What is 'Equilibrium'
Equilibrium is the state in which market supply and demand balance each other and, as a result, prices become stable. Generally, when there is too much supply for goods or services, the price goes down, which results in higher demand. The balancing effect of supply and demand results in a state of equilibrium.
BREAKING DOWN '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 that the market is in a state of equilibrium.
As proposed by New Keynesian economist and Ph. D. Huw Dixon, there are three properties to a state of equilibrium; the behavior of agents is consistent, no agent has an incentive to change its behavior, and that the equilibrium is the outcome of some dynamic process. Dr. Dixon names these principles equilibrium property 1, or P1, P2, and P3 respectively.
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. The understanding of this series of cause and effect were all viewed in a vacuum.
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.
The term used for when markets are not at equilibrium is disequilibrium. Disequilibrium either happens in a flash, or is a characteristic of a certain market. At times disequilibrium can spillover from one market to another, for instance if there aren’t enough companies to ship coffee internationally then the coffee supply for certain regions could be reduced, effecting 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.
Paul Samuelson argued in a 1983 paper Foundations of Economic Analysis published by Harvard University that giving equilibrium markets what he described as a ‘normative meaning’ or a value judgment was 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 in the mid 1800s. Higher profits from selling to the British made it so the Irish/British market was at equilibrium price was higher than what farmers could pay, contributing to one of the many reasons people starved.