Equilibrium

Equilibrium is a concept used to explain price fluctuations. The changing needs and wants of the individuals will cause price movements in goods. These prices tend toward an equilibrium, or final price, where the quantity demanded is equal to the quantity supplied. Equilibrium, although useful to describe price movements, never occurs except temporarily and imperfectly (for example in the 'close' of the stock market). Market prices, to some economists, are said to be in equilibrium rather than moving toward equilibrium. For example, the mathematical school and the efficient market hypothesis base their theories on a constant equilibrium.

Equilibrium, as a mental tool, explains the fluctuations of market prices. Prices are moved by the "invisible hand" toward the final or equilibrium price. However, the future equilibrium--and therefore the final price--is also always moving. "The final price," says Mises, "can only be defined by defining the conditions required for its emergence. No definite numerical value in monetary terms or in quantities of other goods can be attributed to it." Present conditions may suggest how prices will move, but never the magnitude. Ludwig von Mises writes:

"'This hypothetical future state of equilibrium will appear when all methods of production have been adjusted to the valuations of the actors and to the state of technological knowledge. Then one will work in the most appropriate locations with the most adequate technological methods. [But, of course,] Today's economy is different.'"

Austrian Framework: The ERE
The Evenly Rotating Economy (ERE) is an fictitious system in which there are no price changes whatever – i.e., there is perfect price stability and a Final Price is achieved. Using this concept, the Final State of Rest can be defined and thereby various aspects of an economy can be compared with it. In particular, it may illustrate the function of entrepreneurship and to demonstrate meaning of profit and loss by hypothesizing a system where they are absent.

The imaginary construction of the evenly rotation economy helps define equilibrium, all prices are final prices, and the rate of originary interest (the discount of future goods against present goods) is the same for all commodities. In the evenly rotating economy, all the factors of production are employed in such a way that they provide the highest valued service possible.

On the evenly rotating economy, Ludwig von Mises writes:

"'The same market transactions are repeated again and again. The goods of the higher orders pass in the same quantities through the same stages of processing until ultimately the produced consumers' goods come into the hands of the consumers and are consumed. No changes in the market data occur. Today does not differ from yesterday and tomorrow will not differ from today...Therefore prices--commonly called static or equilibrium prices--remain constant too.'"

The unchanging evenly rotating economy leaves "no room for the entrepreneurial function." That is, future prices will be the same as current prices and the entrepreneur has no reason to combine factors of production anew based on the anticipation of future prices; there is no future price as different from the current price, and therefore, no entrepreneur.

Price Fixing and Equilibrium
Fixing the price of a good at a different price from that determined by the market, will lead to shortages or oversupply of the good. That is, the fixed-price does communicate the relative scarcity of a good and production is forced out of line with the needs of consumers. A price near and moving toward equilibrium will continuously remove shortages or oversupplies of goods.

The same is true with manipulation of the interest rate (although the interest rate should not be thought of as a price). In Austrian theory, interest rates coordinate the consumption and production of goods. In the long run, savings must occur before future consumption occurs. In The Monetary Theory and The Trade Cycle, Hayek states:

"'Every given structure of production — i.e., every given allocation of goods as between different branches and stages of production — requires a certain definite relationship between the prices of the finished products and those of the means of production. In a state of equilibrium, the difference necessarily existing between these two sets of prices must correspond to the rate of interest, and at this rate, just as much must be saved from current consumption and made available for investment as is necessary for the maintenance of that structure of production.'"

For example, if production is started on a new line of business, the consumers need to have saved in the past to purchase these future goods. (If they have not and this line of production does not divert their purchases from other lines of business, it will incur losses.) If the savings of a population is low, therefore the supply of loanable funds being low, then the interest rate will need to be higher to signify the time preference of consumption now (i.e., low savings) compared with future consumption. The higher rate of interest will ensure that the funds are loaned out to lines of production which can return the greatest profit and best supply the needs of the consumers.

Austrian Business Cycle Theory is based primary on the artificial lowering of the interest rate from the near equilibrium rate and causing malinvestment in the structure of production.

Classical Examples
In Principles of Political Economy and Taxation, David Ricardo uses increased profits to quickly illustrate the equilibrium effect of price on the structure of production.

"If a merchant sells imported wine for greater than, say, 20%, 'the profits of this individual merchant would exceed the general rate of profits, and capital would naturally flow into this advantageous trade, till the fall of the price of wine had brought everything back to the former level.'"

The "former level" being a near equilibrium condition.

Modern Austrian Debate
In, Hulsmann refutes the ERE and thereby the traditional Austrian exposition of equilibrium as having unrealistic assumptions and being a self-contradictory concept:


 * the conditions under which the final state of rest is supposed to be established—namely, stable conditions—can never be given. The market process itself brings about continual change, it implies a constant need for readjustment.

In turn, Hulsmann rejects the ERE and uses equilibrium analysis in general as a method, and not as a standard of comparison (as other Austrian authors use it to understand the origin of interest and the function of entrepreneurs). Instead, he defines equilibrium analysis as a method comparing existing behavior with counterfactual behavior in terms of success or failure relative to an objective standard chosen on a case-by-case basis.

Links

 * Human Action complete text (pdf)