What is Disequilibrium
Disequilibrium is a situation where internal and/or external forces prevent market equilibrium from being reached or cause the market to fall out of balance. This can be a short-term byproduct of a change in variable factors or a result of long-term structural imbalances.
Disequilibrium is also used to describe a deficit or surplus in a country’s balance of payments.
BREAKING DOWN Disequilibrium
A market in equilibrium is said to be operating efficiently as its quantity supplied equals its quantity demanded at an equilibrium price or a market clearing price. In an equilibrium market, there are neither surpluses or shortages for a good or service. Looking at the graph for the wheat market below, the price at Pe is the single price which incentivizes both farmers (or suppliers) and consumers to engage in an exchange. At Pe, there is a balance in the supply and demand for wheat.
Sometimes, certain forces bring about a movement in the price of a commodity or service. When this happens the proportion of goods supplied to the proportion demanded becomes imbalanced, and the market for the product is said to be in a state of disequilibrium. This theory was originally put forth by economist John Maynard Keynes. Many modern economists have likened using the term "general disequilibrium" to describe the state of the markets as we most often find them. Keynes noted that markets will most often be in some form of disequilibrium --- there are so many variable factors that affect financial markets today that true equilibrium is more of an idea.
Following our graph for wheat market, if prices increased to P2, suppliers will be willing to provide more wheat from their storage barns to sell in the market, since the higher price would cover their production costs and lead to higher profits. However, consumers may reduce the quantity of wheat that they purchase, given the higher price in the market. When this imbalance occurs, quantity supplied will be greater than quantity demanded, and a surplus will exist, causing a disequilibrium market. The surplus in the graph is represented by the difference between Q2 and Q1, where Q2 is the quantity supplied and Q1 is the quantity demanded. Given the excess commodity supplied, suppliers will want to quickly sell the wheat before it gets rancid, and will proceed to reduce the sales price. Economic theory suggests that in a free market, the market price for wheat will eventually fall to Pe if the market is left to function without any interference .
What if the market price for wheat was P1. At this price, consumers are willing to purchase more wheat (Q2) at the lower price. On the other hand, since the price is below the equilibrium price, suppliers will provide a smaller amount of wheat (Q1) to sell as the price may be too low to cover their marginal costs of production. In this case, when Pe falls to P1, there will be a shortage of wheat as the quantity demanded exceeds the quantity supplied for the commodity. Since resources are not allocated efficiently, the market is said to be in disequilibrium. In a free market, it is expected that the price would increase to the equilibrium price as the scarcity of the good forces the price to go up.
Reasons for Disequilibrium
There are a number of reasons for market disequilibrium. Sometimes, disequilibrium occurs when a supplier sets a fixed price for a good or service for a certain time period. During this period of sticky prices, if quantity demanded increases in the market for the good or service, there will be a shortage of supply.
Another reason for disequilibrium is government intervention. If the government sets a floor or ceiling for a good or service, the market may become inefficient if quantity supplied is disproportionate to the quantity demanded. For example, if the government sets a price ceiling on rent, landlords may be reluctant to rent out their extra property to tenants, and there will be excess demand for housing due to the shortage of rental property.
From the standpoint of the economy, disequilibrium can occur in the labor market. A labor market disequilibrium can occur when the government sets a minimum wage, that is, a price floor on the wage that an employer can pay its employees. If the stipulated price floor is higher than the labor equilibrium price, there will be an excess supply of labor in the economy.
When a country’s current account is at a deficit or surplus, its balance of payments (BOP) is said to be in disequilibrium. A country’s balance of payments is a record of all transactions conducted with other countries during a given time period. Its imports and exports of goods are recorded under the Current Account section of the BOP. A significant deficit on the current account where imports are greater than exports would result in a disequilibrium. The US, UK, and Canada have large current account deficits. Likewise, when exports are greater than imports, creating a current account surplus, there is a disequilibrium. China, Germany, and Japan have large current account surpluses.
A balance of payments disequilibrium can occur when there is an imbalance between domestic savings and domestic investments. A deficit in the current account balance will result if domestic investments is higher than domestic savings, since the excess investments will be financed with capital from foreign sources. In addition, when the trade agreement between two countries affects the level of import or export activities, a balance of payments disequilibrium will surface. Furthermore, changes in an exchange rate when a country’s currency is revalued or devalued can cause disequilibrium. Other factors that could lead to disequilibrium include inflation or deflation, changes in the foreign exchange reserves, population growth, and political instability.