THIS CHAPTER SHOWS how equilibrium can be reached in a capital market and describes the characteristics of such an equilibrium. We present a series of cases, each of which assumes agreement among investors concerning the chances of alternative future outcomes. More complex (and realistic) cases are covered in later chapters.
A standard definition of equilibrium is:
A condition in which all acting influences are canceled by others, resulting in a
stable, balanced or unchanging system.*
We will use a much simpler definition: a financial economy is in equilibrium when no further trades can be made. But of course in the real world trading seldom stops, and when it does stop, it is typically because low-cost markets are temporarily closed. The implication is that financial markets never really reach a state of equilibrium. Conditions change, there is new information, and people begin to act on the new information before they have fully acted on the old information. In actuality, people make trades to move toward an equilibrium target but the target is constantly changing.
Despite this completely valid observation, we need to understand the properties of a condition of equilibrium in financial markets, because markets will usually be headed toward such a position. And the more efficient the financial system, the smaller will be the discrepancies between market conditions and those of full equilibrium. Moreover, we will see that for many purposes the most important aspects of equilibrium for portfolio choice concern the levels of broad market indices, overall consumption, and other macroeconomic variables, which are likely to be closest to their equilibrium levels.
Understanding the nature of a financial market in equilibrium is a crucial step toward understanding real financial markets. The goal of this book is to explore the relationships between investors' characteristics and investment
*Source: The American Heritage® Dictionary of the English Language, Fourth Edition. Copyright
© 2000 by Houghton Mifflin Company. All rights reserved.