Equilibrium is the state in which market supply and demand balance each other, and as a result prices become stable. Generally, an over-supply of goods or services causes prices to go down, which results in higher demand—while an under-supply or shortage causes prices to go up resulting in less demand. The balancing effect of supply and demand results in a state of equilibrium.
The equilibrium price is where the supply of goods matches demand. When a major index experiences a period of consolidation or sideways momentum, it can be said that the forces of supply and demand are relatively equal and the market is in a state of equilibrium. Economists find that prices tend to fluctuate around the equilibrium levels. If the price rises too high, market forces will incentivize sellers to come in and produce more. If the price is too low, additional buyers will bid up the price. These activities keep the equilibrium level in relative balance over time. Economists like Adam Smith believed that a free market would trend towards equilibrium. For example, a dearth of any one good would create a higher price generally, which would reduce demand, leading to an increase in supply provided the right incentive. The same would occur in reverse order provided there was excess in any one market. Modern economists point out that cartels or monopolistic companies can artificially hold prices higher and keep them there in order to reap higher profits. The diamond industry is a classic example of a market where demand is high, but supply is made artificially scarce by companies selling fewer diamonds in order to keep prices high. As noted by Paul Samuelson in his 1983 work Foundations of Economic Analysis, the term equilibrium with respect to a market is not necessarily a good thing from a normative perspective, and making that value judgment could be a misstep. Markets can be in equilibrium, but it may not mean that all is well. For example, the food markets in Ireland were at equilibrium during the great potato famine in the mid-1800s. Higher profits from selling to the British made it so the Irish and British market was at an equilibrium price that was higher than what consumers could pay, and consequently many people starved. When markets aren't in a state of equilibrium, they are said to be in disequilibrium. Disequilibrium can happen in a flash in a more stable market or can be a systematic characteristic of certain markets. At times disequilibrium can spill over from one market to another—for instance, if there aren’t enough transport companies or resources available to ship coffee internationally then the coffee supply for certain regions could be reduced, affecting the equilibrium of coffee markets. Economists view many labor markets as being in disequilibrium due to how legislation and public policy protect people and their jobs, or the amount they are compensated for their labor. Economic equilibrium refers broadly to any state in the economy where forces are balanced. This can be related to prices in a market where supply is equal to demand, but can also represent the level of employment, interest rates, and so on. The process by which equilibrium prices are reached is through a process of competition. Among sellers to be the low-cost producer to grab the largest market share, and also among buyers to snatch up the best deals. General equilibrium considers the aggregation of forces occurring at the macro-economic level, and not the micro forces of individual markets. It is a cornerstone of Walrasian economics.
Economists have found that there is a level of persistent unemployment that is observed when there is general equilibrium in an economy. This is known as underemployment equilibrium, and is predicted by Keynesian economic theory. Lindahl equilibrium is a special case where, in theory, the optimal amount of public goods is produced and the cost of public goods is fairly shared among everyone. It describes an ideal state rarely, if ever, achieved in reality, but is used to help craft tax policy and is an important concept in welfare economics. Because prices may swing above or below the equilibrium level due to proximate changes in supply or demand at a given moment, it is best to look at this effect over time, known as intertemporal equilibrium. The concept is also used in understanding how firms and households budget and smooth spending over longer time horizons. In game theory, Nash equilibrium is a state of play whereby the optimal strategy involves considering the optimal strategy of the other player or opponent.
The prisoner's dilemma is a common situation in game theory that exemplifies the Nash equilibrium. A store manufactures 1,000 spinning tops and retails them at $10 per piece. But no one is willing to buy them at that price. To pump up demand, the store reduces its price to $8. There are 250 buyers at that price point. In response, the store further slashes the retail cost to $5 and garners five hundred buyers in total. Upon further reduction of the price to $2, one thousand buyers of the spinning top materialize. At this price point, supply equals demand. Hence $2 is the equilibrium price for the spinning tops.
When a market is in equilibrium, prices reflect an exact balance between buyers (demand) and sellers (supply). While elegant in theory, markets are rarely in equilibrium at a given moment. Rather, equilibrium should be thought of as a long-term average level.
The amount supplied that exactly equals demand is the equilibrium quantity. In such a case, there will neither be an oversupply nor a shortage.
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Which of the following best describes a market in equilibrium?
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