Definition
In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an overall general equilibrium. General equilibrium theory contrasts to the theory of partial equilibrium, which only analyzes single markets.
General Equilibrium Theory
What is the ‘General Equilibrium Theory’
General equilibrium theory, or Walrasian general equilibrium, attempts to explain the functioning of economic markets as a whole, rather than as individual phenomena. The theory was developed by the French economist Leon Walras. It stands in contrast with partial equilibrium theory, or Marshellian partial equilibrium, which only analyzes specific markets.
Explaining ‘General Equilibrium Theory’
Walras developed general equilibrium theory to solve a much-debated problem in economics. Up to that point, most economic analyses only demonstrated partial equilibrium — the price at which supply equals demand and markets clear — in individual markets. It was not yet shown that equilibrium could exist for all markets at the same time.
Uses of General Equilibrium Theory
General equilibrium theory tried to show how and why all free markets tended toward equilibrium in the long run. The important fact was that markets didn’t necessarily reach equilibrium, only that they tended toward it. As Walras wrote in 1889, “The market is like a lake agitated by the wind, where the water is incessantly seeking its level without ever reaching it.”
Assumptions
There are many assumptions, realistic and unrealistic, inside the general equilibrium framework. Each economy is considered to have a finite number of goods in a finite number of agents. Each agent has a continuous and strictly concave utility function, along with possession of a single pre-existing good (the “production good”). In order to increase his utility, each agent must trade his production good for other goods to be consumed.
Alternatives to General Equilibrium Theory
Austrian economist Ludwig von Mises developed an alternative to long-run general equilibrium with his so-called Evenly Rotating Economy (ERE). This was another imaginary construct and shared some simplifying assumptions with general equilibrium economics: no uncertainty, no monetary institutions and no disrupting changes in resources or technology. The ERE was designed to illustrate the necessity of entrepreneurship by showing a system where none existed.
Further Reading
- Classical general equilibrium theory – ideas.repec.org [PDF]
- Temporary general equilibrium theory – www.sciencedirect.com [PDF]
- Money and general equilibrium theory – ideas.repec.org [PDF]
- Arrow and general equilibrium theory – www.jstor.org [PDF]
- Advances in General Equilibrium Theory – ideas.repec.org [PDF]
- Temporary general equilibrium theory – www.jstor.org [PDF]
- Equilibrium theory in infinite dimensional spaces – www.sciencedirect.com [PDF]
