How to Calculate the Equilibrium Level of Income

Supply and demand for the macro and micro economy.

Sep 11, 2015 at 10:01PM

The equilibrium level of income is when an economy or business has an equal amount of production and market demand. The definition is a bit abstract, so let's use a simple example of a manufacturing business to explain what it actually means.

The equilibrium level of income is the point at which a business is able to sell all of the goods it planned to. Pretty simple.

The company produces its product to that level, and then sells exactly the same amount. The company's output -- its production -- is equal to the consumer demand to buy the product.

That micro example is pretty easy to understand, and we can use that simplicity to expand our understanding to the macroeconomic level. At the national level, gross domestic product, or GDP, represents the business manufacturing its products. All the businesses, consumers, investors, and government spending in the economy represent the consumers buying those products.

An economy is said to be at its equilibrium level of income when aggregate supply and aggregate demand are equal. In other words, it is when GDP is equal to total expenditure.

How to calculate the equilibrium level of income
To calculate the equilibrium level of income, you'll need a few economic figures to plug into a formula. This exercise can quickly become quite complex when factoring in government spending, inflation, GDP, and a myriad of other macroeconomic calculations.

Most simply, the formula for the equilibrium level of income is when aggregate supply (AS) is equal to aggregate demand (AD), where AS = AD.

Adding a little complexity, the formula becomes Y = C + I + G, where Y is aggregate income, C is consumption, I is investment expenditure, and G is government expenditure.

Using this formula, an analyst can observe how a change in any of the factors will impact the level of income. For example, if government spending increases, and all other expenditures stay constant, the level of aggregate income must also increase to maintain the equilibrium level of income.

Why does the equilibrium level of income matter?
The calculation of the equilibrium level of income is normally a task for economists, but the application and understanding of this concept has merit for investors of all walks. Let's break it down.

When aggregate demand exceeds aggregate supply, businesses will increase their output. Think back to our manufacturing business: If their customers are making more and more orders, the company will increase their production -- the output. Why? Because there's more money to be made!

That process leads the company to buy more raw materials, invest in new equipment, and perhaps even hire more workers. The aggregate effect is very positive for the economy.

In the inverse situation, when aggregate demand falls short of aggregate supply, the manufacturing company builds too much product and can't sell it all. The company's inventory will accumulate in the warehouse, which increases its overhead expenses, reduces its cash, and hurts profits. The company must decrease its production, potentially downsizing its employment base or cutting prices to unload the excess inventory. When that happens to businesses nationally, it's clearly a bad thing for the economy.

When output and demand are in the balance though, the company can continue humming along, manufacturing its products, selling them, and maintaining prices, employment, and profits.

Understanding this dynamic is helpful in understanding the business cycle at a macro level, just as it's helpful in understanding how a specific company's business prospects change over time. It's supply and demand, applicable to both the micro and the macro.

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4 in 5 Americans Are Ignoring Buffett's Warning

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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