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.
Competitive equilibrium is also called Walrasian 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, demand tends to fall and supply rises—and when prices are slashed, demand increases and supply declines.
Eventually, these two forces end up balancing out. The supply and demand curve intersects and a price that suits all parties is reached. Suddenly, what buyers are willing to pay equals what suppliers are willing to sell the goods they produce for.
At equilibrium prices, each agent maximizes his or her objective function subject to his or her technological limitations and resource constraints, and the market clears the aggregated supply and demand for the products in question.
Benefits of Competitive Equilibrium
The competitive equilibrium can be considered a specialized branch of game theory that deals with making decisions in large markets. It serves many purposes, operating as a benchmark for efficiency in economic analysis.
In a capitalist market, vital regulatory functions, such as ensuring stability, competency and fairness are left to the mechanisms of pricing. Thus, competitive equilibrium theory of equilibrium prices acquired a prominent place in mathematical economics. With the advent of the internet, extensive research has been done at the intersection of computer science and economic theory.
Competitive equilibrium can be used to predict the equilibrium price and total quantity in the market, as well as the quantity consumed by each individual and output per firm. 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.
The theory relies on the assumption of competitive markets, where 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. Competitive markets are an ideal, and a standard by which other market structures are evaluated.
Competitive Equilibrium vs. General Equilibrium
The defining characteristic of competitive equilibrium is that it is competitive. By contrast, a general equilibrium’s defining characteristic is that it is an equilibrium on more than one market; as opposed to the partial equilibrium in which we hold at least one price fixed and analyze the response of other markets/prices only.
The difference between the two types of equilibriums is all about the emphasis. Any general equilibrium is a competitive equilibrium, but not any competitive equilibrium is necessarily general equilibrium.
- Competitive equilibrium is achieved when profit-maximizing producers and utility-maximizing consumers settle on a price that suits all parties.
- At this equilibrium price, the quantity supplied by producers is equal to the quantity demanded by consumers.
- The theory serves many purposes, operating as a benchmark for efficiency in economic analysis.