Ludwig von Mises Institute

Equilibrium

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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." [1] 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."[2]

The fictional system of the evenly rotating economy is said to be in equilibrium.[1]

Price Fixing and Equilibrium[edit]

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 β€” i.e., every given allocation of goods as between different branches and stages of production β€” 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."[3]

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[edit]

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."[4]

The "former level" being a near equilibrium condition.

References[edit]

  1. ↑ 1.0 1.1 Ludwig von Mises. XVIII. The Scope and Method of Catallactics, 5. The State of Rest and the Evenly Rotating Economy, Human Action, online version, referenced 2011-02-04.
  2. ↑ Ludwig von Mises. XXVI. Economic Calculation under Socialism, 6. The Differential Equations of Mathematical Economists, Human Action, online version, referenced 2011-04-25.
  3. ↑ Friedrich Hayek. The Monetary Theory and The Trade Cycle, 5. Lecture V: Unsettled Problems of Trade Cycle Theory, Monetary Theory and The Trade Cycle, online version, referenced 2011-02-05.
  4. ↑ David Ricardo Principles of Political Economy and Taxation, VII. On Foreign Trade, (Amherst, New York: Prometheus Books) 89

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