Equilibrium

The term equilibrium has often to be used in economic analysis.  In fact,

Modern Economics is sometimes called equilibrium analysis.  Equilibrium
means a state of balance.  When forces acting in opposite directions are
exactly equal, the object on which they are acting is said to be in a state of
equilibrium.

Types of Equilibrium

Basically, there are three types of any equilibrium:

(a)   Stable Equilibrium: There is stable equilibrium, when the object

concerned, after having been disturbed, tends to resume its original
position.  Thus, in the case of a stable equilibrium, there is a tendency for the
object to revert to the old position.

(b)   Unstable Equilibrium: On the other hand, the equilibrium is unstable

when a slight disturbance evokes further disturbance, so that the original
position is never restored.  In this case, there is a tendency for the object to
assume newer and newer positions once there is departure from the original
position.

(c)    Neutral Equilibrium: It is neutral equilibrium when the disturbing

forces neither bring it back to the original position nor do they drive it further
away from it.  It rests where it has been moved.  Thus, in the case of a neutral
equilibrium, the object assumes once for all a new position after the original
position is disturbed.

When the word equilibrium is used to qualify the term value, then according to
Professor Schumpeter, a stable equilibrium value is an equilibrium value that
if changed by a small amount, calls into action forces that will tend to
reproduce the old value; a neutral equilibrium value is an equilibrium value
that does not know any such forces; and an unstable equilibrium value is an
equilibrium value, change in which calls forth forces which tend to move the
system farther and farther away from the equilibrium value.

In the following figure 2,the stable equilibrium is shown.  When in equilibrium

at point P, the producer produces an output OM and maximises his profits.  In
case the producer increases his output to OM2 or decreases it to OM1, the size
of profits is reduced.  This automatically brings in forces that tend to establish
equilibrium again at P.

Figure 3 represents the case of unstable equilibrium.  Initially the producer is

in equilibrium at point P, where MR = MC and he is maximising his profits.  If
now he increases his output to OM1, he would be in equilibrium output at point
P1, where he will obtain higher profits, because, at this output, marginal
revenue is greater than marginal cost. Thus there is no tendency to return to
the original position at P.

Figure 4 represents the situation of neutral equilibrium.  In this case, MR = MC

at all levels of output so that the producer has no tendency to return to the old
position and every time a new equilibrium point is obtained, which is as good
as the initial one.
Other Forms of Equilibrium

(a) Short-term and Long-term Equilibrium:Equilibrium may be short-term

equilibrium or long-term equilibrium as in case of short-term and long-term
value.  In the short-term equilibrium, supply is adjusted to change in demand
with the existing equipment or means of production, there being no time
available to increase or decrease the factors of production.  However, in case
of long-term equilibrium, there is ample time to change even the equipment or
the factors of production themselves, and a new factory can be erected or
new machinery can be installed.

(b) Partial Equilibrium:Partial equilibrium analysis is the analysis of an

equilibrium position for a sector of the economy or for one or several partial
groups of the economic unit corresponding to a particular set of data.  This
analysis excludes certain variables and relationship from the totality and
studies only a few selected variables at a time.  In other words, this method
considers the changes in one or two variables keeping all others constant, i.e
ceteris paribus(others remaining the same).The ceteris paribus is the crux of
partial equilibrium analysis.

The equilibrium of a single consumer, a single producer, a single firm and a

single industry are examples of partial equilibrium analysis.  Marshall’s theory
of value is a case of partial equilibrium analysis.  If the Marshallian method
(i.e., partial equilibrium analysis) is to be effective, even in its own terms,
when applied to a hypothetical and idealised market, it necessary that the
market should be small enough so that its inter-dependence with the rest of
the hypothetical economy could be neglected without much loss of accuracy.

(i)            Consumer’s Equilibrium: With the application of partial

                 

equilibrium analysis, consumer’s equilibrium is indicated when he is getting

maximum aggregate satisfaction from a given expenditure and in a given set
of conditions relating to price and supply of the commodity.

(ii)            Producer’s Equilibrium: A producer is in equilibrium

               

when he is able to maximise his aggregate net profit in the economic

conditions in which he is working.

(iii)            Firm’s Equilibrium: A firm is said to be in long-run

             

equilibrium when it has attained the optimum size when is ideal from
the viewpoint of profit and utilisation of resources at its disposal.

(iv)            Industry’s Equilibrium: Equilibrium of an industry shows

             

that there is no incentive for new firms to enter it or for the existing
firms to leave it.  This will happen when the marginal firm in the
industry is making only normal profit, neither more nor less. In all
these cases; those who have incentive to change it have no
opportunity and those who have the opportunity have no incentive.

(c) General Equilibrium Analysis: Leon Walras (1834-1910), a Neoclassical

economist, in his book ‘Elements of Pure Economics’, created his theoretical
and mathematical model of General Equilibrium as a means of integrating
both the effects of demand and supply side forces in the whole
economy.  Walras’ Elements of Pure Economics provides a succession of
models, each taking into account more aspects of a real economy.  General
equilibrium theory is a branch of theoretical microeconomics.  The partial
equilibrium analysis studies the relationship between only selected few
variables, keeping others unchanged.  Whereas the general equilibrium
analysis enables us to study the behaviour of economic variables taking full
account of the interaction between those variables and the rest of the
economy.  In partial equilibrium analysis, the determination of the price of a
good is simplified by just looking at the price of one good, and assuming that
the prices of all other goods remain constant.

General equilibrium is different from the aggregate or macro-economic

equilibrium.  General equilibrium tries to give an understanding of the whole
economy using a bottom-top approach, starting with individual markets and
agents.  Whereas, the macro-economic equilibrium analysis utilises top-
bottom approach, where the analysis starts with larger aggregates.  In macro-
economic equilibrium models, like Keynesian type, the entire system is
described by relatively few, appropriately defined aggregates and functional
relationships connecting aggregate variables such as total consumption
expenditure, total investment, total employment, aggregate output and the
like.  In macro-economic analysis, many important variables and relationships
tend to be disappeared in the process of aggregation.

There are two major theorems presented by Kenneth Arrow and Gerard
Debreu in the framework of general equilibrium:

(i)                  The first fundamental theorem is that every market

equilibrium is Pareto optimal under certain conditions, and

(ii)                The second fundamental theorem is that every Pareto

optimum is supported by a price system, again under certain
conditions.

Uses of General Equilibrium

1.      To get an overall picture of the economy and study the problems

involving the economy as a whole or even large segments / sectors of it.

2.      It shows that the quantities of demanded goods / factors are equal
to the quantities supplied.  Such a condition implies that there is a full
employment of resources.

3.      It also provides with an ideal datum of economic efficiency.  It

brings out the fact that long-run competitive equilibrium is a standard of
efficiency for the entire economy.  Only when the competitive economy
obtains general equilibrium shall its economic efficiency be at its peak
 and there shall be no further gains made by any reallocation of
resources.

4.      General equilibrium also represents the state of optimum

production of all commodities, because there can be no over-
production or under-production under such conditions.

5.      It also provides an insight into the way the multitudes of individual
decisions are integrated by the working of the price mechanism.  It,
therefore, solves the fundamental problems of a free market
economy, viz., what to produce, how to produce, how much to produce,
etc.  This analysis shows that such decisions with regard to innumerable
consumers and producers are co-ordinated by the price mechanism.

6.      The general equilibrium analysis also gives us the clue for

predicting the consequences of an economic event.

7.      It also helps in the field of public policy.  The formulation of a

logically consistent public policy requires a complete understanding of
the various sector markets and aspects of individual decision-making
units, and the impact of policy on the whole economy.

Limitations of General Equilibrium Analysis

1.      The Walrasian general equilibrium system is essentially static.  It

treats the coefficient of production as fixed.  It considers the supply of
resources to be given and consistent. It also takes tastes and
preferences of the society as fixed.

2.      It ignores leads and lags, for it considers everything to happen

instantaneously.  It is supposed to work just in the same way as an
electric circuit does.  In the real world, all economic events have links
with the past and the future.

3.      Walrasian general equilibrium analysis is of little practical utility.  It

involves astronomical volumes of calculations for estimating the various
quantities and practices.  This makes its application practically
impossible.  Even the use of computers cannot be of much help
because such a system cannot aid in collecting and recording the
innumerable sets of prices and quantities that are required to formulate
these equations.  The critics further argue that even if such a solution
exists, the price mechanism may not necessarily cover it.
 4.      Last but not least, the general equilibrium analysis falls to the
ground as its star assumption of perfect competition is contrary to
the actual conditions prevailing in the real world.

General Disequilibrium (Keynesian Theory)

Neoclassical economics thinks in terms of a market system in which supply

equals demand in every market, so that no unemployment could ever
occur.  But this is an assumption.  Keynes suggests a market system in which
Disequilibrium can occur in some markets, including labour market, and in
which the disequilibrium can spread contagiously from one market to
another.  Keynes’ idea was that, when this spreading disequilibrium settles
down, there would be a kind of equilibrium – not supply and demand
equilibrium, but often termed as ‘general disequilibrium’.

Take an example of a commodity, say cellular telephone sets, its equilibrium

of demand and supply is shown in the following figure:

In the above figure, MC curve is the marginal cost curve for the
commodity.  Originally, the market is in equilibrium at price P1 with demand
curve D1.  Then, for any reason, demand for that commodity decreases to D2,
Neoclassical economists tells us that the new equilibrium will be at price
P3.  But, in fact, the prices do not drop quite that far, instead, prices drop to
P2.  Perhaps this is because the businessmen do not know just how far they
need to cut their prices, and are cautious to avoid cutting too much.  At a price
P2, the seller can sell only Qd amount of output.  By producing Qd amount of
output at price P2, the producers are not maximising their short-run profit. We
have ‘disequilibrium’ in the sense that production is not on the marginal cost
curve.  At P2, the sellers can sell Qd amount of output, but they cannot
produce the same amount of output.  Here is a qualification.  Producer might
temporarily produce more that Qd, in order to build up their inventories.  But
there is a limit to how much inventories they want, so they will cut their
production back to Qd eventually.

With a reduction of demand for cellular phones, any economist would expect a
reduction in the quantity of that commodity produced.  Neoclassical
economics leads us to expect that the price would drop to P3 and output cut
back to Qe.  At the same time, a certain number of workers would be laid off
and would switch their efforts into their second best alternatives, working in
other industries, perhaps at somewhat lower wages.  But the ‘disequilibrium
model’ states that the production and layoffs would go even further, with
output dropping to Qd.  A reduction in income does not only reduce the
demand for cellular phones, but it also reduces the demand for all other
normal goods as well.  This disequilibrium will spread contagiously through
many different goods markets, through the effect of disequilibrium on
income.  So every other industry will face a reduction in demand because of
the reductions in productions in many other industries.