What Is Competitive Equilibrium?
Competitive equilibrium is a condition in which profit-maximizing producers and utility-maximizing consumers in competitive markets with freely determined prices arrive atanequilibrium price. At this equilibrium price, thequantity suppliedis equal to thequantity demanded. In other words, all parties—buyers and sellers—are satisfied that they're getting a fair deal.
Key Takeaways
- Competitive equilibrium is achieved when profit-maximizing producers and utility-maximizing consumers settle on a price that suits all parties.
- At this equilibrium price, thequantity supplied by producersis equal to thequantity demanded by consumers.
- The theory serves many purposes, including as an analytical tool and a benchmark for efficiency in economics.
Understanding Competitive Equilibrium
As discussed in the law of supply and demand, consumers and producers generally want two different things. The former wants to pay as little as possible, while the latter seeks to sell its goods at the highest possible price.
That means when prices are hiked, the quantity that sellers demand tends to fall and the quantity sellers are willing to supply rises—and when prices are slashed, quantity demanded increases and quantity supplied declines.
Whenever these quantities are not in balance, a shortage or surplus occurs on the market. Under these conditions, entrepreneurs have an incentive (in the form of profit opportunities) to engage in arbitrage, or to reallocate real resources, up until the point where buyers and sellers can agree on one combination of price and quantity in the market. At this point, supply and demand curves intersect, the quantity supplied equals the quantity demanded, and the market is said to be in equilibrium.
At equilibrium prices, both buyers and sellers maximize their economic gains relative to the limits of technology and the resources they have available. Not everyone gets everything they want, but all parties in the market balance their wants against unavoidable scarcity of economic goods as best they can. Because of this, competitive equilibrium is considered a kind of ideal goal for economic efficiency.
Benefits of Competitive Equilibrium
The competitive equilibrium serves many purposes, describing how markets might settle on one price for all buyers and sellers, explaining how production and consumption can be brought in to balance without a central planner, and operating as a benchmark for efficiency in economic analysis.
Economists have long observed that in many markets, buyers and sellers tend to settle around one market price for a given good and that businesses tend to be more or less successful at matching the the amounts and types of goods that they bring to market with the things that consumers want. And that all this seems to happen even without a government official or other authority, or any single person, calculating what the official market prices and quantities should be. The theory of competitive equilibrium is the explanation that they devised to explain how this can happen: when buyers and sellers co-cooperatively calculate the appropriate market prices and quantities together through their acts of buying and selling.
Because competitive equilibrium sets a balance between the interests of all market participants, it can be used to analyze the effects of changes to supply and demand and to benchmark the desirability of government policies that alter market conditions. Moreover, it is often used extensivelyto analyze economic activities dealing with fiscal or tax policy, in finance for analysis of stock markets and commodity markets, as well as to study interest, exchange rates, and other prices.
Special Considerations
The theory relies on the assumptions of competitive markets. Each trader decides upon a quantity that is so small compared to the total quantity traded, such that their individual transactions have no influence on the prices. All buyers and sellers have the same information, including all information relevant to supply and demand. Buying and selling goods, or shifting goods and resources between markets or lines of production, involve zero transaction costs. Because these assumptions are not very realistic, competitive equilibrium is only an ideal, and a standard by whichother market structures are evaluated, rather than a prediction that real world markets will always achieve competitive equilibrium.
Competitive Equilibriumvs. General Equilibrium
Competitive equilibrium is often used to describe just a single market for one good. An extension of competitive equilibrium to all markets in an economy simultaneously is known asgeneral equilibrium. General equilibrium is also called Walrasian equilibrium.
The difference between the two types of equilibriais allabout the emphasis; one market or many connected markets considered together. Both types of equilibria can be described as competitive. The analysis of competitive equilibrium in one market, holding conditions in all other markets to be constant, is also known as partial equilibrium, in order to distinguish it from general equilibrium.
FAQs
What Is Competitive Equilibrium? Competitive equilibrium is a condition in which 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.
What is an example of a competitive equilibrium? ›
A possible CE is: the price of the car is 15, Bob gets the car and pays 15 to Alice. This is an equilibrium because the market is cleared and both agents prefer their final bundle to their initial bundle. In fact, every price between 10 and 20 will be a CE price, with the same allocation.
What is an example of a market equilibrium in real life? ›
When there is a surplus in the ice-cream market, for instance, sellers of ice cream find their freezers increasingly full of ice cream they would like to sell but cannot. They respond to the surplus by cutting their prices. Prices continue to fall until the market reaches the equilibrium.
What is an example of equilibrium in economics? ›
Economists like Adam Smith believed that a free market would tend toward equilibrium. For example, a dearth of any one good would create a higher price generally, which would reduce demand, leading to an increase in supply provided the right incentive.
What conditions are required for a competitive equilibrium? ›
Conditions for competitive equilibrium
The theoretical requirements for a market to be in competitive equilibrium are as follows: many buyers and sellers, all acting independently. identical (homogeneous) goods. all the buyers and sellers are aware of the prices at which others are trading.
What is a good example of equilibrium? ›
A few examples of equilibrium are: A book kept on a table at rest. A car moving with a constant velocity. A chemical reaction where the rates of forward reaction and backward reaction are the same.
What occurs at the competitive equilibrium? ›
What Is Competitive Equilibrium? Competitive equilibrium is a condition in which 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.
What are the types of equilibrium with examples? ›
There are three types of equilibrium: stable, unstable, and neutral. Figures throughout this module illustrate various examples. Figure 1 presents a balanced system, such as the toy doll on the man's hand, which has its center of gravity (cg) directly over the pivot, so that the torque of the total weight is zero.
What is an example of equilibrium in society? ›
Equilibrium is not just an abstract or theoretical concept. It has real-world implications for the lives of people in society. For example, when there is equilibrium in the economy, it means that there is a balance between supply and demand, and that everyone has access to the basic necessities of life.
What is an example of equilibrium in the goods market? ›
The goods market is in equilibrium when AD = AS. This is also the point where the economy is producing at its full employment potential output Y. The equation for Y is as follows: Y = C + I + G (we ignore trade and assume the economy is in autarky here, for simplification).
An equilibrium is said to be stable if small, externally induced displacements from that state produce forces that tend to oppose the displacement and return the body or particle to the equilibrium state. Examples include a weight suspended by a spring or a brick lying on a level surface.
What is an example of a general equilibrium in economics? ›
Léon Walras and General Equilibrium Theory
Walras used the example of a simple economy to hone his theory. If only two goods could be exchanged, referred to as x and y, everyone in the economy would be either a buyer or a seller.
What is an example of equilibrium price in economics? ›
The equilibrium price formula is based on demand and supply quantities; you will set quantity demanded (Qd) equal to quantity supplied (Qs) and solve for the price (P). This is an example of the equation: Qd = 100 - 5P = Qs = -125 + 20P.
What are the benefits of competitive equilibrium? ›
This drive for efficiency benefits consumers through lower prices and better-quality products. The competitive equilibrium model promotes economic stability. The continuous adjustments in prices and quantities help prevent persistent surpluses or shortages in the market.
How to work out competitive equilibrium? ›
Here is how to find the equilibrium price of a product:
- Use the supply function for quantity. You use the supply formula, Qs = x + yP, to find the supply line algebraically or on a graph. ...
- Use the demand function for quantity. ...
- Set the two quantities equal in terms of price. ...
- Solve for the equilibrium price.
Market equilibrium in a perfectly competitive market is achieved when the market demand equals the market supply. In the short run , this equilibrium will be affected by the demand, while in the long run, the demand as well as supply will be impacting the equilibrium.
What is an example of equilibrium in game theory? ›
For example, in the game rock-paper-scissors, the Nash equilibrium is that each player should choose each option exactly one-third of the time, because if a player chooses one option more than the others, the other player can exploit that tendency to win a greater percentage of the matches.
What is an example of a general equilibrium? ›
Equilibrium is a set of prices, or a price ratio, where the number of bananas demanded by both Gilligan and Mary Ann exactly equals the total number available and the number of coconuts demanded by both Gilligan and Mary Ann exactly equals the total number available.
