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# Economic equilibrium

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 textbook model of perfect competition, equilibrium occurs at the point at which quantity demanded and quantity supplied are equal.[1] 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 the quantity is called the "competitive quantity" or market clearing quantity. However, the concept of equilibrium in economics also applies to imperfectly competitive markets, where it takes the form of a Nash equilibrium.

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• ✪ Market equilibrium | Supply, demand, and market equilibrium | Microeconomics | Khan Academy
• ✪ The Equilibrium Price and Quantity
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• ✪ Microeconomics Practice Problem - Economic Equilibrium and Demand and Supply Schedules
• ✪ Short run and long run equilibrium and the business cycle | AP Macroeconomics | Khan Academy

So, let's say we are in the apple market. What I want to do in this video is think about both demand and supply for the apples at different prices. Let's draw ourselves a little graph here. We already know this right over here, the vertical axis is the price axis, and this we're going to say is price per pound. The horizontal axis this is the quantity. The quantity of apples. Let's put some tick marks here. Let's say that's $1 a pound,$2 a pound, $3 a pound,$4 a pound, and $5, and let's say this is thousands of pounds produce and we have to set a period. Let's say this is for the next week, and so this is 1000 pounds, 2000, 3000, 4000, and 5000. Now, let's think about both the supply and the demand curves for this market, or potential supply and demand curves. First I will do the demand. If the price of apples were really high, and I encourage you to always think about this when you are about to draw your demand and supply curves. If the price of apples were really high, what would happen to consumers? Well, they wouldn't demand much. The quantity demanded would be low. If the price were high, maybe the quantity demanded is like 500 apples. And once again I am being very careful to say the quantity demanded is 500 apples. I'm not saying the demand is 500 apples. The demand is the entire relationship. The actual specific quantity, we call that the quantity demanded. The price of$5 of quantity demanded would be about 500. Maybe at a price of $1, the quantity demanded would be maybe 4000 pounds. Our demand curve might look something like this. Might look something like that. Let me draw it a little bit less bumpy. So, our demand curve might look something like that. I can label it. That is our demand curve. I'll think about our supply curve. Well, there some price below which we aren't even willing to produce apples. Let's say that's like 50 cents. So at 50 cents that's where were even just willing to start producing apples. Let's say if apples ... if the price of apple got to a dollar where the quantity we've be willing to supply is about a 1000 pounds, and it just keeps increasing as the price increases. So this is the supply curve, and when I talk about we, I'm talking about all the suppliers in this market. We could be doing this for a specific supplier. We could be doing this for a specific market. We could be doing for the global apple market. However, you want to view it, but for the sake of this video let's just assume its like our little town that is fairly isolated and all of that. Let's think about what happens in different scenarios. What happens if the suppliers of the apples going into that week for their own planning purposes ... They just think for whatever reason, that their only going to be able to sell the apples at$1 per pound. Given the supply curve, they only supply 1000 pounds. This is what the suppliers plan for, and this is where they set the price point at $1. One dollar per pound. Now, what's going to happen in that scenario? Well in that scenario they supplied 1000. The quantity supplied is 1000 pounds. Let me write this down. So, I'll do it in pink for this scenario. So, this scenario the quantity supplied is 1000 pounds. What is the quantity demanded? Quantity demanded. This is all the scenario where the price ... the price or the initial price that the growers or producers set was$1 per pound. One dollar per pound. Well the quantity demanded at $1 per pound is 4000 pounds of apples. 4000 pound of apples. What do we have here? Well, here we have a shortage. We have a shortage of 3000 apples at that price point. At a dollar, a lot more people are going to want to buy apples, and the producers just didn't ... I guess they didn't figure that out right. They didn't produce enough apples. Now what will naturally start happening? If you have the shortage ... you have all these people who want to buy apples, and you only have so many apples there, what might happen in the next period in the next week? Well, first of all, those apples that are out there they might get bid up, so, the prices start going to start going up. The prices are going to start going up. People are going to start bidding up the apples. They want them so badly. Their going to start bidding them up, and as they start getting bid up, the producers are going to say, "Wow! There's so many people are running out of apples. We also need to increase the quantity produce." The quantity will also go up. The price will go up. If you look at from the suppliers point of view. The price will go up, and the quantity will go up. They will move along this line there. So maybe in the next period there's less of a shortage, or they move away from that shortage situation. If the price and quantity increase a little bit, so maybe the price goes to$2, and the quantity goes to ... I don't know, this looks like about 1900 ... 1900 pounds, now all of a sudden you have less of a shortage. I think you see that I'm getting to an interesting point over here. I won't go there just yet. I won't go there just yet. Let's think about another situation. Let's think about after this happens. Price and quantity increases so much that essentially overshoots this interesting point right over here. So in the next week the suppliers they'll say, "Wow! People want our apples so badly, let's set the price really high at $3, and at$3 we're really excited about producing apples." So, we the suppliers are going to produce ... let me do this in a color I haven't used yet. We the suppliers are going to produce at $3 a pound. We are hoping to sell 3000 pounds of apples. This is where, maybe, they adjust to the next week. What's going to happen there at a price of$3. That's the scenario right over here. The price of $3. So, the price is now$3 per pound. Well, now the quantity supplied is going to be 3000 pounds. I could write 3000 pounds. What is the quantity demanded? The quantity demanded is now much lower. The price is high now, because the consumers might want to go buy other things, or they can't afford an apple, or whatever it might be. Now the quantity demanded, now that's looks like about 1300. 1300 pounds. What situation do we have now? Well, now we have a much bigger supply then ... or the quantity supply is much bigger than the quantity demanded. Now we face a surplus. So, now we have a surplus. Let me draw that line there. I want to make it clear this is all the same scenario. We now have a surplus of ... what is this? 700 will get us to 2000. We have a surplus of 1700 pounds of apples. Now what happens in a surplus situation? Well, apples won't stay good forever, so maybe the producers get a little desperate. They start selling. They start reducing the price, maybe to start attracting some consumers. They start reducing the price. When they start seeing that the prices are going down, and you have this glut of apples, there're all going bad and not getting sold, the quantity is also going to start going down. They'll produce fewer and fewer apples, so we'll move here along the supply curve. As you decrease the price, what's going to happen to the demand curve? Well the demand is going to go up. Over here the prices was too high, so it's natural for the sellers to lower the price. When you lower the price it also reduces the quantity. We go this way. When you lower the price it increases demand. You go that way. If the price from the get-go were too low, then you have this huge shortage, things get bid up. The prices go up. As the price goes up, the suppliers want to produce more. They move up the curve. As the price goes up then the people will demand less. You see that's it's all converging on a point right over here where the two lines intersect. Let me do that in a ... its all converging right over there. That's the price at which the quantity supplied will equal the quantity demanded. We call this, which looks like for this scenario, maybe about $2.15. Let me just write it there$2.15. We call that the equilibrium price. Equilibrium price is 2.15 a pound. It's the price at which the quantity supplied is equal to the quantity demanded. This quantity supplied is equal to the quantity demanded. That's the equilibrium quantity. That right over here looks like it's right about ... I don't know ... 2200 pounds. 2200 pounds. Assuming that nothing else changes, this is a good scenario for both the consumers and the producers. They keep producing 2200. They charge this price, and everything's happy. All the apples get sold and none of them go bad. ## Contents ## Properties of equilibrium Three basic properties of equilibrium in general have been proposed by Huw Dixon.[2] 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 P<P0 • B – excess supply – when P>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 how you might get there. 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.[3] 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, your 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...".[4] 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,[5]:Ch.3,p.52 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.[6] ## 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.[7] 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: {\displaystyle {\begin{alignedat}{2}Q_{s}&=125+1.5\cdot P\\Q_{d}&=189-2.25\cdot P\\\\Q_{s}&=Q_{d}\\\\125+1.5\cdot P&=189-2.25\cdot P\\(1.5+2.25)\cdot P&=(189-125)\\P&={\frac {189-125}{1.5+2.25}}\\P&={\frac {64}{3.75}}\\P&=17.067\\\end{alignedat}}} 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.[8]

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.[9] 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.