Competitive Equilibrium

What Is Competitive Equilibrium?

Competitive equilibrium is a condition in which profit-maximizing producers and utility-maximizing consumers in competitive markets with freely determined prices arrive at an equilibrium price. At this equilibrium price, the quantity supplied is equal to the quantity demanded. In other words, all parties — buyers and sellers — are satisfied that they're getting a fair deal.

Understanding Competitive Equilibrium

As discussed in the law of supply and demand, consumers and producers generally want two different things. The former wants to pay as little as possible, while the latter seeks to sell its goods at the highest possible price.

That means when prices are hiked, the quantity that sellers demand tends to fall and the quantity sellers are willing to supply rises — and when prices are slashed, quantity demanded increases and quantity supplied declines.

Whenever these quantities are not in balance, a shortage or surplus occurs on the market. Under these conditions, entrepreneurs have an incentive (in the form of profit opportunities) to engage in arbitrage, or to reallocate real resources, up until the point where buyers and sellers can agree on one combination of price and quantity in the market. At this point, supply and demand curves intersect, the quantity supplied equals the quantity demanded, and the market is said to be in equilibrium.

At equilibrium prices, both buyers and sellers maximize their economic gains relative to the limits of technology and the resources they have available. Not everyone gets everything they want, but all parties in the market balance their wants against unavoidable scarcity of economic goods as best they can. Because of this, competitive equilibrium is considered a kind of ideal goal for economic efficiency.

Benefits of Competitive Equilibrium

The competitive equilibrium serves many purposes, describing how markets might settle on one price for all buyers and sellers, explaining how production and consumption can be brought in to balance without a central planner, and operating as a benchmark for efficiency in economic analysis.

Economists have long observed that in many markets, buyers and sellers tend to settle around one market price for a given good and that businesses tend to be more or less successful at matching the the amounts and types of goods that they bring to market with the things that consumers want. And that all this seems to happen even without a government official or other authority, or any single person, calculating what the official market prices and quantities should be. The theory of competitive equilibrium is the explanation that they devised to explain how this can happen: when buyers and sellers co-cooperatively calculate the appropriate market prices and quantities together through their acts of buying and selling.

Because competitive equilibrium sets a balance between the interests of all market participants, it can be used to analyze the effects of changes to supply and demand and to benchmark the desirability of government policies that alter market conditions. Moreover, it is often used extensively to analyze economic activities dealing with fiscal or tax policy, in finance for analysis of stock markets and commodity markets, as well as to study interest, exchange rates, and other prices.

Special Considerations

The theory relies on the assumptions of competitive markets. Each trader decides upon a quantity that is so small compared to the total quantity traded, such that their individual transactions have no influence on the prices. All buyers and sellers have the same information, including all information relevant to supply and demand. Buying and selling goods, or shifting goods and resources between markets or lines of production, involve zero transaction costs. Because these assumptions are not very realistic, competitive equilibrium is only an ideal, and a standard by which other market structures are evaluated, rather than a prediction that real world markets will always achieve competitive equilibrium.

Competitive Equilibrium vs. General Equilibrium

Competitive equilibrium is often used to describe just a single market for one good. An extension of competitive equilibrium to all markets in an economy simultaneously is known as general equilibrium. General equilibrium is also called Walrasian equilibrium.

The difference between the two types of equilibria is all about the emphasis; one market or many connected markets considered together. Both types of equilibria can be described as competitive. The analysis of competitive equilibrium in one market, holding conditions in all other markets to be constant, is also known as partial equilibrium, in order to distinguish it from general equilibrium.