What is Equilibrium?

Equilibrium is like warm water…

Imagine you have two buckets of water. In one, the temperature is hot, say 100 degrees Fahrenheit. In the other, the temperature is 40 degrees Fahrenheit. If you mix those buckets of water, some of the heat from the hot water moves to warm up the cold water. Once all of the hot water (buyers) and cold water (sellers) find each other, they reach a balance at some temperature (price) in the middle. What you end up with is a warm bucket of water at the equilibrium temperature.

In economics, equilibrium is the point at which market forces balance. The law of supply says that producers will bring more product to the market only if the price increases. At the same time, the law of demand states that consumers will increase their purchases if prices fall. Together, the law of supply and demand creates a market, which uses the price of a good to allocate a limited amount of products.

It might help to think of a seesaw on the playground. Imagine a buyer on one side and a seller on the other. If they weigh the same amount, the seesaw balances. Now, add another buyer to the left side. The seesaw is out of balance, pushing the buyer’s side down and lifting the sellers up. Or imagine the opposite. If there are more sellers than buyers, the seller’s side goes down, and the buyer’s side goes up. Only when there are equal weights on either side does the seesaw balance.

Having too many buyers has the same effect in the market. The buyers end up competing with each other, giving the seller more power. Consequently, the seller increases the price to encourage one of those buyers to leave. But if too many sellers are in the market, it lifts the consumers’ position. Consumers demand a lower price until one of the suppliers goes away. The market uses price changes to bring things back to balance.

The real world is a little more complicated than a seesaw, but the imagery works. Now, consider a broader market of millions of potential buyers and sellers. Assume the sellers have a total of 50,000 boxes of candy. They want to set a price that attracts exactly 50,000 sales. Say that a $5 price tag would only result in 30,000 transactions. That’s out of balance and they would have excess supply. Let’s say that a $2 price would have 70,000 customers ready to buy. That’s out of balance too, but now you have excess demand.

The equilibrium is the price that exactly balances the number of willing customers to the volume for sale. That means they don’t end up with any leftover inventory or customers who leave empty handed. In this example, we can assume that $3.50 is the price that exactly sells all 50,000 boxes. That’s the market equilibrium.

There are three ways to find the equilibrium price, depending on what information you have. First, if you have supply and demand curves for the same product, you can find the equilibrium graphically. Simply plot both curves on the same graph. The place they touch is the equilibrium. Likewise, if you have the equations that form those curves, you can set them equal to each other and find the equilibrium using algebra.

Second, if you have data, you can use statistical analysis and business calculus to figure it out. That’s a bit more of a challenge that usually requires some graduate-level microeconomics courses. So we won’t cover that here.

Third, you can find the equilibrium through experimentation. If you’re trying to sell a product that a lot of other people are also selling, just look at their prices. If multiple competitors are charging the same price, they’ve likely learned that’s the price where the market balances. You’ll just need to figure out how the market will change when you add your products to the mix.

If you’re offering a new product, start by putting a price tag on it, then watch how fast it sells. If you sell out quickly, you’re below the equilibrium. You should probably increase the price. If your inventory isn’t moving, you’re above the balance point. You’ll probably want to reduce the price.

Of course, there’s a lot of variation in what people buy day to day. It might take a long time to find the right price to move the volume you’re targeting. Plus, you’ll want to make sure you’re trying to sell the correct quantity too. Sometimes fewer sales at a higher price could end up making you more profit.

Anything that reduces the supply of — or increases the demand for — your product will cause the equilibrium price to rise. In theory, the supply and demand of a product come from stable underlying determinants. That is, people tend to have the same tastes and preferences, the same income, and the same costs of production from day to day. That means that a market’s equilibrium should be stable, ceteris paribus (all else equal). But, in the real world, things don’t always stay the same.

Imagine that you sell hamburgers and your market is stable. You nailed down the price so that just the right number of customers lined up to match how fast you could cook the burgers. Then, something changes. Maybe a taco truck pulls up in the parking lot. This new competition disrupts the balance between your production and customer base. In this case, you either need to reduce your price to attract more customers, or you need to cook fewer burgers to match your lower customer base.

All sorts of things can disrupt the status quo and cause the equilibrium to shift. Increasing costs of production cause prices to rise. That could come from wage increases, tax hikes, or some underlying change in the market for the things you use in your business. Changes in demand for your product also move the equilibrium. That could be anything from changing preferences, altered prices of other things people buy, or fluctuations in the income levels of your customers.

The difference between static, dynamic, and disequilibria is a little complicated. A mental picture might help.

Picture a bowl sitting on your desk. Now, imagine placing a marble on the rim. After you let go of it, the marble rolls around for a while. It eventually stops at the bottom of that bowl. The conditions of this situation are static. The bowl’s shape isn’t changing, you aren’t moving the bowl around, and gravity is constant.

Because the conditions are static, it always leads to the same outcome — a stopping point at the bottom of the bowl. The resting point of the marble is a static equilibrium. If you push the marble (but don’t move the bowl), you’ve created a temporary disequilibrium (out of balance). But, you haven’t changed the location of the balance point. So, if you leave everything alone, the marble will return to that state of equilibrium.

A dynamic equilibrium is tougher to imagine. It would mean the underlying conditions are changing but in a balanced way. It would be like that bowl was in a moving car and you kept moving the bowl to compensate for turns and bumps.

In economics, the best example is the effect of inflation. In a static equilibrium state, we understand the relationship between price and quantity. If the price goes up, customers buy less, and producers cut back. However, inflation lifts the price of everything. So, things might cost more, but you also earn more money. Taken together, the quantity you purchase doesn’t change even though the price does. That’s a dynamic equilibrium.

The concept of equilibria is critical to economic theory because it implies that the natural forces of supply and demand are working. So, if things get out of balance, you don’t have to do anything. The economic system will work itself back to its general equilibrium (natural balancing point) without any help from the government.

This idea is the foundation of the laissez-faire (aka leave it alone) approach to government invention, which underpins the notion of free enterprise and capitalism that Adam Smith (the father of modern economics) introduced. Keynesian Economics (a macroeconomics theory attributed to John Maynard Keynes) softens up that argument, suggesting the government can adjust spending levels and taxation to help get an economy back on track with less disruption to the people.

Equilibrium theory extends to all kinds of markets. Financial markets find equilibrium interest rates by balancing the supply and demand for debt. Labor markets use wages as its price mechanism to balance the supply and demand for jobs. The importance of equilibrium theory touches just about every corner of economics.