Chapter 3

Equilibrium Analysis in Economics

3.1 The Meaning of Equilibrium

Like any economic term, equilibrium can be defined in various ways. One definition here
is that an equilibrium for a specific model is a situation that is characterized by a lack
of tendency to change. Or more generally, it means that from the various feasible and
available choices, choose “best” one according to a certain criterion, and the one being
finally chosen is called an equilibrium. It is for this reason that the analysis of equilibrium
is referred to as statics. The fact that an equilibrium implies no tendency to change may
tempt one to conclude that an equilibrium necessarily constitutes a desirable or ideal state
of affairs.
This chapter provides two examples of equilibrium. One is the equilibrium attained by
a market model under given demand and supply conditions. The other is the equilibrium
of national income model under given conditions of consumption and investment patterns.
We will use these two models as running examples throughout the course.

3.2 Partial Market Equilibrium - A Linear Model

In a static-equilibrium model, the standard problem is that of finding the set of values of
the endogenous variables which will satisfy the equilibrium conditions of model.

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Partial-Equilibrium Market Model

Partial-equilibrium market model is a model of price determination in an isolated market

for a commodity.
Three variables:

Qd = the quantity demanded of the commodity;

Qs = the quantity supplied of the commodity;

P = the price of the commodity.

The Equilibrium Condition: Qd = Qs .

The model is
Qd = Qs
Qd = a − bp (a, b > 0)
Qs = −c + dp (c, d > 0)

The slope of Qd = −b, the vertical intercept = a.

The slope of Qd = d, the vertical intercept = −c.

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 Note that, contrary to the usual practice, quantity rather than price has been plotted
vertically in the figure.
One way of finding the equilibrium is by successive elimination of variables and equa-
tions through substitution.
From Qs = Qd , we have
a − bp = −c + dp

and thus
(b + d)p = a + c.

Since b + d ̸= 0, then the equilibrium price is

a+c
p̄ = .
b+d

The equilibrium quantity can be obtained by substituting p̄ into either Qs or Qd :

ad − bc
Q̄ = .
b+d

Since the denominator (b+d) is positive, the positivity of Q̄ requires that the numerator
(ad − bc) > 0. Thus, to be economically meaningful, the model should contain the
additional restriction that ad > bc.

3.3 Partial Market Equilibrium - A Nonlinear Model

The partial market model can be nonlinear. Suppose a model is given by

Qd = Qs

Qd = 4 − p2

Qs = 4p − 1

As previously stated, this system of three equations can be reduced to a single equation
by substitution.
4 − p2 = 4p − 1

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 or
p2 + 4p − 5 = 0

which is a quadratic equation. In general, given a quadratic equation in the form

ax2 + bx + c = 0 (a ̸= 0),

its two roots can be obtained from the quadratic formula:

√
−b ± b2 − 4ac
x̄1 , x̄2 =
2a

where the “+” part of the “±” sign yields x̄1 and “−” part yields x̄2 . Thus, by applying
the quadratic formulas to p2 + 4p − 5 = 0, we have p̄1 = 1 and p̄2 = −5, but only the first
is economically admissible, as negative prices are ruled out.

The Graphical Solution

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3.4 General Market Equilibrium
In the above, we have discussed methods of an isolated market, wherein the Qd and Qs of
a commodity are functions of the price of that commodity alone. In the real world, there
would normally exist many substitutes and complementary goods. Thus a more realistic
model for the demand and supply function of a commodity should take into account
the effects not only of the price of the commodity itself but also of the prices of other
commodities. As a result, the price and quantity variables of multiple commodities must
enter endogenously into the model. Thus, when several interdependent commodities are
simultaneously considered, equilibrium would require the absence of excess demand, which
is the difference between demand and supply, for each and every commodity included in
the model. Consequently, the equilibrium condition of an n−commodity market model
will involve n equations, one for each commodity, in the form

Ei = Qdi − Qsi = 0 (i = 1, 2, · · · , n)

where Qdi = Qdi (P1 , P2 , · · · , Pn ) and Qsi = Qsi (P1 , P2 , · · · , Pn ) are the demand and
supply functions of commodity i, and (P1 , P2 , · · · , Pn ) are prices of commodities.
Thus solving n equations for P :

Ei (P1 , P2 , · · · , Pn ) = 0

we obtain the n equilibrium prices P̄i – if a solution does indeed exist. And then the Q̄i
may be derived from the demand or supply functions.

Two-Commodity Market Model

To illustrate the problem, let us consider a two-commodity market model with linear
demand and supply functions. In parametric terms, such a model can be written as

Qd1 − Qs1 = 0

Qd1 = a0 + a1 P1 + a2 P2

Qs1 = b0 + b1 P1 + b2 P2

Qd2 − Qs2 = 0

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 Qd2 = α0 + α1 P1 + α2 P2

Qs2 = β0 + β1 P1 + β2 P2

By substituting the second and third equations into the first and the fifth and sixth
equations into the fourth, the model is reduced to two equations in two variable:

(a0 − b0 ) + (a1 − b1 )P1 + (a2 − b2 )P2 = 0

(α0 − β0 ) + (α1 − β1 )P1 + (α2 − β2 )P2 = 0

If we let
ci = ai − bi (i = 0, 1, 2),

γi = αi − βi (i = 0, 1, 2),

the above two linear equations can be written as

c1 P1 + c2 P2 = −c0

γ1 P1 + γ2 P2 = −γ0

which can be solved by further elimination of variables.

The solutions are
c2 γ0 − c0 γ2
P̄1 =
c1 γ2 − c2 γ1
c0 γ1 − c1 γ0
P̄2 =
c1 γ2 − c2 γ1
For these two values to make sense, certain restrictions should be imposed on the
model. First, we require the common denominator c1 γ2 − c2 γ1 ̸= 0. Second, to assure
positivity, the numerator must have the same sign as the denominator.

Numerical Example

Suppose that the demand and supply functions are numerically as follows:

Qd1 = 10 − 2P1 + P2

Qs1 = −2 + 3P1

Qd2 = 15 + P1 − P2

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 Qs2 = −1 + 2P2

By substitution, we have
5P1 − P2 = 12

−P1 + 3P2 = 16

which are two linear equations. The solutions for the equilibrium prices and quantities
are P̄1 = 52/14, P̄2 = 92/14, Q̄1 = 64/7, Q̄2 = 85/7.
Similarly, for the n−commodities market model, when demand and supply functions
are linear in prices, we can have n linear equations. In the above, we assume that an equal
number of equations and unknowns has a unique solution. However, some very simple
examples should convince us that an equal number of equations and unknowns does not
necessarily guarantee the existence of a unique solution.
For the two linear equations,

 x+y =8
 x+y =9

we can easily see that there is no solution.

The second example shows a system has an infinite number of solutions:

 2x + y = 12
 4x + 2y = 24

These two equations are functionally dependent, which means that one can be derived
from the other. Consequently, one equation is redundant and may be dropped from the
system. Any pair (x̄, ȳ) is the solution as long as (x̄, ȳ) satisfies y = 12 − x.
Now consider the case of more equations than unknowns. In general, there is no
solution. But, when the number of unknowns equals the number of functional independent
equations, the solution exists and is unique. The following example shows this fact.

2x + 3y = 58

y = 18

x + y = 20

Thus for simultaneous-equation model, we need systematic methods of testing the

existence of a unique (or determinate) solution. There are our tasks in the following
chapters.

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3.5 Equilibrium in National-Income Analysis
The equilibrium analysis can be also applied to other areas of economics. As a simple
example, we may cite the familiar Keynesian national-income model,

Y = C + I0 + G0 (equilibrium condition)

C = a + bY (theconsumption function)

where Y and C stand for the endogenous variables national income and consumption
expenditure, respectively, and I0 and G0 represent the exogenously determined investment
and government expenditures, respectively.
Solving these two linear equations, we obtain the equilibrium national income and
consumption expenditure:
a + I0 + G0
Ȳ =
1−b
a + b(I0 + G0 )
C̄ =
1−b

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