Lesson 1, Topic 1
In Progress

Concepts of Equilibrium and Disequilibrium


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The word equilibrium means at rest. Equilibrium in the market is the combination of price and quantity from which there is no tendency for buyers or sellers to move away. In a graphical representation, equilibrium means the intersection point of the supply and the demand curves.

Equilibrium Price or Market Clearing Price is the price at which the quantity demanded of a good equals the quantity supplied.

Equilibrium Quantity is the quantity that corresponds to the equilibrium price. This is the quantity at which the amount of the good that buyers are willing and able to buy equals the amount that sellers are willing and able to sell, and both equal the amount actually bought and sold.

Demand & Supply of Compact Discs – P* is the equilibrium price and Q* is the equilibrium quantity

Disequilibirum in the market arises at any price at which the quantity demanded is not equalto the quantity supplied. In other words, this is a situation of either a surplus or shortage in the market.

If the quantity supplied is greater than the quantity demanded, it is termed as a surplus or excess supply.

If the quantity demanded is greater than the quantity supplied, it is known as a shortage or

excess demand.

What happens when there is a shortage or a surplus?

The situation of surplus

When we look at this diagram, we can see that there is a surplus at a price of $15: the quantity supplied is 150 units where as the quantity demanded is 50 units. Suppliers will not be able to sell all they had hoped to sell at $15. As a result their stock of goods will grow above the level they usually hold in preparation for the demand changes. If the sellers want to reduce this stockpile of goods, either they have to reduce the price or cut back on production or they could do both. Therefore there will be a tendency for price and the output to fall until the equilibrium is achieved. This is shown in the diagram with the downwardarrows.

The situation of shortage

At the price of $5, there is a shortage. Quantity demanded is greater than the quantity supplied. Buyers will not be able to buy all that they hoped to buy at $5. Some buyers will offer to buy at higher prices so that the sellers would sell to them rather than to the other buyers. When the sellers realize this, they will raise the prices to get more profit, and also they will try to increase output since it is profitable to do so. This tendency for the price and output to increase will continue until the equilibrium is achieved.

Difference between Equilibrium and Disequilibrium

The upcoming discussion will update you about the difference between equilibrium and disequilibrium in micro and macro economics.

Equilibrium and its absence, disequilibrium, are concepts familiar in some degree to all students, from their study of economics or of other social or physical sciences.

The definition of equilibrium in the physical sciences as a state of balance between opposing forces or action applies without modification in the field of economic theory.

Disequilibrium in turn simply becomes the absence of a stale of balance—a state in which opposing forces produce imbalance.

In economics we are continuously dealing with variables whose values change over time, therefore, the state of balance that defines equilibrium may perhaps be better expressed as a state of no change over time. This is not to say that economic equilibrium is a motionless state in which no action takes place; rather, it is a state in which there is action, but action of a repetitive nature.

Each time period exactly duplicates the preceding time period. This state of equilibrium is maintained, even though the forces acting on the system are in a continuous state of change, as long as the net effect of these changing forces does not disturb the established position of equilibrium.

Let us turn for a moment to micro-economic theory and consider the ordinary supply and demand analysis of price determination for a single commodity in which quantity suppliedvaries

directly with price and quantity demanded varies inversely with price. In figure 8.1 supply (S), and demand (D), are in equilibrium only at a price of OP and a quantity of OA. At any price higher or lower than OP, there is disequilibrium.

At any price above OP the quantity supplied will exceed the quantity demanded, and at any price below OP the quantity demanded will exceed the quantity supplied. In this particular model, in the event of disequilibrium, the forces are such as to move price back to the equilibrium level of OP and quantity back to the equilibrium level of OA.

Throughout this discussion it is assumed for simplicity that the particular equilibrium indicated by any pair of supply and demand curves will be attained as long as those curves remain unchanged for whatever time period is required for the adjustment process to work itself out.

Actually, the mere fact that such an equilibrium exists does not necessarily mean that the system will move to it even over time. What happens depends on the nature of the dynamic process by which the system adjusts to disequilibrium, and this process is not necessarily one that carries the system to the equilibrium position.

Supply and demand are functions that indicate the different quantities of a commodity that will be supplied and demanded at various prices for a particular time period. As flow variables, supply and demand may be expressed in terms of quantity per minute, hour, day, week, or any other timeperiod.

If supply and demand in each time period is the same as in the preceding time period, the equilibrium quantity of the commodity purchased or sold will be OA and the equilibrium price will be OP, one time period after the other.

The market is in balance, but it is not motionless, because sellers continually bring more of the commodity to market and buyers continually take more of it away. In other words, the market is in equilibrium; there is no change in the magnitude of the price and quantity variables.

Over time, of course, changes in supply and demand take place. Depending on the direction and the magnitude of the changes in supply or demand or both, equilibrium price and quantity may increase or decrease, with price and quantity changing in opposite directions or in the same direction.

S’ and D’ in figure illustrate this last possibility. The new equilibrium price becomes OP’, and the new equilibrium quantity becomes OP’. As long as a supply curve sloping upward to the right intersects a demand curve sloping downward to the right, any possible change in supply and demand will define a new equilibrium price and a new equilibrium quantity at the point of intersection of the twocurves.

In practice, the new equilibrium price and quantity are not instantaneously established. The process takes time, and during this time price and quantity are changing, and the market is by definition in disequilibrium. If the changes in supply and demand are frequent, sizeable, or erratic, equilibrium may never be established.

Before the market can reach that price-quantity combination that represents equilibrium for one set of supply and demand conditions, the supply and demand conditions change. In such a situation, the market is constantly moving toward equilibrium, but equilibrium always recedes before it can be reached.

However, even for markets in continuous disequilibrium, the concept of equilibrium is a valuable analytic tool. If at any point in time an equilibrium position exists, this at least tells us which way the system is going to move next, even though we know that before the system gets to the equilibrium position toward which it is momentarily headed, it will be detoured by a change in the forces that change the equilibrium position.

Figure was chosen to illustrate the concept of equilibrium because it is the simplest possible micro-economic model of a system with an equilibrium solution. This model contains only three variables quantity of the commodity supplied, quantity of the commodity demanded, and price of the commodity and only three relationships among these variables.

Two are functional relationships: Quantity demanded is an inverse function of price, and quantity supplied is a direct function of price.

The third relationship specifies the condition necessary for equilibrium: The quantity that suppliers wish to sell must be equal to the quantity that demanders wish to purchase, or, in brief, supply must equal demand.

All the variables that cause shifts in the supply and demand curves such as buyers’ incomes and tastes, the prices of other commodities, and the prices of inputs used in producing the commodity are assumed to remain temporarily unchanged in order to focus attention on the way in which the equilibrium price is determined under given conditions of supply and demand.

Although the model for a single commodity is the more familiar, there is a macroeconomic modelthatparallelsthemicro-economicone.Themicroeconomicmodelcoversjustoneofthe

many thousands of different goods and services supplied and demanded in markets; the macro- economic model covers all of these goods and services at once.

Therefore, in the macro-economic model of Figure 8.2, the amounts measured along the horizontal axis are different aggregate quantities of goods and services.

Because each of the many goods and services in such an aggregate has its own price, what is measured along the vertical axis must correspondingly be the price level or an approximately weighted average of the prices of all the goods and services whose combined quantity is measured along the horizontal axis.

Because Figure 8.2 shows for the aggregate of goods and services what Figure 8.1 shows for any single good or service, it is appropriate to designate the curves in figure 8.2 also as supply and demand curves, but to distinguish their much broader content from that of the curves in Figure

8.1 by affixing an adjective, aggregate supply (AS) and aggregate demand (AD).

In microeconomics, any reference to the demand for a good or service immediately suggests a curve like the sloping D curve in Figure 8.1.

However, in macroeconomics, reference to aggregate demand may suggest a curve like the falling AD curve in Figure 8.2 which relates the aggregate quantity of all goods and services demanded to the price level of all goods and services, or it may suggest a quite different functional relationship, namely, that between the aggregate quantity of all goods and services which all buyers seek to purchase and the aggregate income of allbuyers.

To avoid the possible confusion that results from attaching the same name to quite different relationships or curves, in this text we will use the concept of aggregate demand to describe only the kind of relationship shown in figure 8.2 – we will adopt other terminology to cover the other kind of relationship.

Such a distinction has the added advantage of giving the same meaning to the concept of demand whether we are working in microeconomics or macroeconomics.

Paralleling the meaning of the intersection between the D and S curves for a single commodity in figure 8.1, the intersection of the AD and AS curves in figure 8.2 indicates the price level at which the aggregate quantities of goods and services supplied and demanded are equal.

As in the case of a single commodity, at any price level higher or lower than that indicated by this intersection, there is disequilibrium. At a higher price level, the aggregate quantity supplied will exceed the aggregate quantity demanded and the price level will tend to fall to achieve equilibrium; at a lower price level, the opposite will be found and the price level will tend to rise to achieveequilibrium.

If the price level is higher or lower than that required for equilibrium, obviously the prices of some individual goods and services will have to change in the process of attaining aggregate equilibrium. Less obviously, the prices of some individual goods and services may also change while the equilibrium price level and quantity remain unchanged at the levels indicated by the intersection of the given aggregate supply and demand curves.

That is, because shifts may occur in the individual supply and demand curves, changes may also occur in the equilibrium price, equilibrium quantity, or in both for individual goods and services without the occurrence of any shift in the aggregate supply or aggregate demand curve.

In this case, the shifts in the curves for particular goods are such that the increase in the equilibrium quantity of some goods is just matched by the decrease in the equilibrium quantity of others, and the rise in the equilibrium price for some goods is just matched by the decrease in the equilibrium price for others.

In other words, there may be offsetting shifts in the supply and demand curves for individual commodities that leave the aggregate supply and aggregate demand curves unchanged. There is, however, no need for the changes to be offsetting in this way. On balance, shifts in the demand curves for some individual items may produce some shift in the aggregate demand curve.

Similarly, shifts in the supply curves of some items may produce some shift in the aggregate supply curve. Therefore, the combination of price level and aggregate quantity which identifies an initial macroeconomic equilibrium can be displaced by shifts in supply and demand curves for some individual goods and services.

The idea of macroeconomic equilibrium may also be illustrated in a different way. Suppose water flowed into a reservoir at a rate of 100,000 gallons per day and out of the reservoir at a rate of 90,000 gallons per day. These flows would be described as equilibrium flows as long as they did not vary in size from day to day or over the period of time consideredrelevant.

This produces flow equilibrium, but it necessarily also produces a disequilibrium in the stock of water. If the stock of water were measured at the same point in time each day, the gauge would show that the stock was growing by 10,000 gallons each day.

Because the stock is changing, there is stock disequilibrium; because the flows are constant, there is flow equilibrium. Stock disequilibrium is therefore logically consistent with flow equilibrium. Over time, however, a sufficient change in stock will begin to affect the previously constant flows. Unless the stock of water is permitted to overflow the banks of the reservoir, there must be a change in the inflow (from 100,000 to 90,000 gallons per day), in the outflow (from 90,000 to 100,000 gallons per day), or in both (to 95,000 gallons per day). If changes of this sort are made in the size of the flows, the system will be one in which both flows and stocks are inequilibrium.

An analogous situation is found in the flow of investment (capital goods produced), the flow of capital goods consumed, and the stock of capital goods. Gross investment at a constant rate of Rs. 95 billion per year and capital consumption at a constant rate of Rs. 55 billion per year defines a flow equilibrium. These flows also define a stock disequilibrium in which the stock of capital increases every year by the amount of Rs. 40billion.

This is one indication that this is a “growing” economy if we measure economic “growth” by the accumulation of capital. In contrast, an economy exhibiting equilibrium in both flows and stock, with, say, gross investment of Rs. 55 billion and capital consumption of Rs. 55 billion per year, is a “stationary” economy if we define a “stationary” economy as one whose stock of capital neither increases nor decreases overtime.

Flow equilibrium may therefore be described as short-run equilibrium, and both flow and stock equilibrium may be described as long-run equilibrium. Because stock equilibrium cannot exist without flow equilibrium, long-run equilibrium cannot exist without short-run equilibrium.

In short-run equilibrium, we disregard the dis-equilibrating effects that flows produce on stocks and consider only the conditions necessary to achieve flow equilibrium ; in long-run equilibrium, however, the counter effects produced on flows by disequilibrium in stocks must be recognized, and conditions for full equilibrium encompass those necessary for both flow and stock equilibrium.

An economic theory or model abstracts from the infinite complexity of the real world by establishing what are believed to be the significant relationships among a limited number of variables deemed relevant to the problem at hand. The concept of equilibrium is a valuable tool of theory because it identifies a position in which the values of the model’s variables are in balance.

This helps simplify the complexity of the real world, where these same variables may actually be in continuous short-and long-run disequilibrium. Disequilibrium is also a valuable tool of theory, but in a different sense: By simplifying less, it more closely approximates economic reality.

In fact, it may be said that short-run equilibrium analysis is a maximum in simplification and long-run disequilibrium analysis is a minimum in simplification. The more difficult branch of macroeconomic theory is therefore that which deals with systems in long- run disequilibrium by admitting into the analysis continuing changes in both flows and stocks.

ACTIVITY 8.1

  1. Define National Income.
  2. What is equilibrium? Show demand and supply axis to explainequilibrium.
  3. What happens when there is a shortage or asurplus?
  4. State the differences between equilibrium anddisequilibrium.