Competitive market equilibrium

Competitive, or Walrasian, market equilibrium is the traditional concept of economic equilibrium, appropriate for the analysis of commodity markets with flexible prices and many traders, and serving as the benchmark of efficiency in economic analysis. It relies crucially on the assumption of a competitive environment where buyers and sellers take the terms of trade (prices) as a given parameter of the exchange environment. Basically, each trader decides upon a quantity that is such small compared to the total quantity traded in the market that their individual transactions have no influence on the prices.

A Walrasian or competitive equilibrium consists of a a vector of prices and an allocation such that given the prices, each trader by maximizing his objective function (profit, preferences) subject to his technological possibilities and resource constraints plans to trade into his part of the proposed allocation, and such that the prices make all net trades compatible with one another ('clear the market') by equating aggregate supply and demand for the commodities which are traded.

Although this rather narrow concept of economic equilibrium is inappropriate in many situations, such as oligopolostic market structures, public goods and externalities, collusion, or markets with price rigidities, it hightlights the close connection between unregulated free price formation in competitive markets and allocative efficiency. For a broad variety of preferences, technologies, and ownership structures, competitive equilibria maximize social welfare in the sense of maximizing the sum of aggregate consumer and producer surplus (see economic rents). Not only do Walrasian markets provide an exchange institution that leads to efficient outcomes, but any efficient allocation can be reached as a competitive equilibrium by an appropriate redistribution of the traders' intial resources.

In addition, Walrasian markets minimize the informational requirements to complete a transaction: each trader only has to know the characteristics of the object traded, the price, and his own objective function (preferences, technology). However, complete information on prices and on the characteristic of the commodities is necessary to retain the efficiency features of free price formation in competitive markets. If there is asymmetric information on the quality of the commodities, prices only insufficiently signal the relative opportunity costs of economic decisions, and, as a result, allocative decisions will no longer lead to efficient market outcomes. Even worse, the repercussions of adverse quality updating can make markets break down completely, with no voluntary trade taking place at all. (Potential market breakdowns in the presence of commodities of varying quality and asymmetric information have become famous as the lemons problem.)

If markets are 'thin', traders have market power, and the competitive paradigm does no longer apply. Instead, prices are explained from matching strategically formed price 'bids' (buying demands) and price 'asks' (selling offers). Accordingly, more general models of competitive markets are described as auctions. However, as the number of bidders grows large, the strategic equilibrium bids from common value auctions approach the competitive price. A similar result holds for competitive markets with perfect information where the traders are free to form coalitions which maximize the joint gains from trade. Then, the coalitionally stable outcomes form a large set, which includes in particular the (efficient) competitive allocation. Again, as the number of trader becomes large, the set of outcomes which is stable under collusive behavior shrinks, and it approaches the (unique) competitive outcome again. Thus, in the limit, both the coalitional and the strategic approach to describing competitive markets collapse into the simple competitive (Walrasian) paradigma. This fact both underlines the benchmark role of perfectly competitive market equilibrium for the allocation of goods, and the restrictive nature of the Walrasian concept of competitive markets.

Entry by: Jan Vleugels

December 1, 1997
Direct questions and comments to: Glossary master