Economic Equilibrium

A state in a market-based economy in which economic forces – such as supply and demand – are balanced

What is Economic Equilibrium?

Economic equilibrium is a state in a market-based economy in which economic forces – such as supply and demand – are balanced. Economic variables in their equilibrium are in their natural state without the impact of external influences.

 

 

Understanding Economic Equilibrium

Economic equilibrium is the result of opposing economic variables towards their natural state.

In economics – which is the study of economies or the methods and organization of the production, distribution, and consumption of goods and services – the market-based economy is one in which the forces of supply and demand determine where capital is allocated as well as general consumption behaviors.

In modern society, almost every economy is structured as a market-based economy because it is much more efficient than any other form of economic structure. The efficiency of the forces of supply and demand is that capital is allocated effectively without any external organization.

Economic equilibrium is the state in which the market forces are balanced, where the current prices stabilize between even supply and demand.

Prices are the indicator of where the economic equilibrium is. If prices are too high, the quantity of a product or service demanded will decrease to the point that suppliers will need to lower the price.

On the other hand, if prices are too low, the quantity of a certain product or service demanded will increase to the point that suppliers will either produce more or raise the price.

Economic equilibrium is actually only a theory. The markets are always evolving and are so dynamic that the market never truly reaches an equilibrium.

 

Example of the Efficiency of the Market-Based Economy

Consider a small town with one farm that grows all the food to feed the townspeople. How will the food be distributed? In a centralized economy, the food will be given to one person or entity who decides where the food will be allocated.

However, the process may take a lot of time and effort, and it may not allocate the food effectively. What if someone is allergic to peanuts, yet they are allocated peanuts by the central planner? It is difficult to keep track of every preference and allergy of the townspeople.

Another way of distributing food is with the institution of a market. People can trade items for food, and they can meet their own preferences. Food in high demand will end up being priced higher, and the farmers will know which food to grow more of. It is a simple example, but it demonstrates the effectiveness of the market-based economy.

 

Types of Economic Equilibrium

As defined in microeconomics – which studies economies at the level of individuals and companies – economic equilibrium is the price in which supply equals demand for a product or service.

It is commonly understood as the most common form of economic equilibrium. It is where the supply and demand curves on a price-quantity graph intersect as shown below:

 

Economic Equilibrium

 

There is a supply curve and demand curve. The supply curve goes up as price and quantity increase. Since there is a higher price, more goods and services are willing to be supplied.

On the other hand, the demand curve goes down as price and quantity increase. It is because when there is a higher price, fewer goods and services are demanded. It applies to most normal goods, such as food, clothing, electronics, etc.

It can also be seen that there are certain price and quantity levels in which the graphs intersect. That point represents the economic equilibrium.

In macroeconomics – the study of the overall economy as opposed to individuals and companies – the equilibrium can be represented in different forms. There is an equilibrium for the money supply, aggregate demand/supply, interest rates, inflation rates, production, etc.

 

Equilibrium vs. Disequilibrium

The state of equilibrium is a theoretical concept. There are always movements happening that do not allow the economy to reach a sedentary position.

When the economy is not in a state of equilibrium, it is known as disequilibrium. Realistically, we are always in a state of disequilibrium that is trending towards a theoretical equilibrium. However, there may be certain situations where disequilibrium becomes more pronounced.

For example, protectionist laws by a country, which enact tariffs and quotas, put the international markets in prolonged disequilibrium since the demand for certain products is capped.

 

Related Readings

CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Supply and Demand
  • Microeconomics
  • Market Economy
  • Demand Curve

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