What is general equilibrium theory in macroeconomics?
General Equilibrium Theory is a macroeconomic theory that explains how supply and demand in an economy with many markets interact dynamically and ultimately result in price equilibrium. The theory assumes that there is a gap between real prices and equilibrium prices.
The objective of the theory is to identify the precise set of circumstances under which the equilibrium price is likely to achieve stability.
Key points to remember
- General equilibrium theory in macroeconomics shows how supply and demand in a multi-market economy interact and create a price equilibrium.
- French economist Léon Walras is credited with developing and developing the theory of general equilibrium at the end of the 19th century.
- Walras applied the theory to multi-market parameters by introducing a third good in his model, which then allowed him to calculate price ratios.
- Walras’s contributions to theory helped evolve economics into a study that includes mathematical analysis at its core.
Léon Walras and the theory of general equilibrium
The theory is most closely associated with Leon Walras, who wrote “Elements of Pure Economics” in 1874. Although the idea was vaguely mentioned by previous economists, he was the first to articulate it in depth.sese
Walras began his explanation of general equilibrium theory by describing the simplest economy imaginable. In this economy, there were only two goods that could be traded, called x and y. Everyone in the economy was assumed to be a buyer of one of these products and a seller of the other. In this model, supply and demand would be interdependent, because the consumption of each of the goods would depend on the wages earned from the sale of each of the goods.sese
The price of each commodity would be decided through a tendering process, which Walras called “groping”. He described it in terms of an individual seller calling the price of a good in the market and consumers responding by buying or refusing to pay. Through a process of trial and error, the seller would adjust the price according to demand, thus establishing the break-even price. Walras believed that there would be no exchange of goods until the equilibrium price was reached, an assumption that has been criticized by others.sese
In describing equilibrium on a larger scale, Walras applied this principle to multi-market contexts, which are much more complex. He introduced a third good to his model, called z. From this, three price ratios could be determined, one of which would be redundant because it would not give any information that could not be identified from the others.seThis redundant good could be identified as the standard by which all other price relationships could be expressed. The standard would provide a guide to exchange rates.
The bottom line
Theoretically, Walras’ theory had transformational effects. Economics, once a literary and philosophical discipline, was now considered a deterministic science. His insistence that economics could be reduced to disciplined mathematical analysis persists today.
In more recent terms, we can also say that Walras’s equilibrium theory has lasting effects. It blurs the lines between microeconomics and macroeconomics, because the economy that relates to individual households and businesses cannot be seen as existing separately from macroeconomics.