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
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.
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.
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:
[The] incidence of financing constraints is likely to depress investment below its equilibrium level. Policies aimed at reducing or eliminating the market imperfections that give rise to financing constraints could thus have a positive effect on business investment (Dobrinsky, 2007).
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.
In 2005, one of the most destructive storms in US history blew ashore along the Gulf coast. Hurricane Katrina took countless lives,...
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