What Is Disequilibrium?
Let me explain disequilibrium to you directly: it's a situation where internal and/or external forces stop market equilibrium from happening or knock the market out of balance. This might be a short-term effect from changes in variables or come from long-term structural issues.
I should also note that disequilibrium describes a deficit or surplus in a country's balance of payments.
Key Takeaways
- Disequilibrium is when external forces cause a disruption in a market's supply and demand equilibrium, leading to a state where supply and demand are mismatched.
- It happens for reasons like government intervention, labor market inefficiencies, or actions by a supplier or distributor.
- Disequilibrium usually gets resolved as the market shifts to a new equilibrium state.
- For example, people get motivated to produce more of overpriced goods, boosting supply to match demand and dropping the price back to equilibrium.
- Examples range from short-term events like flash crashes to long-term ones like recessions and depressions.
Understanding Disequilibrium
You need to understand that sometimes forces cause the price of a commodity or service to move. When that happens, the ratio of goods supplied to those demanded gets imbalanced, putting the market into disequilibrium. Economist John Maynard Keynes originally proposed this idea.
Many modern economists use 'general disequilibrium' to describe how markets often are. Keynes pointed out that markets are usually in some disequilibrium because so many variables affect financial markets today—true equilibrium is more of a concept than reality.
A market in equilibrium operates efficiently with supply equaling demand at the equilibrium price, meaning no surpluses or shortages. Equilibrium balances supply and demand, stabilizing prices.
Generally, oversupply lowers prices, increasing demand, while undersupply raises prices, decreasing demand. This balancing leads to equilibrium, but disequilibrium occurs when supply, demand, or price adjustments fail as expected.
Important Note on Market Forces
Market forces tend to pull disequilibrium states back to equilibrium. That's because people can profit from buying underpriced assets and selling overpriced ones, so arbitrageurs help push supply and demand into balance.
Disequilibrium in Action
Consider a hypothetical graph of supply and demand in the wheat market. The price at Pe is the one that motivates both farmers and consumers to trade. At Pe, supply and demand for wheat are balanced.
If prices rise to P2, suppliers will offer more wheat from storage to sell, as the higher price covers costs and boosts profits. But consumers might buy less due to the cost. This creates a surplus where supply exceeds demand, leading to disequilibrium.
The surplus is the gap between Q2 (supplied) and Q1 (demanded). Suppliers will lower prices to sell before spoilage, and in a free market, the price should fall back to Pe without interference.
Now, if the price drops to P1, consumers want more wheat (Q2) at the lower cost, but suppliers provide less (Q1) because it doesn't cover costs. This shortage means demand exceeds supply, putting the market in disequilibrium.
In a free market, the price should rise to equilibrium due to scarcity.
Reasons for Disequilibrium
There are several reasons markets fall into disequilibrium. One is when a supplier fixes a price for a period, and if demand rises, supply shortages occur due to sticky prices.
Government intervention can cause it too. Setting a price floor or ceiling makes the market inefficient if supply and demand don't match. For instance, a rent ceiling might make landlords unwilling to rent, creating housing shortages and excess demand.
In the labor market, a minimum wage above equilibrium leads to excess labor supply.
From an economic view, disequilibrium hits when a country's balance of payments shows a current account deficit or surplus. This records transactions with other countries; high imports over exports cause deficits, like in the US, UK, and Canada, while surpluses occur with higher exports, as in China, Germany, and Japan.
Disequilibrium can stem from imbalances between domestic savings and investments, where excess investments funded abroad create deficits. Trade agreements affecting imports/exports, exchange rate changes, inflation, deflation, foreign reserve shifts, population growth, and political instability also contribute.
How Is Disequilibrium Resolved?
Disequilibrium comes from mismatches in supply and demand, resolved by market forces or government action.
In the labor shortage example, policies for unemployed workers or training investments can fix it. Innovations in manufacturing, supply chains, or technology address imbalances.
Say a company's product demand drops due to high price; they can innovate to lower costs, regaining market share with more supply at a reduced price, reaching a new equilibrium.
Real-World Example
Disequilibrium can strike quickly in stable markets or be ongoing in others. Flash crashes are a quick example, where mass sell orders wipe out bids, crashing prices in a spiral worsened by algorithmic trading.
The first major one was on May 6, 2010, when the Dow Jones fell over 1,000 points in under 10 minutes, losing 9% before recovering 70% by day's end, evaporating over a trillion in equity.
It was blamed on a U.K. trader spoofing the market with rapid buys and sells of E-mini S&P futures. An SEC report said a large sell order created unstable disequilibrium.
Disequilibrium FAQs
What Happens When Disequilibrium Occurs? If equilibrium stays unbalanced, prices get too low or high, harming markets and the economy. Actors buy underpriced goods or sell overpriced ones to restore balance.
What Causes Disequilibrium? It's often from supply-demand imbalances, which can spill over, like transport shortages affecting coffee supply. Labor markets are often in disequilibrium due to laws protecting jobs and wages.
How Can Disequilibrium Be Prevented? Reduce market frictions, trade barriers, some regulations, and improve efficiency and information flow to maintain equilibrium.
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