Definition of general equilibrium theory
What is general equilibrium theory?
General equilibrium theory, or Walrasian general equilibrium, attempts to explain the workings of macroeconomics as a whole, rather than as sets of individual market phenomena.
The theory was first developed by French economist Leon Walras at the end of the 19th century. It contrasts with the theory of partial equilibrium, or Marshallian partial equilibrium, which only analyzes specific markets or sectors.
Key points to remember
- General equilibrium analyzes the economy as a whole, rather than analyzing single markets as with partial equilibrium analysis.
- General equilibrium shows how supply and demand interact and tend towards equilibrium in an economy with multiple markets operating at the same time.
- The balance between competing levels of supply and demand in different markets ultimately creates a price equilibrium.
- French economist Leon Walras introduced and developed the theory at the end of the 19th century.
Understanding general equilibrium theory
Walras developed the theory of general equilibrium to solve a much debated problem in economics. So far, most economic analysis has shown only partial equilibrium – that is, the price at which supply equals demand and clear markets – in individual markets. It has not yet been demonstrated that equilibrium can exist for all markets at once as a whole.
General equilibrium theory has attempted to show how and why all free markets tend towards long-term equilibrium. The important fact was that the markets did not necessarily reach equilibrium, only that they tended towards it. As Walras wrote in 1889, “The market is like a lake stirred by the wind, where the water is constantly seeking its level without ever reaching it”.
General equilibrium theory is based on the coordination processes of a free market price system, widely popularized for the first time by Adam Smith’s “The Wealth of Nations” (1776). This system says that traders, in a bidding process with other traders, create transactions by buying and selling goods. These transaction prices act as signals for other producers and consumers to realign their resources and activities on more profitable lines.
Walras, a talented mathematician, believed he had proven that any individual market was necessarily in equilibrium if all other markets were also in equilibrium. This became known as Walras’ law.
General equilibrium theory views the economy as a network of interdependent markets and seeks to prove that all free markets ultimately evolve towards general equilibrium.
There are many assumptions, realistic and unrealistic, in the context of general equilibrium. Every economy has a finite number of goods in a finite number of agents. Each agent has a continuous and strictly concave utility function, as well as the possession of a single pre-existing good (the “production good”). To increase his utility, each agent must exchange his productive good for other goods to be consumed.
There is a specified and limited set of market prices for commodities in this theoretical economy. Each agent relies on these prices to maximize their utility, thus creating a supply and demand for various goods. Like most equilibrium models, markets lack uncertainty, imperfect knowledge, or innovation.
Alternatives to general equilibrium theory
Austrian economist Ludwig von Mises developed an alternative to long-term general equilibrium with his so-called uniform rotation economy (ERE). It was another imaginary construct and shared some simplifying assumptions with general equilibrium economics: no uncertainty, no monetary institutions, and no disruptive changes in resources or technology. ERA illustrates the need for entrepreneurship by showing a system where one did not exist.
Another Austrian economist, Ludwig Lachmann, argued that the economy is a continuous, unstable process filled with subjective knowledge and subjective expectations. He argued that equilibrium could never be proved mathematically in a general or non-partial market. Those influenced by Lachmann imagine the economy as an open evolutionary process of a spontaneous order.