In economics, an equilibrium refers to a state in which the opposite market forces are balanced, resulting in a stable point, and they don’t want to deviate from that particular point. However, sometimes an equilibrium can be “bad,” meaning that it leads to negative outcomes for one or more parties involved. This blog post will explore the concept of a bad equilibrium in economics and its implications.
What is Bad Equilibrium?
A bad equilibrium happens when the way the market is right now is not best for everyone, but no one wants to change it. This can happen for several reasons, such as an imbalance of power, insufficient information, or outside pressures.
For example, imagine a situation where two firms produce a similar product. Both firms charge a high price, resulting in high profits for both. However, the high price also means that many consumers cannot afford the product, resulting in a low level of overall demand. Despite the fact that lowering prices would increase demand and benefit consumers, neither firm is motivated to do so, as they would lose out on profits. This leads to a bad equilibrium, as consumers are not getting the optimal outcome.
Bad equilibria can sometimes be self-reinforcing, making them increasingly difficult to change. For example, imagine a scenario where a particular neighborhood experiences high crime. This may lead residents to take increased security measures, such as installing bars on windows or hiring private security guards. However, these measures can make the neighborhood appear less welcoming to potential residents and businesses, leading to a further decline in economic activity and a higher level of crime. This creates a self-reinforcing cycle of decline in which the bad equilibrium becomes increasingly entrenched.
Getting out of a bad equilibrium can be hard because it often takes coordinated action from more than one person or group. For example, if two companies charge high prices, the government or a new company entering the market may need to break the equilibrium. In the case of the high-crime neighborhood, the cycle of decline may need to be broken by a combination of more police, community involvement, and money spent on economic development.
Bad Equilibrium in Micro Economics
In microeconomics, a bad equilibrium refers to a situation where the market fails to allocate resources efficiently, resulting in a suboptimal outcome for all parties involved. This can occur when the market is dominated by a few large players who have the power to influence the market outcome and prevent competition.
For example, imagine a market where only one dominant firm has a monopoly on a certain product. This dominant firm can set high prices and limit output, resulting in consumers paying more than they would in a competitive market, and the dominant firm earns excess profits. This creates a bad equilibrium where the dominant firm has no incentive to innovate, and other firms have no incentive to enter the market and compete.
Coming out of a bad equilibrium in microeconomics requires a combination of regulatory and policy interventions. Regulatory interventions can include measures like antitrust laws, which prevent dominant firms from engaging in anti-competitive behavior. Policy interventions can include measures such as subsidies, which encourage entry into the market and promote innovation.
Bad Equilibrium in Macro Economics
In macroeconomics, a bad equilibrium can occur when an economy is stuck in a low-growth, high-unemployment state due to various factors, such as market failures, external shocks, or policy failures. This can result in the economy not producing at its full potential, and many people are unemployed or underemployed.
For example, imagine an economy lacking investment due to a lack of confidence among investors, resulting in low economic growth and high unemployment. This lack of investment leads to a decrease in demand, reducing the incentive for firms to invest and resulting in a self-reinforcing cycle of low growth and high unemployment. This creates a bad equilibrium where the economy is stuck in a low-growth, high-unemployment state.
Breaking out of a bad equilibrium in macroeconomics requires a combination of monetary, fiscal, and structural policies. Monetary policy, such as lowering interest rates, can increase the money supply and stimulate spending. Fiscal policy, such as increasing government spending or cutting taxes, can increase aggregate demand and encourage investment. Structural policies, such as improving infrastructure, education, and training programs, can increase productivity and competitiveness.
Bad Equilibrium Diagram
Let us clarify the concept of bad equilibrium with the help of the diagram below.
In the above diagram, let us assume a perfect competition market where the equilibrium condition in price and output determination takes place at that point where MC = MR and MC cuts MR from below. This can be found at point E2. This is the case of good equilibrium as both conditions are fulfilled.
However, point E1 can not be neglected as MC has cut MR, and MC = MR. But, since MC cuts MR from above at that point, it can be termed as a point of bad equilibrium.
MC = Marginal Cost
MR = Marginal Revenue
AR = Average Revenue
P = Price