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Equilibrium Price Definition – What Does Equilibrium Price Mean?

What Is Equilibrium Price?

Equilibrium PriceEquilibrium is the state in which market supply and demand balance each other. As a result, prices become stable.  The equilibrium price is that stable price which, if attained in the market, will be maintained.  At least until some disturbing factor causes a change in demand or supply conditions. Generally, an over-supply of goods or services causes prices to go down.  This results in higher demand.  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 and stable equilibrium price.

A market is said to have reached an equilibrium price when the supply of goods matches demand and a stable price is achieved. A market in equilibrium demonstrates three characteristics.  The behavior of agents is consistent.  There are no incentives for agents to change behavior.  And, a dynamic process governs the equilibrium outcome. Disequilibrium is the opposite of equilibrium.  It is characterized by volatility and changes in conditions that affect market equilibrium and prices.

Equilibrium Price – A Deeper Look

The equilibrium price is where the supply of goods matches demand and a stable price is achieved. 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 like Adam Smith believed that a free market would tend towards equilibrium. For example, a shortage of any single good would create a higher price generally.  This 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.  They can 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.  Unfortunately, that was higher than what consumers could pay.  Consequently, many people starved.

(Source: investopedia.com)

Equilibrium Price vs Equilibrium Quantity

The equilibrium price is the only price where the desires of consumers and the desires of producers agree. It is where the amount of the product that consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). This mutually desired amount is called the equilibrium quantity. At any other price, the quantity demanded does not equal the quantity supplied.  As a result, the market is not in equilibrium at any other.

Example of Equilibrium Price and Quantity

Suppose your business manufactures 5,000 silk ties and sells them at $10 per item. However, no one is willing to buy them at this price. So, you reduce the price to $9 to generate demand. At this price point, you attract 2,500 buyers. This is still not enough, so the business slashes the price further to $7 and yields a total of 4,000 buyers.

It’s only when you reduce the price to $5 per piece that 5,000 orders for the widgets materialize. At the $5 price point, equilibrium price and equilibrium quantity are identical – simply, supply equals demand. This means that $5 is the equilibrium price for the silk ties.

The only stable price is the equilibrium price

If the price is not at equilibrium, the actions of buyers and sellers will push the price back towards equilibrium.  Changes in the determinants of supply and demand result in a new equilibrium price and quantity. When there is a change in supply or demand, the old price will no longer be in equilibrium. Instead, there will be a shortage or surplus, and the price will subsequently adjust until there is a new equilibrium.

Equilibrium vs. Disequilibrium

When markets aren’t in a state of equilibrium, they are said to be in disequilibrium. Disequilibrium can happen quickly even in a stable market.  Or, it can be an ongoing, systematic characteristic of certain other markets. At times disequilibrium can spillover from one market to another.  For example, 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.  This may be due to how legislation and public policy protect people and their jobs.  Or, it may be due to the amount they are compensated for their labor.

Whenever markets experience imbalances, market forces drive prices toward equilibrium. A surplus exists when the price is above equilibrium, which encourages sellers to lower their prices to eliminate the surplus. A shortage will exist at any price below equilibrium, which leads to the price of the good increasing.

Changes in Equilibrium 

For example, imagine the oil price is $50 per barrel, but the equilibrium price is $30 per barrel, what happens? Well, the quantity demanded is lower than the quantity supplied and there’s a surplus. Sellers can’t sell as much as they’d like at $50 per barrel, so they lower the price. As the price goes down, demand goes up. Eventually, the price reaches equilibrium and the quantity demanded equals the quantity supplied.  However, when the price of oil is too low, the quantity demanded can be higher than the quantity supplied.  In that case, there can be a shortage. The correction process works much the same way. Buyers compete by bidding up the price so that they can get more oil. Sellers have an incentive to raise the price so that, once again, price and quantity reaches equilibrium.

Equilibrium Price and Economic Efficiency

Equilibrium is important to create both a balanced market and an efficient market. If a market is at its equilibrium price and quantity, then it has no reason to move away from that point.  That’s because it’s balancing the quantity supplied and the quantity demanded. However, if a market is not at equilibrium, then economic pressures come into play.  They move the market up or down as required toward the equilibrium price and equilibrium quantity. This happens either because there is more supply than what the market is demanding or because there is more demand than the market is supplying. This balance is a natural function of a free-market economy.

Also, a competitive market that is operating at equilibrium is an efficient market. Economists typically say a market is efficient when it is impossible to improve the situation of one party without imposing a cost on another. Conversely, if a situation is inefficient, it becomes possible to benefit at least one party without imposing costs on others.

Up Next: Day Trading For Beginners – What Is A Day Trader

Day trading can be summarized simply as buying security.  Then, quickly selling or closing out the position within a single trading day.  Ideally, a day trader wants to “cash-out” by the end of each day with no open positions to avoid the risk of losses by holding security overnight.  Day trading is not for everyone and carries significant risks. It requires an in-depth understanding of how the markets work and various strategies for profiting in the short term.  Short term profits require a very different approach compared to traditional long term, buy and hold investment strategies.

 

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