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What Is General Equilibrium Theory?
Let me explain general equilibrium theory, also known as Walrasian general equilibrium, to you directly. This theory aims to describe how the entire macroeconomy works, not just isolated market events.
I want you to know it was first created by the French economist Leon Walras in the late 19th century. It differs from partial equilibrium theory, or Marshallian partial equilibrium, which focuses only on specific markets or sectors.
Key Takeaways
- General equilibrium looks at the economy as a whole, unlike partial equilibrium which examines single markets.
- It demonstrates how supply and demand interact and move toward balance in an economy with multiple markets operating simultaneously.
- The interplay of supply and demand across markets leads to a price equilibrium.
- French economist Leon Walras introduced and developed this theory in the late 19th century.
Understanding General Equilibrium Theory
Walras created general equilibrium theory to address a key debate in economics. Before that, most analyses showed only partial equilibrium—the point where supply meets demand and markets clear—in single markets. No one had proven that equilibrium could exist across all markets at once.
This theory shows how and why all free markets tend toward equilibrium over the long run. Remember, markets don't always hit equilibrium; they just move toward it.
As Walras put it around 1900, 'The market is like a lake agitated by the wind, where the water is incessantly seeking its level without ever reaching it.'
General equilibrium builds on the free market price system, popularized by Adam Smith's 'The Wealth of Nations' in 1776. In this system, traders bid and transact by buying and selling goods.
These transaction prices signal to producers and consumers to adjust their resources and activities for better profitability.
Walras, being a skilled mathematician, argued he proved that if all other markets are in equilibrium, any single market must be too. This is known as Walras’s Law.
Special Considerations
You should note there are many assumptions in the general equilibrium framework, some realistic and some not. Each economy has a finite number of goods and agents. Every agent has a continuous, strictly concave utility function and owns one pre-existing good, the 'production good.'
To boost their utility, agents trade this production good for consumable goods.
There's a fixed set of market prices for goods in this theoretical setup. Agents use these prices to maximize utility, generating supply and demand. Like most equilibrium models, it excludes uncertainty, imperfect knowledge, or innovation.
Alternatives to General Equilibrium Theory
Austrian economist Ludwig von Mises offered an alternative with his Evenly Rotating Economy (ERE). This is another theoretical construct sharing assumptions like no uncertainty, no money institutions, and no changes in resources or tech. The ERE shows why entrepreneurship is essential by depicting a system without it.
Another Austrian, Ludwig Lachmann, saw the economy as an ongoing, unstable process full of subjective knowledge and expectations. He claimed equilibrium can't be mathematically proven in a general market.
Followers of Lachmann view the economy as an open-ended evolutionary process of spontaneous order.
What Does Equilibrium Theory Tell Us?
General equilibrium theory informs us that in every market of an economy, supply and demand actively interact, leading to price equilibrium. All markets are linked, so decisions in one affect others.
What Are the Limitations of General Equilibrium?
The limitations stem from its assumptions: markets are perfectly competitive, all participants have perfect knowledge and optimize accordingly, and there are no externalities. None of these hold true in reality.
What Is the 2 x 2 x 2 General Equilibrium Model?
The 2 x 2 x 2 model illustrates the theory by assuming two factors of production, two commodities, and two consumers.
The Bottom Line
Leon Walras developed general equilibrium theory to show how all markets in an economy interact and tend toward balance. Though influential, it depends on assumptions like perfect knowledge and no uncertainty, which critics challenge as unrealistic in actual economies.
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