Market Equilibrium Theory

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The concept of “market equilibrium” is the touchstone of classical, free-market economics. It is the product of the free market and is based on the more general concept of “perfect competition.” The basic structure is that producers and consumers will eventually come to a freestanding agreement that reflects the minimum utility—or expected benefit—of both parties. Sellers provide rock-bottom prices while consumers have bargained them down to their lowest level of utility—any lower and they will not sell. The result of this is market equilibrium.

Perfect Competition

One of economist Adam Smith's theoretical contributions to economics is the idea of perfect competition. This is a theoretical world where consumers negotiate with sellers selling the same product. The consumers have total information about prices and the manufacturing process and thus are totally rational in their decision making. This theoretical market is the structure that creates equilibrium. Ultimately, the minimal profit will accrue to sellers while consumers get the lowest possible prices. Supply and demand, in other words, are in total balance.

Expected Utility

In Smith's imaginary market, competition, as well as the rationality of consumers, leads to equilibrium. In any economic model, the lack of total information and even a lack of total logical rationality can be accounted for without doing harm to the general theory. The basic idea is that competition leads to the lowest price that will maintain sellers in business. If there is any bump in a single seller's price, then consumers will go elsewhere. The result is a “race to the bottom.” The expected utility of the consumer is the lowest possible price that will not force sellers to leave the market. The expected utility of sellers is to stay in business and keep up with the competition, which means that they must sell at the lowest possible price.

Applications

Equilibrium is an assumed basis of most classical economic models. The idea of equilibrium is a conceptual exercise rather than a reality. Of course, real economic life is far more complicated than Smith's imaginary model. It is, however, the central theoretical assumption of market economics. The basic application, then, is used to predict prices within the specific variables offered by a specific market, such as the number of workers, local demand, transport costs and the general economic climate.

Example

This theory can be used to predict wages. Say there are five supermarkets in a specific area. There are five available workers, all looking for the same or similar jobs in a supermarket. Since there are five workers and only five supermarkets, the competition to hire them will be intense. Workers, being rational, will realize they are in demand and will demand higher wages. The supermarkets will realize there is a wage above which they will not pay, or they will begin to lose money. Equilibrium will be reached when workers agree to work for a high wage that reflects the demand for them, but is not so high that the supermarkets will lose money in hiring them. If the number of available workers goes up to 100, the wage will go down, until it reaches the absolute minimum for which workers will work.

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