Concept and Uses of Equilibrium in the Methodology of Economics

The Concept of Equilibrium:

In the methodology of economics, concept of equilibrium occupies an important place.

The concept of equilibrium is employed in almost every theory of economics in the fields of price income and growth.

Word equilibrium means a state of balance. When two opposing forces working on an object are in balance so that the object is held still, the object is said to be in equilibrium.

In other words, when the object under the pressure of forces working in opposite directions has no tendency to move in either direction, the object is in equilibrium. Thus, a system can be said to be in equilibrium when the various important variables in it show no change and when there are no pressures or forces working which will cause any change in the values of important variables.

Thus, by consumer’s equilibrium we mean that in regard to the allocation of money expenditures among various goods the consumer has reached the state where he has no tendency to re-allocate his money expenditure. Similarly, a firm is said to be in equilibrium when it has no tendency to change its level of output, that is, when it has no tendency either to increase or to contract its level of output.

Whether it is the price, level of income or employment, solution always lies in the equilibrium value. Thus, the important topic in microeconomics is that how the prices of goods are determined and the prices are in equilibrium when the quantity demanded and the quantities supplied of the goods are equal. At the market price at which the quantity demanded and the quantities supplied are equal, both buyers and sellers would be satisfied.

Therefore, that once would be ultimately settled in the market and there would be no tendency for it to change unless some changes in the determining conditions of demand and supply occur. Likewise, the levels of income and employment in advanced capitalist countries are determined by their equilibrium levels at which aggregate demand is equal to aggregate supply.

It may, however, be pointed out that equilibrium in economic activities may never be realised in actual practice. But the importance of the equilibrium analysis lies in the fact that if other things remain the same the economy would tend towards the equilibrium values. What happens is that before the final equilibrium is reached changes occur in the determining factors so that the system tends to move towards new equilibrium value corresponding to the new changed conditions.

Partial Equilibrium Analysis:

Two types of equilibrium have been distinguished:

(1) Partial Equilibrium,

(2) General Equilibrium.

In partial equilibrium approach to the pricing, we seek to explain the price determination of a commodity, keeping the prices of other commodities constant and assuming that demands of various commodities are not interdependent. In explaining partial equilibrium approach, Marshall writes. “The forces to be dealt with are, however, so numerous that it is best to analyse a few at a time and to work out a number of partial solutions as auxiliaries to our main study.

Thus we begin by isolating the primary relations of supply, demand and price in regard to a particular commodity. We reduce to inaction all other forces by the phrase, ‘other things being equal.’ We do not suppose that they are inert, but for the time being we ignore their activity. This scientific device is a great deal older than science. It is the method by which consciously or unconsciously sensible men dealt from the time immemorial with every difficult problem of everyday life.”

Thus, in Marshallian explanations of pricing under perfect competition demand function (or a demand curve) for a commodity is drawn with the assumption that prices of other commodities remain constant. Similarly, supply curve of a commodity is constructed by assuming that prices of other commodities, prices of resources or factors and production function remain the same.

Then the Marshall’s partial equilibrium analysis seeks to explain the price determination of a single commodity through the intersection of demand and supply curves, prices of other goods and resources etc. remaining constant. That is, the data of the system are taken as given and kept the same and the determination of price-output equilibrium of a single commodity.

Given the assumption of ceteris paribus it explains the determination of the price of a good independently of the prices of all other goods. With the change in the data, new demand and supply curves will be formed and, corresponding to these, new price of the commodity will be determined. This partial equilibrium analysis of price determination also studies how the equilibrium price changes as a result of change in the data. But, given the independent data, the partial equilibrium analysis discusses only the price determination of a commodity in isolation and does not analyse how the prices of various goods are inter-dependent and inter-related and how they are simultaneously determined.

It should be noted that partial equilibrium analysis is based on the assumption that the changes in a single sector do not significantly affect the rest of the sectors. Thus, in partial equilibrium analysis, if the price of a good changes, it will not affect the demand for other goods. Prof. Lipsey rightly writes. “All partial equilibrium analyses are based on the assumption of ceteris paribus. Strictly interpreted, the assumption is that all other things in the economy are unaffected by any changes in the sector under consideration (say sector A). This assumption is always violated to some extent, for anything that happens in one sector must cause changes in some other sectors. What matters is that the changes induced throughout the rest of the economy are sufficiently small and diffuse so that the effect they in turn have on the Sector A can be safely ignored.”

General Equilibrium Analysis:

In general equilibrium analysis, the price of a good is not explained to be determined independently of the prices of other goods. Since the changes in price of a good X affect the prices and quantities demanded of other goods and in turn the changes in prices and quantities of other goods will affect the quantity demanded of the good X, the general equilibrium approach explains the mutual and simultaneous determination of prices of all goods and factors. Thus, general equilibrium analysis looks at multi-market equilibrium. It considers the way in which the prices of all goods in an economic system are determined simultaneously, each in its own free market.

As stated above, partial equilibrium approach assumes that the effect of the change in price of a good X will be so diffused in the rest of the economy (i.e., over all other goods) as to have negligible effect on the prices and quantities of other individual goods. Therefore, where the effect of a change in the price of a good on the prices and quantities of some other goods is significant, as is there in the case of inter-related goods, the partial equilibrium approach cannot be validly applied in such cases and therefore the need for applying general equilibrium analysis which explains the mutual and simultaneous determination of their prices and quantities.

General equilibrium analysis deals with inter-relationship and inter-dependence between equilibrium adjustment of prices and quantities of various goods and factors with each other. General equilibrium exists when, at the going prices, the quantities demanded of each product and each factor are equal to their respective quantities supplied.

A change in the demand or supply of any good or factor would cause changes in prices and quantities of all goods and factors and there will begin adjustment and readjustment in demand, supply and prices of other goods and factors till the new general equilibrium is established. Indeed, the general equilibrium analysis is solving a system of simultaneous equations.

Model Building in Economics:

In order to explain the behaviour of individual consumer, producer or industry or the economy as a whole the economists have constructed analytical models. An economic model usually consists of a set of equations that express relationships between variables that are relevant for the problem to be investigated. Each equation attempts to explain the behaviour of one variable, that is, it seeks to establish cause and effect relationship in respect of an individual variable.

It is worth mentioning that causation does not always run in one direction. There is a mutual relationship among various variables, that is, a variable influences the other variables and in turn is influenced by them. For instance, consumption depends upon income and also consumption being an important constituent of aggregate demand influences income. Therefore, in such a system values of various variables are to be determined simultaneously. Therefore, models which involve more than one equation attempt to solve these equations simultaneously.

Another noteworthy point about a model is that it does not represent the real economic world in its entirety; it only represents its main significant features. Thus, a model is an abstraction from reality. In order to build a model, one has to make some unrealistic assumptions to simplify it. Indeed, the real economic world is too complex to be represented by a model which would reflect all its features.

Therefore, one has to abstract from reality to some extent so that some useful and meaningful features of reality are brought out. However, a model is not a complete abstraction from reality; it abstracts from reality is some ways in order to pinpoint those features of reality which are significant and useful for explaining the behaviour of a consumer, producer or the economic system as a whole.

Now, an important question is why economists are interested in building models.

Economic models are built for purposes of:

(a) Analysis and

(b) Prediction.

By analysis we mean how adequately we can explain the behaviour of an economic agent, that is, consumer, producer or the economic system. From a set of assumptions we derive through deductive logic certain laws which describe the behaviour of an economic agents (consumer, producer or the whole economy) and which have a quite general application.

On the other hand, prediction implies the ability of a model to forecast the effects of changes in some magnitudes in the economy. For instance, a model of price determination through demand and supply is generally used to forecast the effect of imposition of an excise duty or sales tax on the price of a commodity.

The validity of a model may be judged on the basis of either its explanatory or predictive power, or the realism of its assumptions, or the extent of its applicability (i.e. its generality). Economists differ as to what is more important attribute of a valid model. According to Milton Friedman, the most important attribute of a model is its predictive power, that is, to what extent it can correctly predict the behaviour of an economic unit.

If the model has a good predictive power, then, according to his view, it is immaterial whether its assumptions are realistic or not. On the contrary, Paul Samueison is of the view that realism of assumptions and the analytical power of the model to explain the behaviour of consumers, producers or the economic system are the essential attributes of a valid and satisfactory model.

It may be noted that the general view among economists is that the most important attribute of a model depends on its purpose, that is, whether the model builder wants to use it for predicting the effect of a change in some variable or for analysing and explaining the particular behaviour of an economic agent (consumer, producer or economic system).

Realism of assumptions and explanatory power are important features of a good model if the purpose of the model is the explanation of why a system behaves as it does. However, as mentioned above, some unrealistic assumptions have to be made to simplify the analysis of model building.

The economic models express inter-relationship among variables. In the field of microeconomics the variables with which economists are generally concerned are demand, supply, prices of goods and factors such as labour, capital, land and so on. On the other hand, in macroeconomics, the important variables are national income, aggregate consumption, aggregate investment, general price level, aggregate supply and so on.

Endogenous and Exogenous Variables in Economic Models:

Let us make clear the meaning of endogenous and exogenous variables in economic models. For example, in the demand-supply model of pricing described above, price (p) and quantity (q) are inter-related; the value of one depends on the value of the other.

Therefore, in solving the equations of demand and supply we obtain the value of p and then find out the value of q by substituting the value of p in either the demand or supply equation. The price and quantity are therefore endogenous variables; the values of one depends on the value of the other and are therefore determined within the system.

On the other hand, the exogenous variables are those whose values are not determined by other variables within the model. Let us take an example. As is well known, apart from the price of output, the supply of agricultural output depends to a great extent on the amount of rainfall in a place.

Thus, writing the supply function of agricultural output including rainfall as a variable we have:

Q_s = a + b P + cR

Where a is the intercept term, R stands for the average rainfall in a place. Rainfall is an exogenous variable as it is not determined by other variables, Q and Pin the system. Changes in price of the agricultural output or the quantity of output do not affect the rainfall. It is worth mentioning that the changes in the exogenous variables such as rainfall would cause a shift in the whole supply curve.

In the Keynesian macro-model of income determination, investment (1) has been treated as an exogenous variable as it is taken to be independent of income or consumption, that is, other variables in the system. However, if instead of a given investment-independent of income, it is taken as a function of income, it would then be an endogenous variable. It should be further noted that investment is an exogenous variable in the simple Keynesian model of determination of income.

In the complete Keynesian model the money market is considered along with the goods market to determine jointly the level of national income and the rate of interest. In this complete Keynesian model, the other variables such as rate of interest, demand for money are also included as endogenous variables. Investment is determined by the rate of interest which in turn depends on the demand for and supply of money. Thus, in this complete Keynesian model, investment becomes an endogenous variable.