Introduction to Market Equilibrium

Economic studies take different shapes across the world. However, when talking about the world economy, there are certain aspects that make everything seem like one. It is very difficult to fully understand the economy by simply looking at it from one point of view. Consumer decisions, as well as firm marketing decisions. We all have to make decisions, even when we don’t want to. And these decisions are involved in the making of the market.

One of the major characteristics of economies is fluctuations. At times, the economy picks and performs to the highest, whereas other times meet the lowest areas of the economy. It is these changes that make the world around. Both consumers and producers interact in a market environment to create a balance with the markets. Without consumers buying their goods, firms would not have the ability nor the reason to produce. And without firms making products, we would have anything to consume. This interaction describes what a market is.

Markets are generally imperfect. In other words, there is always scarcity within an economy at any given time. It is the aspect of economic growth and development that brings about economic fluctuations. This development depends on the available resources – which are limited, yet must serve unlimited human needs. For instance, if someone wanted to live in a nice house, they will need money for it, which means they will have to find work. But with the increasing population, work is becoming more and more scarce. Those who can employ look for specific skills, which not every consumer will have. And perhaps competition in their area of expertise is out through the roof. This means they will have to be more careful about their consumption choices.

A perfect economy is where consumption and production are on the same level. This means there is no producer who comes with exaggerated prices, and all consumers are able to buy the goods and services without exhausting the company’s resources. Also, producers can make enough goods and serves with surety that they will be fully consumed. In such a situation, everyone gets what they want at the best deals. Consumers cannot complain about high prices, and producers cannot complain about low prices. And this leads us to a state of economic equilibrium.

What is the economic equilibrium?

Understand economic equilibrium is vital to modern economies because it helps us know where an economy should be. It acts as a point of reference for a perfect economy so that when something wrong happens, stakeholders can come together to try and rectify it. There is always something happening in an economy. As stated above, producers and consumers interact at different levels within markets for the benefit of both parties. Economic equilibrium can be easily referred to as a point of consensus between the two parties.

Another idea could be that economic equilibrium is a state achieved when there is a balance within economic forces. In this case, economic variables remain the same without any changes from the equilibrium values where external influences are absent. It can also be called market equilibrium. There is a combination of economic variables, which usually involve price and quantity. People are often referred to as rational decision-makers, whereby they will decide based on the level of benefit that comes from the product displayed. When one is not good enough, they will leave it for another. And when there are two similar products with the same value, they will go for the cheapest. On the other hand, producers base their decisions on the rate of consumption and the availability of raw materials. When the market is good, they will give more, but when it is low, they will give less.

The terms economic equilibrium also appears in interest rates of aggregate consumption spending. Financial markets play a vital role in the development and stability of markets. Refer back to the 2008/2009 economic crises, which were initiate because of the failure of financial markets. It all began with an economic bubble the preceded this period. Financiers were not careful enough to vet who received their loans, and the securities they gave, especially in the housing industry, soon dropped in value. Those who had borrowed were no longer able to pay back, which led to a tragedy affecting all other industries. Governments quickly came up with fiscal and monetary policies to restore the economy, some of which are being applied even today. They create these measures based on the assumptions of what a balanced economy should be. Hence, the reduced interest rates while adding more liquidity to banks so that more borrowers would be interested.

Even though economic equilibrium is something good that should be applauded, it does not easily happen in real life. In fact, it is just a theoretical state of rest where all economic transactions that are expected to occur, considering the state of all relevant economic variables, have happened.

Equilibrium can also be considered a state of equity. It is an idea borrowed from the physical science, by economists who look at economic processes as initiators of physical phenomena such as velocity, friction, or fluid pressures. When there is a balance in these physical forces, there will be no further changes. It is like a point of elasticity for a rubber band. When stretched to the last point, you cannot expect any further process to take place because it is at its last point where the pulling pressure and its extension are equal. Consider a balloon too; you blow in as much air as possible to inflate it, whereby the increasing force in the air increases the pressure inside the balloon. In the end, the pressure inside is greater than the pressure outside, meaning the pressures are not balanced. This is what causes the balloon to expand so that there is a balance between the pressures. And when the balloon stops expanding, it means the two pressures are at equilibrium.

We can think of a similar situation on the economic environment, in reference to market prices, supplies, and demand. There is no day you will find the prices of goods given higher than their quantity. If this were to happen, consumption would rise rapidly with buyers demanding larger quantities of goods that suppliers are not able, or not willing to offer. Similar to the pressure within and around the balloon, there will be no balance between these two aspects. We can always take the consequences of such a situation will not be good. It could lead to the production of fake goods on the market, apart from the overwhelming supply. The same condition can be linked to oversupply in the market. Too many goods on the market without enough consumption will lead to disequilibrium.

For an economy to be perfect, therefore, something has to give. As stated in the beginning, consumers are rational decision-makers. Hence, they will have to offer higher prices to induce sellers to release their products. Besides, most consumers make a buying decision based on the price. Consider the fashion industry; for instance, quality is directly linked to high prices, where a more expensive gown is perceived of better quality than a cheaper one. This happens in many other consumer products.

Such situations are responsible for the fluctuations within markets. And they will remain so until the pressure equalizes. When demand is high, supply will go down, and supply will always be higher when demand is high. Eventually, it will reach a state of balance where quantity demand is equal to quantity supply. Such a state is referred to as market equilibrium.

Properties of economic equilibrium

Huw Dixon proposed that there are three properties of economic equilibrium. They include:

1. That the behavior of agents is consistent

2. There is no agent that can be incentivized to alter its behavior

3. Equilibrium is a result of some dynamic process, which is stability

We can use different situations to describe these properties:

Competitive equilibrium

Competitive equilibrium is one of the best examples of equilibrium. In this case, supply is equal to demand, and property one is justified. In this equilibrium, the amount supplied and the amount demands are at the same level at the equilibrium prices. 

The second property is also satisfied because demand is used to maximize utility as given at the market price. There is no one on the demand side incentivized to offer more or less of the current price. In the same way, supply is determined when firms use their profits at the market price. In this case, no firm will want to supply any more or less at the equilibrium price. In either situation, agents on the demand or supply side will not have any incentive to change their actions.

Think about what happens when the prices are about equilibrium. We can use this to determine whether or not the third property is fulfilled. In this case, it means the supply is in excess, with more supply than demand – which tends to initiate a downward pressure situation to restore the equilibrium. And when the price is below the equilibrium, supply goes into shortage as demand surges pulling prices along – which ends up returning prices to an equilibrium. Note, however, that not all equilibria are equal in the third property. If there is no stability within an equilibrium, the question of reaching it comes it. Even if the property one and property two are stable, the market will only get to a stage of instability if property three remains absent.

A static equilibrium is critical in a simple microeconomic story of supply and demand, but equilibrium can also be dynamic. As if that is not enough, it can also be economic-wide or general, depending on the actions of the factors involved. If there is a change in demand and supply, then equilibrium can change. For instance, too much demand will have an effect on equilibrium, leading to low prices of goods. When this happens, consumers will buy more, leading to scarcity of the gods, hence, increasing the price once more. Eventually, there will come a new equilibrium, at which, there will be no change in the price or on the amount of demand and supply – until another shift in demand or supply comes up again.

Nash Equilibrium

The Nash equilibrium has been used widely by many economists to represent competitive equilibrium. They use it whenever a strategic element of the action of agents, as well as the ‘price taking’ assumption of the competitive equilibrium, are not appropriate. The Nash equilibrium was applied by Antoine Augustin Cournot when he recorded in his book in 1838. In this case, both firms produce the same product. Based on the total amount of the two both firm’s products, they all have the same price, which is determined by a demand curve. In this end, the profit of each firm is determined as the revenue, minus the cost of production. In this strategy, each firm comes with different strategies. If there is a variation in the output of one firm, it will affect the market price and extend to the second firm's revenue. The payoff function that profits each firm is a function of the two inputs as presented by the firms. The Nash equilibrium is seen where both firms are making outputs that maximize their specific outputs.

Under this condition, property two is satisfied since none of the firms are incentivized to deviate from the Nash equilibrium, considering the other firm's output. And since the payoff function keeps the market price consistent with supply outputs, and revenues from both firms are equal, property two is also achieved. In terms of property three, Cournot suggested that it was stable, considering the use of the concept, as shown by best response variations. Each firm comes out with a reaction on a given output of the other firm. Hence, this is downward in sloping, whereby the best response would be to give out less when the other firm’s output is more. And the best response dynamic means the companies have to begin from a certain position before adjusting their output to meet the new demand. But this is just a stability story that has attracted so much criticism.

Author: James Hamilton