What is equilibrium?

Equilibrium is the state in which supply and demand in the market balance each other, so prices become stable. Generally speaking, an oversupply of a good or service causes prices to fall, which leads to increased demand—and a lack or shortage of supplies causes prices to rise, which leads to less demand. The balancing effect of supply and demand leads to a state of equilibrium.

key takeaways

  • When the supply of a commodity matches the demand, the market reaches an equilibrium price.
  • Equilibrium markets exhibit three characteristics: agents behave consistently, agents have no incentive to change their behavior, and dynamic processes control the equilibrium outcome.
  • Disequilibrium is the opposite of equilibrium and is characterized by changes in the conditions that affect market equilibrium.

Understanding Equilibrium

Equilibrium price is where the supply of a good matches the demand. When the main indexes show consolidation or sideways momentum, it can be said that the forces of supply and demand are relatively balanced, and the market is in a state of equilibrium.

Balanced Annotation

Economists such as Adam Smith believed that the free market would tend to equilibrium. For example, a lack of any one commodity usually produces a higher price, which reduces demand, which leads to an increase in supply with the right incentives. If there is excess in either market, the same will happen in reverse order.

Modern economists point out that cartels or monopolies can artificially inflate prices and keep them high for higher profits. The diamond industry is a classic example of high market demand, but companies sell fewer diamonds in order to keep prices high, artificially making supply scarce.

As Paul Samuelson pointed out in his 1983 work Fundamentals of Economic Analysis, From a normative standpoint, the term equilibrium in the market is not necessarily a good thing, and making such value judgments may be wrong.

Markets can be in equilibrium, but that may not mean all is well. For example, during the potato famine of the mid-1800s, the food market in Ireland was in equilibrium. Higher profits selling to the UK put Irish and UK markets at equilibrium prices above what consumers can afford, so many people go hungry.

balance and imbalance

When markets are not in equilibrium, we say they are in disequilibrium. Imbalances can occur instantaneously in more stable markets, or they can be a systematic feature of some markets.

Occasionally, imbalances can spill over from one market to another – for example, if there are not enough carriers or resources available to ship coffee internationally, coffee supply in certain regions may be reduced, affecting the balance of the coffee market . Economists argue that many labor markets are unbalanced because of how legislation and public policy protect people and their jobs, or how much they get paid for their labor.

example of balance

A store makes 1,000 tops and retails them for $10 each. But no one wants to buy them at that price. To increase demand, the store dropped the price to $8. There were 250 buyers at that price. In response, the store further slashed retail costs to $5, attracting a total of 500 buyers. After the price fell further to $2, 1,000 buyers of tops showed up. At this price, supply equals demand. Therefore, $2 is the equilibrium price of the top.

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