Economic equilibrium

Economic equilibrium is a state of balance in an economy. It occurs when the forces of supply and demand are perfectly matched. In this state, economic variables like price and quantity stop changing. This balance is often called the market clearing price. At this price, the amount of goods sellers provide equals the amount buyers want. This concept was borrowed from the physical sciences. In physics, a system is in equilibrium when physical forces are balanced. In economics, this means no further changes happen unless something external shifts the market.

To understand how this works, we can look at three specific properties. Economist Huw Dixon proposed these three rules to describe equilibrium. The first property, P1, is consistency. This means the behavior of all agents in the market is consistent with the price. The second property, P2, is incentive. This means no single person or company has a reason to change their strategy. If they tried to change, they would not improve their own situation. The third property, P3, is stability. This means the equilibrium is the result of a dynamic process that brings the market back to balance.

In a competitive equilibrium, these properties work together. At the equilibrium price, the quantity supplied equals the quantity demanded. Buyers choose amounts to maximize their utility, which is their satisfaction. Sellers choose amounts to maximize their profits. Because both sides are satisfied, no one has an incentive to change. We can see stability by looking at what happens when the price is wrong. If the price is too high, there is an excess supply. This extra stock puts downward pressure on the price. If the price is too low, a shortage occurs. This shortage pushes the price back up toward the equilibrium.

Not all markets behave this way, such as in a monopoly. A monopoly is when one company controls the entire market. In this case, the company sets its production where marginal revenue equals marginal cost. Marginal revenue is the extra money earned from selling one more unit. Marginal cost is the extra cost of producing that unit. In a monopoly, the equilibrium does not satisfy property P1. This is because the amount demanded by consumers is not equal to the amount supplied by the firm. Consumers actually have an incentive to demand more at the market price. However, the monopolist has no incentive to change because they are already maximizing profit.

Another important type of balance is the Nash equilibrium. This concept is used when companies must think about each other's moves. It was first used by Antoine Augustin Cournot in his 1838 book. He studied a Cournot duopoly, where two firms compete in the same market. In this model, each firm chooses its output based on what the other firm does. This is called strategic interdependence. The Nash equilibrium occurs when both firms choose the best possible output for themselves, given the output of their competitor.

Finding the exact equilibrium price requires specific mathematical tools. Economists often plot supply and demand curves on a graph. The point where these two lines intersect is the equilibrium.

At this intersection, the quantity demanded and the quantity supplied are identical. If the price moves away from this point, the market forces of surplus or shortage will pull it back. This automatic correction is a key difference between free markets and central planning. In central planning, governments try to set prices, which often leads to persistent shortages.

It is vital to remember that equilibrium does not always mean a situation is fair. Economists like Paul Samuelson warn that a market can be in balance even during a crisis. A famous and tragic example is the Great Famine in Ireland from 1845 to 1852. During this time, food was exported to England because it was more profitable. The equilibrium price for potatoes was high enough for profit, but too high for Irish farmers to afford. This meant the market was in a steady state, even though many people were starving. Equilibrium describes how a system balances, not how a system treats people.