopoly.
Firm 1's reaction function q1=R1(q2) gives its optimal output q1 to a
given output q2 of firm 2. Likewise, firm 2's reaction function
q2=R2(q1). The Cournot-Nash equilibrium occurs where the two
reaction functions intersect and both firms are choosing the optimal
output given the output of the other firm.
The Nash equilibrium is widely used in economics as the main
alternative to competitive equilibrium. It is used whenever there is a
strategic element to the behavior of agents and the "price taking"
assumption of competitive equilibrium is inappropriate. The first use of
the Nash equilibrium was in the Cournot duopoly as developed by Antoine Augustin Cournot in his 1838 book.
Both firms produce a homogenous product: given the total amount
supplied by the two firms, the (single) industry price is determined
using the demand curve. This determines the revenues of each firm (the
industry price times the quantity supplied by the firm). The profit of
each firm is then this revenue minus the cost of producing the output.
Clearly, there is a strategic interdependence between the two
firms. If one firm varies its output, this will in turn affect the
market price and so the revenue and profits of the other firm. We can
define the payoff function which gives the profit of each firm as a
function of the two outputs chosen by the firms. Cournot assumed that
each firm chooses its own output to maximize its profits given the
output of the other firm. The Nash equilibrium occurs when both firms
are producing the outputs which maximize their own profit given the
output of the other firm.
In terms of the equilibrium properties, we can see that P2 is
satisfied: in a Nash equilibrium, neither firm has an incentive to
deviate from the Nash equilibrium given the output of the other firm. P1
is satisfied since the payoff function ensures that the market price is
consistent with the outputs supplied and that each firms profits equal
revenue minus cost at this output.
Is the equilibrium stable as required by P3? Cournot himself argued that it was stable using the stability concept implied by best response dynamics.
The reaction function for each firm gives the output which maximizes
profits (best response) in terms of output for a firm in terms of a
given output of the other firm. In the standard Cournot model this is
downward sloping: if the other firm produces a higher output, the best
response involves producing less. Best response dynamics involves firms
starting from some arbitrary position and then adjusting output to their
best-response to the previous output of the other firm. So long as the
reaction functions have a slope of less than -1, this will converge to
the Nash equilibrium. However, this stability story is open to much
criticism. As Dixon argues: "The crucial weakness is that, at each
step, the firms behave myopically: they choose their output to maximize
their current profits given the output of the other firm, but ignore the
fact that the process specifies that the other firm will adjust its
output...". There are other concepts of stability that have been put forward for the Nash equilibrium, evolutionary stability for example.
Normative evaluation
Most economists, for example Paul Samuelson, caution against attaching a normative
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 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 such as Adam Smith maintained that the free market 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 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 points to cases where equilibrium does not correspond to market clearing (but instead to unemployment), as with the efficiency wage hypothesis in labor economics. In some ways parallel is the phenomenon of credit rationing,
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, where the monopolistic firm maintains an artificial shortage to prop up prices and to maximize profits. Finally, Keynesian macroeconomics points to underemployment equilibrium, where a surplus of labor (i.e., cyclical unemployment) co-exists for a long time with a shortage of aggregate demand.
Solving for the competitive equilibrium price
To
find the equilibrium price, one must either plot the supply and demand
curves, or solve for the expressions for supply and demand 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 $6.00, then we see that producers will decrease the price to
increase the quantity demanded for the good, thus eliminating the excess
and taking the market back to equilibrium.
Influences changing price
A
change in equilibrium price may occur through a change in either the
supply or demand schedules. For instance, starting from the above
supply-demand configuration, an increased level of disposable income may produce a new demand schedule, such as the following:
| Price ($) | 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 2,000 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.
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 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,
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 stock also grow at that same rate, with output per worker and the capital stock per worker unchanging. Similarly, in models of inflation a dynamic equilibrium would involve the price level, the nominal money supply, nominal wage rates, and all other nominal values growing at a single common rate, while all real values are unchanging, as is the inflation rate.
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.
Disequilibrium
Disequilibrium characterizes a market that is not in equilibrium. Disequilibrium can occur extremely briefly or over an extended period of time. Typically in financial markets it either never occurs or only momentarily occurs, because trading takes place continuously and the prices of financial assets can adjust instantaneously with each trade to equilibrate supply and demand. At the other extreme, many economists view labor markets
as being in a state of disequilibrium—specifically one of excess
supply—over extended periods of time. Goods markets are somewhere in
between: prices of some goods, while sluggish in adjusting due to menu costs, long-term contracts, and other impediments, do not stay at disequilibrium levels indefinitely, and many goods markets such as commodity markets are highly organised and liquid and have essentially instantaneous adjustment of their prices to equilibrium levels.
