General equilibrium theory, also known as Walrasian general equilibrium, endeavors to explain how the macroeconomy operates as a whole, rather than as isolated individual market phenomena.
The theory was pioneered by the French economist Leon Walras in the late 19th century, distinguishing itself from partial equilibrium theory or Marshallian partial equilibrium, by analyzing an integrated economy rather than specific markets or sectors.
Key Takeaways
- General equilibrium provides a holistic analysis of the economy, contrasting sharply with the focus on singular markets in partial equilibrium analysis.
- It shows how supply and demand interact across multiple markets, driving them toward an overall balance.
- The interplay of competing levels of supply and demand within diverse markets ultimately results in a price equilibrium.
- French economist Leon Walras developed and introduced this insightful theory during the late 19th century.
Understanding General Equilibrium Theory
Walras developed general equilibrium theory to address a crucial issue in economic thought. Up to this point, economic analysis largely focused on partial equilibrium, defined as the price at which supply equals demand within individual markets. The concept of achieving simultaneous equilibrium across all markets collectively remained unproven.
General equilibrium theory aimed to substantiate how and why all free markets gravitate towards equilibrium over time. Importantly, markets may not necessarily reach equilibrium at all instances; rather, they tend toward it. As Walras eloquently described in 1889, “The market is like a lake agitated by the wind, where the water incessantly seeks its level without ever reaching it.”
Building on Adam Smith’s notions, Walras illustrated that traders engage in a coordinated bidding process to create transactions. These transactions act as signals, guiding producers and consumers to reorganize resources along more profitable lines. Walras, using his mathematical prowess, demonstrated that an individual market achieves equilibrium if all other markets are simultaneously in equilibrium, a principle subsequently known as Walras’s Law.
The theory envisions an economy as a network of interdependent markets naturally progressing toward general equilibrium.
Special Considerations
General equilibrium theory operates under several assumptions, ranging from realistic to purely theoretical. It assumes a finite number of goods and agents within the economy. Each agent has a continuous and strictly concave utility function and controls a particular pre-existing good, dubbed the “production good.” By trading this production good, the agent seeks to elevate their utility by acquiring other goods.
Within this framework, a defined set of market prices helps agents maximize utility, spawning supply and demand across various goods. Crucially, most equilibrium models lack components of uncertainty, imperfect knowledge, or innovation.
Alternatives to General Equilibrium Theory
Famed Austrian economist Ludwig von Mises formulated an alternative dubbed the Evenly Rotating Economy (ERE), sharing certain simplifying assumptions with general equilibrium economics such as the absence of uncertainty, monetary institutions, and disruptive technological changes. The ERE underscores the importance of entrepreneurship by illustrating a system devoid of entrepreneurial actions.
Similarly, Austrian economist Ludwig Lachmann posited that the economy constitutes an ongoing, evolving process permeated with subjective knowledge and expectations. He argued that general equilibrium, particularly in non-partial markets, could never be proven mathematically. Lachmann’s followers view the economy as an open-ended evolution stemming from spontaneous order.
Related Terms: Partial Equilibrium, Walras’s Law, Adam Smith, Austrian Economics, Ludwig von Mises, Ludwig Lachmann.
