Equilibrium (business)

This paper provides a theoretical discussion of the elements that create a state of equilibrium and examines some of the "x-factors" that can impact the establishment of that state. In painting a more "real-world" image of equilibrium and how supply- and demand-side forces relate thereto, one can better understand this concept outside of the laboratory.

Keywords Capital; Demand; Elasticity; Equilibrium; Price; Supply

Economics > Equilibrium

Overview

Johann Wolfgang von Goethe once said that the world is so divinely organized "that every one of us, in our place in time, is in balance with everything else" (Columbia Quotations, 1996). With a multitude of systems and societies throughout the world, Goethe's image of the world may seem idealistic, given its positive take on what others may see as chaotic and messy. At the same time, Goethe's idea is somewhat heartening, as it suggests that the chaos is not as daunting as one might have previously concluded — all one must do is find and link the complementary parts.

Equilibrium (a balanced state) is an essential component of any system. In biology, it is established when two or more systems, in the right ratio, coexist without violent reaction. An ecosystem, for example, is comprised of countless separate animals, plants and natural resources — no one system within that environment draws a disproportionate share of food or space, or else the delicate balance of the ecosystem will become destabilized.

In macroeconomics, equilibrium is also an essential state of being. Like the biological ecosystem, in an economy, neither aggregate supply or aggregate demand can be the primary focus of fiscal policy — laws and regulations must respect the relationship between these two separate entities or else equilibrium does not exist and the "economic ecosystem" falters.

In a vacuum, economic equilibrium is established when the demand for a certain product is offset by the supply. If a new type of automobile is introduced into the marketplace, for example, consumers will seek to purchase it. If, however, the price of that car is too high for consumers, the supplier and consumer are left without connectivity. Then again, should the price of the vehicle be reduced and/or consumer wealth increases, supply and demand may meet at a certain price point. This point is equilibrium.

The above-referenced phrase, "in a vacuum," albeit somewhat cynical, is rather pivotal to the discussion. Even basic economics, while suggesting that supply-demand equilibrium (once established) is difficult to destroy from within, acknowledges that factors external to these two systems can destabilize the relationship. These "mitigating circumstances" are wide-ranging, from trade relationships and international investments to war, natural disaster and political upheaval.

This paper examines some of these "x-factors" in greater depth, casting a spotlight on some of the influences that exist which can impact the establishment of a state of equilibrium. In painting a more "real-world" image of equilibrium and how supply- and demand-side forces relate thereto, we can better understand this concept outside of the laboratory.

Supply, Demand & Equilibrium

Aggregate supply, or the total goods and services available in a certain system, and aggregate demand, or the total expenditures of consumers within that system, exist in a somewhat symbiotic environment. If consumer spending is at a low, it is unlikely that they will take advantage of the goods and services on the market. Likewise, if corporations and industries that produce these goods and services for consumers are for any number of reasons unable to meet consumer demand at affordable prices, it is unlikely that the two will find connectivity.

At the center of this dichotomy is price. On the supply side, manufacturers and service providers must cover their own expenses. The cost of doing business in the twenty-first century is high — commercial and corporate taxes, employee salaries, operating costs and repairs and rent are among the bottom line issues that any business must address. The cost of health care and utilities exacerbate an already challenging business environment.

Demand is equally vexing. Like manufacturers' cost of business expenses, consumers are faced with the cost of living, such as rent or mortgage, taxes, income and even employment issues. The rising cost of utilities (specifically, oil), as is the case for businesses, is also a daunting issue facing the aggregate demand side of a macroeconomy.

Keynes on Equilibrium

It is in the central meeting point (or group thereof) between these aggregate supply and aggregate demand elements where equilibrium can be located. Economist John Maynard Keynes, in his General Theory of Employment Interest and Money, identifies a few such points of equilibrium. Keynes, whose central theme in this canonical tome is that aggregate demand is the determining factor for equilibrium, maintained that policymakers would be wise to focus specifically on demand (and in particular, unemployment) as a means to achieving equilibrium (Galbraith, 1993). Implicit here is Keynes's call for government to play an active role in between the amount of money retained by consumers and the money that is available on the supply side.

Of course, Keynes's focus was not on the supply of money available but rather on the amount of money retained by consumers. His view was that income should be linked to interest rates as well as risk factors, the latter of which are somewhat vague — Keynes only alludes to them as "insurable" and not high-risk elements (Wray, 2006). The aggregate supply side of this macroeconomic equation is equally nebulous, deferring to central banks as the primary determinants of these interest rates. This concept stresses two key points of Keynesian economics regarding equilibrium: The key to establishment of equilibrium in this sense is government intervention and/or control; and the focus of that government activity should be on demand.

Keynes's successors, however, employed a more microeconomic approach to the establishment of equilibrium. Hirofumi Uzawa and Robert Lucas, Jr., for example, build upon the notion of equilibrium's strong bond between supply and demand. Uzawa and Lucas argue that a free-market approach to establishment of equilibrium is optimal, but competitive applications only go so far when influenced by external forces. When these elements enter the picture, the integrity of equilibrium becomes vulnerable and government intervention necessary (Gomez, 2002).

It is the view of Keynesian economists that the exogenous elements that can pull apart supply and demand can also aid in the establishment of equilibrium. In fact, the economy does not exist in a vacuum — rather, it operates with a variety of elements, some of which aid long-term health and some of which act as a "poison pill." Indeed, equilibrium, that balance between supply and demand, is contingent upon the mitigation of the negative influences on both of those components. As the next few sections will illustrate, such an endeavor is not easy to undertake.

Supply

Capital

Arguably, one of the most pivotal elements to the establishment of a successful market-based economy is the acquisition of investment capital. In the case of the former Soviet Union nations, the demise of the central Russian investor meant that the USSR's former territories and satellites were left not only to start from scratch — they lacked the capital with which to begin.

Of course, foreign aid and investment have helped these nations build their economic infrastructures, but the absence of domestic financial resources does prevent long-term development, as international aid seeks a return on investment and is therefore ephemeral. In fact, in one study that compared the transitions of former Soviet states versus former Soviet satellites, it becomes evident that those states with domestic capital savings and systems (which allow for both domestic and international investment inflow) will likely foster a stronger business environment.

This point is critical, for many new and redeveloping economies have in place a variety of financial protections designed to soften the shocks to the system caused by transitions. Employing a Keynesian approach, the study suggests, the focus should be on removing such safeguards:

As evidenced above, a market (and equilibrium) depends on investment. Without capital and infrastructure designed to continue the flow of capital funds, equilibrium is prevented.

Workforce

In 2005, one of the most destructive storms in US history blew ashore along the Gulf coast. Hurricane Katrina took countless lives, devastated local infrastructures and left the city of New Orleans under water. Its impacts on the region's economies, from Louisiana to western Florida, were significant and long-term. Thousands of people evacuated the region, many of whom did not return.

The loss of human capital, just as it is with financial capital, is detrimental to the supply side of an economy. The effect on the workforce Katrina had in 2005 is no exception. In Mississippi, the loss of employable personnel was already a painful blow. Many of those who came in to fill vacant positions immediately after the storm hit were from elsewhere, demanding higher wages and incentives to perform the work that absent locals left. Drawing locally-based residents back was still proving difficult years after the storm and the high cost of homebuying and rents, negotiating relevant wages and training all continued to leave a large hole in the workforce in that area for some time after Katrina. After years of recovery efforts, there has been some evidence of repair to the damage to the workforce post-Katrina (LeSage, Kelley Pace, Lam, Campanella & Liu, 2011).

Demand

Wages

It is a conventional belief of macroeconomics that market-level demand is responsive to changes in price (Knight, 2005). If prices are too high, consumers simply will not be able to afford those prices if their income levels remain the same. This demand "elasticity" is a core issue in the establishment of equilibrium, as a mutually-agreeable price for a product is the key to bridging consumers and manufacturers. The solution to meeting prices, according to leading economists, is a rise in consumer wealth. Such an increase removes that elasticity, especially when supplies and prices remain the same.

Of course, a concern exists when wealth rises on the demand side. An increase in income must be equitably distributed, rather than compartmentalized within a larger economy. According to one study, "if the price elasticity of individual demand depends on the consumer's income, then the price elasticity of market demand clearly depends on the income distribution" (Benassi & Chorico, 2004).

In Poland, this issue came into the play during the 1998-2002 recession. That country's transition to a full-fledged free-market economy created a two-faced wage system. On one hand, non-manufacturing private sector industries paid well-educated Poles extremely well, while posts for less-educated workers yielded considerably lower wages. The disparity was a major factor in exacerbating the recession that began at the turn of the 21st century. While upper-level managers and executives were impacted somewhat by austere budgets and a stagnant economy, the larger population of lower-level employees and unemployed residents were weighed down with far greater hardship and severity (Newell & Socha, 2007; Herbst & Rivkin, 2013).

Taxation

Query any consumer on the reason he or she has not yet purchased a new car or television and he or she will likely speak about other expenses taking priority. Once or twice a year, frugality rules with an even tighter reign, as tax returns and assessments add yet another sizable bill to the pile.

Indeed, taxes are a weight for any consumer, as they are for suppliers, and come on virtually every aspect of life: Sales, property and income taxes are among the big three for individual taxpayers. While the assessed percentage added to a purchase, which is used for socially-beneficial programs (such as road repairs, public education and social services), can be clearly seen on a receipt, its impact on equilibrium is not as easily discernable and yet is significant.

A recent study analyzes the effect of taxation on the supply-demand relationship. As the price consumers pay for a product is usually under market price (an incentive for purchasing the item in question) until the supply runs out, a consumer-centered surplus exists. Likewise, manufacturers who continue to sell at below-market prices will do so and, once that supply diminishes, will charge above the market value, thereby creating a supply-side surplus. Taxation takes away from each of these surpluses. However, although a tax is revenue generated which the government will redistribute to consumers and suppliers alike, the fact that the tax drew from these surpluses in addition to sales means that there is far less flexibility in pricing. In other words, when taxes go up, the draw from consumers is even more "taxing" than previously expected (Economist, 1997). Equilibrium, therefore, is even more difficult to establish.

Common Ground: Energy

One of the most unnerving headlines of recent days, at least with respect to the economy, was one that reads, "Price of Oil May Reach $100/Barrel Next Year" (Haldis, 2007). Indeed, oil prices have surpassed $100 per barrel in the years since that 2007 headline, which has served as a headache for both businesses and consumers alike, sending shockwaves throughout the international economy. Coupled with this disturbing truth about global fuel is a rise in energy costs on the whole. For the purposes of this discussion, a hike in the price energy for any industry can have a profound impact on both supply and demand and wreak havoc on pricing (and thus equilibrium).

Certainly, when the price of oil rises, so does the cost of doing business. It is no surprise, therefore, that the fact that crude oil prices skyrocketed at the same time as the US and the rest of the world fell into recessions in both 2001 and 2007 (Engemann, Kliesen, & Owyang, 2011). Businesses have labored to recover, but oil prices have not helped — prices have nearly quadrupled during that time. One industry leader, acknowledging that his company typically sees a profit of 11 percent, now only sees a modest three percent pretax sales profit. This estimate, he maintains, comes with the cost of energy taken into account (Ollinger, 2006).

On the demand side, the situation is equally challenging for consumers. The cost of heating oil has risen from $2.88 in 2008 to over $3.50 per gallon in recent years. The result is a continued crunch on consumers (Hagenbaugh, 2007; Wang, 2013).

Naturally, the higher cost of fuel and utilities has spurred the growth of alternative energy source production, energy-saving technologies and non-fossil fuels. While consumers have been quick to embrace the concepts offered by these non-conventional products, they remain very expensive, due primarily to the limited supply and ongoing development of these products. Consumers, already feeling the pinch from current energy costs, are unlikely to spend even more to purchase these alternatives. One British study revealed that, despite the public awareness of energy alternatives, many households are incapable of installing energy-efficient windows, boilers and alternative sources such as solar power, due to the simple fact that older properties simply cannot be reconfigured in their current state. Other families, intimidated by the high cost of such technology, are also unlikely to make the switch (Faiers, 2007).

Conclusion

Within a macro-economy, there are two countervailing forces at work. On the supply side are the industries — manufacturers, service providers and similar organizations, producing goods, services and items designed to meet the needs of the consumer. On the demand side are the aforementioned consumers themselves. Both of these elements maintain a symbiotic relationship, drawing from each other when the environment is conducive.

At the center of the relationship is price. Suppliers must be able to produce their wares at a rate which will not lose profitability. Consumers must be able to afford purchasing the suppliers' services. The two must find a common ground in order for the relationship to be established, and that that middle area is a price that is mutually agreeable to both parties.

Unfortunately, the supply-demand relationship does not exist in a vacuum, and price-based equilibrium cannot be established. There are external elements tugging at each component, many of which have been discussed in this paper. When those elements enter the equation, the ability for a system to reach a state of equilibrium is diminished.

On the supply side, capital (and a system conducive to generating capital) is a central issue. Without long-term investment, most industries cannot get off the ground. In the case of some fledgling economies, a government's seemingly innocuous economic protections can actually prevent an industry from reaching viability. The concern here is not even about the price of the goods produced: More at issue is whether the business can survive beyond its initial incorporation.

At the same time, supply-side parties must also recruit and retain a well-trained workforce. The example of Hurricane Katrina's impact on the boat-making industry provides evidence of an environment in which the previously viable employee base virtually disappeared for a short time, and their replacements (although well-trained as well) sought higher wages commensurate with the other regions from whence they came. It is likely that, like so many other industries impacted by Katrina's devastation, the blow to the region's workforce had a significant impact on the price of goods manufactured on the Gulf coast.

The plight of the demand-side is in a similar predicament, subject to a variety of external influences. Chief among them is wages and wage distribution across an economic system. As the case of Poland indicates, if only a few benefit from an economic transition with higher wages, while others lag far behind, the establishment of price with suppliers (and therefore equilibrium) becomes far more complex and difficult.

Of course, one cannot discuss the cost of living among consumers without mentioning taxes. While one cannot discount a governmental system's obvious need for tax revenues to pay for public education, business development, health care and social services, there is also an obvious need for policymakers to be mindful of the true costs of taxation to consumers. Without that cognizance, the cost of living among residents might be rendered higher than the casual eye might reveal. The result is an unanticipated inability for consumers to afford certain goods and services. Equilibrium, therefore, is more difficult to reach.

Finally, the rising cost of energy, utilities and oil has played an undeniably significant role on both supply-side and demand-side arenas. For businesses, it means higher overhead costs and, therefore, a higher price to be transferred to the consumer. For consumers, it means a larger fiscal weight on their shoulders and, summarily, less free cash with which to purchase goods and services. Price equilibrium, when the rising cost of oil and utilities enters the picture, seems less attainable as rates increase.

Once equilibrium is established within a macroeconomic system (in other words, when an amicable price for goods and services is established), the relationship between supply and demand is strengthened. However, equilibrium is difficult to establish when either component is weighed down by exogenous influences. Paradoxically, equilibrium is attainable, when attention is paid to the forces that can pull its subgroups apart.

Terms & Concepts

Capital: Domestic or foreign investment in an industry or industries within an economic system.

Demand: Consumer interest in products, goods and services within an economic system.

Elasticity: Price range based on sensitivity between suppliers and consumers.

Equilibrium: Price point at which supply and demand sides of an economic system are mutually agreeable.

Price: Monetary cost of producing and delivering goods and services within an economic system.

Supply: Goods and services produced within an economic system.

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Suggested Reading

Bompard, E., et al. (2007). The impacts of price responsiveness on strategic equilibrium in competitive electricity markets. International Journal of Electrical Power & Energy Systems, 29, 397-407. Retrieved October 18, 2007, from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=24301720&site=ehost-live

Mseka, A. (2007). Marketing in equilibrium. Advisor Today, 102, 20-21. Retrieved October 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26951647&site=ehost-live

Venditti, Alain. (2007, February/March). Capital externalities in two-sector models. Journal of Difference Equations & Applications, 13, 183-195. Retrieved October 18, 2007 from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=24280734&site=ehost-live

Vickrey, D. (2007). Fundamental accounting concepts in general-equilibrium settings. Journal of Theoretical Accounting Research, 3, 1-44. Retrieved October 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26297821&site=ehost-live