What is Competitive Equilibrium

A competitive equilibrium is an equilibrium condition where the interaction of profit-maximizing producers and utility-maximizing consumers in competitive markets with freely determined prices arrive at an equilibrium price. At this equilibrium price, the quantity supplied is equal to the quantity demanded.

BREAKING DOWN Competitive Equilibrium

While the basic supply and demand model is based on individual consumer and firm behavior, the competitive equilibrium model is based on the behavior of aggregate consumers and firms in competitive markets. It can be used to predict the equilibrium price and total quantity in the market, as well as the quantity consumed by each individual and output per firm.

Competitive equilibrium is a state of market, characterized by a set of prices and an allocation of commodities, such that at equilibrium prices, each agent maximizes his objective function subject to his technological limitations and resource constraints, and the market clears the aggregated supply and demand for the products in question.

Competitive equilibrium theory can be considered as a specialized branch of game theory that deals with making decisions in large markets. It is used extensively to analyze economic activities dealing with fiscal or tax policy, in finance for analysis of stock markets and commodity markets, to study interest, and exchange rates and other prices. It serves as a benchmark for efficiency in economic analysis. It relies on the assumption of competitive markets, where each trader decides upon a quantity that is so small compared to the total quantity traded in the market, such that their individual transactions have no influence on the prices. Competitive markets are an ideal, and a standard by which other market structure are evaluated.

In a capitalist market, vital regulatory functions, such as ensuring stability, competency and fairness are left to the mechanisms of pricing. Thus, competitive equilibrium theory of equilibrium prices acquired a prominent place in mathematical economics. With the advent of the Internet, extensive research has been done at the intersection of computer science and economic theory.

Competitive Equilibrium vs. General Equilibrium

The defining characteristic of competitive equilibrium is that it's competitive. By contrast, a general equilibrium's defining characteristic is that it is an equilibrium on more than one market; as opposed to the partial equilibrium in which we hold at least one price fixed and analyze the response of other markets/prices only. The difference between the two types of equilibriums is all about the emphasis. Any general equilibrium is a competitive equilibrium, but not any competitive equilibrium is necessarily general equilibrium.