Equilibrium and Stability Test [11 diagrams]

Learning Objectives

• Equilibrium: Meaning and Definition
• Disequilibrium and Automatic Correction Mechanism
• Stability Test
  • Excess Demand Approach to Stability Test

Equilibrium

Equilibrium or Market Equilibrium is the state of stability in which all significant market factors remain more or less constant over a period, and there is little or no inherent tendency for change. It is also the point where the demand and supply forces for a product interact with each other, which determines the equilibrium price and quantity of that product.

According to N. George Mankiw (2009), "At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to sell."

The equilibrium price is sometimes called the market-clearing price because, at this price, everyone in the
market has been satisfied: Buyers have bought all they want to buy and sellers have sold all they want to sell.
The actions of buyers and sellers naturally move markets toward the equilibrium of supply and demand. The market forces automatically bring the economy to the equilibrium, so some deviation in an economy temporality affects the stability of the equilibrium. To understand this concept, let us consider a figure.

Figure 1 presents the equilibrium of demand and supply for Ice-cream cones. The intersection of the demand and supply curves determines the equilibrium for the ice-cream cones. Thus, the equilibrium quantity is at '7' and the equilibrium price is at '$2'. To check whether this equilibrium is stable or not, let us consider Figure 2.

Disequilibrium and Automatic Correction Mechanism

In Figure 2, the left figure shows excess supply and the right figure shows the excess demand. In the left figure, the excess supply creates competition among the firms' to sell their product. Since there is an abundance of Ice-cream cones in the market, the bargaining power of the buyer is also high. So, the competition among the sellers and the rising bargaining power of the buyers pull the price down to '$2' from '$2.5'. Eventually, the price and quantity of ice-cream cone return back to equilibrium.

Similarly, in the right part of figure 2, there is excess demand for ice-cream cones. The excess demand will pull the price down to '$1.5'. There is a shortage of ice-cream cones in the market at price  '$1.5'. The shortage of ice-cream cones raises the bargaining power of the supplier; also consumers compete to purchase the ice-cream cone by paying more for it. Eventually, the price of the ice-cream cone moves up to '$2' and quantity turns up at '7 units'. Thus, the market forces automatically bring the price and quantity of ice-cream cones at equilibrium.

Stability Test

The existence, uniqueness, and stability of an economy depends upon the nature of demand and supply curves. The demand and supply curve must intersect with each other for the existence of equilibrium. Hence, the interaction of demand and supply curve is the prerequisite for the market equilibrium.

The uniqueness of the equilibrium depends upon the number of times the demand and supply curve intersects. If the demand and supply curve intersect more than ones, then the equilibrium is not unique.

Finally, the stability of an economy depends upon the slope of the demand and supply curves. Existence and uniqueness of equilibrium is the fundamental requirement for the stability of equilibrium. Further, the stability of equilibrium depends upon the slope of demand and supply curves. The equilibrium is stable if the slope of the demand curve is less than the slope of the supply curve. In other words, if the falling demand curve intersects the rising supply curve, then the equilibrium is stable as in Figure 1 and Figure 2.

Figure 3 clearly illustrates the existence, uniqueness, and stability of equilibrium. In Figure 3(A), the supply curve cuts the demand curve from below at a single point, so the equilibrium is unique and stable. Figure 3(B) illustrates the unique but unstable equilibrium as the supply curve cuts demand curve from above at a single point. Figure 3(C) has multiple equilibria since the demand curve cuts the supply curve at more than one point. Finally, Figure 3(D) depicts the inexistence of equilibrium.

Excess Demand Approach to Stability Test

Excess demand is simply the difference between quantity demanded and quantity supplied at the given price level. if the excess demand is greater than 0, then it is called positive excess demand. The excess demand of less than 0 is called negative excess demand.

Excess Demand = Quantity Demanded - Quantity Supplied

We can use the excess demand approach to determine the existence, uniqueness, and stability of equilibrium.

Figure 4 is the replication of Figure 3 but in terms of excess demand approach. In Figure 4(A), the equilibrium is stable because the slope of the excess demand curve is negative. Figure 4(B) has positively sloped excess demand curve, so the equilibrium is unique but is unstable. 'Multiple equilibria' is in Figure 4(C), where excess demand curve cuts price axis more than ones. Finally, In Figure 4, there is no existence equilibrium as excess demand curve fails to cut the price axis.

Now, let us draw a simple conclusion, the equilibrium is unique and stable if:

• The demand and supply forces intersect with each other at only one point
• The slope of the demand curve is less than the slope of the supply curve

Online resources related to this post

Meaning of Equilibrium
Economic Equilibrium

Suggested Readings:

Ahuja. H.L. (1970). Advanced Economic Analysis: Microeconomic Analysis. New Delhi: S. Chand & Company Pvt. Ltd.
Kutosoyiannis, A. (1979). Modern Microeconomics. Houndsmill: Macmillan Press Ltd.
Mankiw, N.G. (2009). Principles of Microeconomics. Mason: South-Western Cengage Learning
Varian. H.R. (2010). Intermediate Microeconomics - A Modern Approach. W W Norton & Company: New York.