What two conditions can lead to disequilibrium in a free market?

A state within a market-based economy in which the economic forces of supply and demand are unbalanced

Disequilibrium is a state within a market-based economy in which the economic forces of supply and demand are unbalanced. It is a state where internal or external forces prevent the market from reaching equilibrium, and the market falls out of balance over time. Disequilibrium can be caused by short-term changes in economic variables or due to long-term structural imbalances.

How It Works

To better understand disequilibrium, it would be beneficial to grasp the state of economic equilibrium first. Economic equilibrium refers to when economic variables are in their natural state, without the impact of external influences. It is also known as market equilibrium.

Equilibrium is achieved when market forces are balanced. A common example is when the supply forces and demand forces for a product reaches a stable point, and the indicator of such stability is a consistent price.

If prices become too high, the demand for a product or service will decline to the point that suppliers will need to reduce the price. Conversely, if prices are too low, the demand for a product or service will increase to the point that suppliers will either raise prices or produce more. In practice, economic equilibrium is only a theory. The market forces are always evolving and dynamically changing so that the market never truly reaches an equilibrium.

The earlier instances where the price becomes too high or too low are examples of disequilibrium. Therefore, a simple way to explain disequilibrium is that it is a market where supply does not match demand, causing an imbalance. In theory, eventually, the markets would find a new economic equilibrium when the market forces rebalance.

Causes of Disequilibrium

In a perfectly efficient market, the market would always remain in economic equilibrium; however, no market in the real world can operate with full efficiency. Various external factors and variables cause the markets to become imbalanced. The external forces may tip either the demand, supply, or both sides of the markets out of their natural state.

Some causes of disequilibrium include:

• Fixed prices
• Government intervention
  • Tariffs and quotas
  • Minimum wage
• Current account deficit/surplus
• Pegged currencies
• Inflation or deflation
• Changing foreign exchange reserves
• Population growth
• Political instability

Practical Example

Disequilibrium can be observed more clearly with commodities since there is an active market of relatively homogenous products. Oil is one of the most widely used commodities as an energy source and as an input to various other manufactured goods, and therefore, it has an active market and real-time pricing.

In early 2020, the Russia-Saudi Arabia oil price war and the Covid-19 pandemic caused a significant disequilibrium for oil prices. The disequilibrium was caused by both supply and demand shocks. On the supply side, Saudi Arabia launched a price war with Russia in which they flooded the global market with a greater supply of oil in order to dramatically decrease the price of oil and put pressure on U.S. shale producers.

On the demand side, the Covid-19 pandemic resulted in quarantine restrictions across the world. Most populations stayed indoors, resulting in a halt in commuting and traveling, which further caused a large downward pressure on oil prices.

It culminated in a historic moment on April 20, 2020, in which the price for WTI oil futures became negative for the first time in recorded history. Essentially, holders of the futures contracts were paying others to take delivery of the oil since the price of the oil decreased so dramatically that the holders of the contracts would rather pay someone else to take delivery. It was because the storage costs were higher than the value of the oil itself, and storage capacity in pipelines were reaching their limits.

It is a clear example of disequilibrium within a market, in which external forces cause supply and demand to shift so dramatically that prices are dislocated.

Resolution of Disequilibrium

As mentioned earlier, disequilibrium ultimately stems from an imbalance between the market forces of supply and demand. It can be resolved either by allowing market forces to redistribute themselves into a new equilibrium or through government intervention.

The two resolutions stem from two different economic theories:

1. Laissez-faire economics
2. Keynesian economics

Laissez-faire economics is rooted in the belief that there should be as minimal government intervention as possible and that the economy will perform better and more efficiently if left alone.

Keynesian economics argues that governments should participate in fiscal activities, such as increasing spending and lowering taxes when there is a recession to artificially stimulate the economy instead of letting a recession play out.

Most modern governments are proponents of Keynesian economics since it results in less time spent in economic recessions and more time spent in economic expansions, which is beneficial for all market participants.

Related Readings

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