Competitive Equilibrium

Updated on February 23, 2024
Article byShrestha Ghosal
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Competitive Equilibrium?

Competitive equilibrium is a fundamental concept in economics that represents a state of balance in the market where the forces of supply and demand interact to determine prices and quantities. In this equilibrium, the market participants, including the buyers and sellers, make decisions independently based on their self-interest.

Competitive Equilibrium

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This equilibrium model leads to the establishment of prices at which the quantity supplied equals the quantity demanded. There is an absence of any persistent surpluses or shortages as market forces naturally adjust to ensure that demand and supply align. It results in an optimal distribution of goods and services.

Key Takeaways

  • Competitive equilibrium is a fundamental economic concept that reflects a condition of equilibrium in the market where supply and demand factors interact to determine prices and quantities.
  • In this state of equilibrium, a large number of buyers and sellers perform transactions according to their own choices, limitations, and knowledge.
  • At a given price level, equilibrium occurs when the quantity supplied equals the quantity demanded.
  • The market participants alter their decisions about production and consumption as prices rise or fall in accordance with the shifts in supply or demand in the market.

Competitive Equilibrium Explained

Competitive equilibrium is a fundamental concept in economics that comprises the interaction of supply and demand forces within a market, leading to a state of balance with stable prices and quantities. In this equilibrium, numerous buyers and sellers engage in transactions based on their individual preferences, constraints, and information. The market reaches a state of equilibrium when the quantity supplied equals the quantity demanded at a particular price level.

This model implies that, in a competitive market, no participant has the incentive to alter their behavior. They perceive the prevailing prices as fair and a reflection of the underlying market conditions. The pricing mechanism acts as a critical element in this equilibrium as it functions as a dynamic signal that guides the efficient allocation of resources. As prices rise or fall in response to changes in demand or supply, market participants adjust their production and consumption decisions accordingly.

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Examples

Let us go through the following examples to understand this equilibrium:

Example #1

Suppose in a stock market, investors bought and sold shares of a new company called Panache Ltd. Initially, the stock price was uncertain, and the investors had various opinions on its value. Some believed that the stock was undervalued and bought it, while others thought it was overvalued and started selling it. As these transactions occurred, the market processed this information and adjusted the stock price.

When the stock price was too high, more sellers entered the market and increased the supply of shares. When the price was too low, more buyers emerged and increased the demand. The market eventually reached a state of equilibrium when the number of shares investors who wanted to buy the stock equaled the number others were willing to sell at a particular price.

Example #2

Economists have a widely recognized supply and demand theory for highly competitive markets in equilibrium. However, many marketplaces in daily lives are far from static equilibrium, with fluctuations driven by trends and price variants. This article proposes that network effects can be one such factor. The conventional opinion holds that this is the result of technical advancement or external events and that the market will eventually balance out on its own. Long-term planning or market friction might produce persistent movements.

Benefits

Some benefits of the competitive equilibrium model include the following:

  • It provides a mechanism for the efficient allocation of resources. In this equilibrium, prices act as signals that guide producers and consumers to make optimal decisions. As prices rise or fall based on changes in supply and demand, resources move toward their most valued uses. It ensures that the general population consumes and produces goods and services in a way that maximizes societal welfare.
  • This equilibrium promotes innovation and efficiency. In a competitive market, firms receive rewards for innovating and improving production processes to gain a competitive edge. 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. This stability contributes to a smoother functioning of the economy and aids in reducing the possibility of economic crises and imbalances.
  • The equilibrium model aligns with the principles of individual freedom and choice. In a competitive market, individuals have the autonomy to make decisions based on their preferences and constraints. It ensures that participants engage in economic activities willingly, which enhances overall economic freedom.
  • This model highlights the automated nature of competitive markets. In this equilibrium, the interactions of several individuals lead to outcomes that are beneficial for society collectively.

Long-Run Competitive Equilibrium vs Short-Run Competitive Equilibrium

The differences between the two are as follows:

Long-Run Competitive Equilibrium

  • The long-run equilibrium is the state in which a market has fully adjusted to any changes. It allowed all the economic agents to make optimal decisions without the influence of temporary factors.
  • In this equilibrium, all firms earn average profits, implying they cover all their costs, including the opportunity cost of capital.
  • The entry and exit of firms have fully responded to profit opportunities or losses, which led to a stable market structure.
  • This equilibrium concept emphasizes the role of free entry and exit in the market.

Short-Run Competitive Equilibrium

  • The short-run equilibrium reflects a temporary state where the market has not fully adjusted to changes, and some economic agents may not be able to make optimal decisions.
  • Factors like shocks in demand or supply, technological changes, or policy interventions can impact prices and quantities in the short run.
  • In the short run, firms may experience economic profit or losses.
  • However, not all firms can immediately enter or exit the market. Barriers to entry or exit may exist, which prevents the market from fully adjusting.

Competitive Equilibrium vs Cournot Equilibrium

The differences between the two are as follows:

Competitive Equilibrium

  • It represents a state in which a market reaches a balance between supply and demand. The forces of competition drive this balance.
  • In this equilibrium, numerous buyers and sellers participate, and no single participant has the power to influence the market price significantly.
  • The intersection of supply and demand determines prices, and they reflect the collective decisions of market participants.
  • Firms in this equilibrium earn average profits, and they efficiently allocate their resources based on consumer preferences and production costs.

Cournot Equilibrium

  • Cournot equilibrium is a concept associated with oligopolistic markets, where a small number of firms dominate the industry. It is named after the economist Augustin Cournot.
  • This equilibrium results from firms setting their output levels strategically by taking into account the expected reactions of their competitors.
  • A Cournot equilibrium has market power and can influence prices. Each firm chooses its output level to maximize profits based on its expectations about how other firms will behave.
  • The equilibrium is reached when the combined output of all firms maximizes industry profits.

Frequently Asked Questions (FAQs)

1. What is the difference between competitive equilibrium and general equilibrium?

Competitive equilibrium is a state in a specific market where numerous buyers and sellers influence the supply and demand balance. However, general equilibrium is a broader economic concept comprising multiple interrelated markets. General equilibrium considers simultaneous equilibrium conditions across all markets in an economy by recognizing that changes in one market impact the others.

2. What are some limitations of competitive equilibrium?

These models have certain limitations. They assume perfect information and overlook real-world information. Additionally, the assumption of perfect competition rarely aligns with actual market conditions. Moreover, the models often neglect transaction costs and barriers to entry, which are crucial factors that influence market dynamics. Furthermore, in dynamic economies, the static nature of these equilibrium models may fail to capture changes over time.

3. What is the unregulated competitive equilibrium?

This equilibrium is a state in a market where the forces of supply and demand solely decide the prices without any external regulations or interventions. In this scenario, market participants, including buyers and sellers, make decisions based on their individual preferences and constraints. The prices adjust to ensure that the quantity supplied equals the quantity demanded.

This has been a guide to what is Competitive Equilibrium. We explain its examples, comparison with Cournot & long-run vs short-run equilibria, benefits. You can learn more about it from the following articles –

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