What is general equilibrium theory?
General equilibrium theory, or Walrasian general equilibrium, explains macroeconomic functioning rather than specific market events.
French economist Leon Walras created the hypothesis in the late 19th century. It differs from Marshallian partial equilibrium theory, which exclusively studies specific markets or sectors.
General Equilibrium Theory
Walras solved a contentious economic topic with the general equilibrium theory. Until then, most economic studies only showed partial equilibrium in isolated markets—the price at which supply matches demand and markets are apparent. All markets could not be in balance at once.
The general equilibrium theory explains why all free markets eventually reach equilibrium. The critical point was that markets moved towards equilibrium but did not necessarily attain it. In 1889, Walras stated, “The wind agitates the market like a lake, where the water incessantly seeks its level without ever reaching it.”
Adam Sm,” that’s “Smith’sl” ‘ of Nations” (1776), “popularized general equilibrium theory based on free market price coordination. This method states that merchants buy and sell items in a bidding procedure. Transaction pricing tells other producers and consumers to focus on more profitable activities.
Skilled mathematician Walras felt he established that any market was in equilibrium if all others were. It became Walras’s general equilibrium theory, which views the economy as a network of interrelated markets and argues that all free markets reach equilibrium.
The general equilibrium framework makes numerous sensible and absurd assumptions. Each economy has finite goods and actors. Each agent has one pre-existing good (the “product” on good”) and a continuous, strictly concave utility function. Agents must exchange their produced goods for consumables to boost utility.
This fictional economy has restricted market pricing for products. Each agent uses these prices to maximize his utility, producing supply and demand for things. Like most equilibrium models, markets lack uncertainty, imperfect information, and innovation.
Austrian economist Ludwig von Mises proposed the Evenly Rotating Economy (ERE) as an alternative to long-run general equilibrium. This hypothetical construct shared certain simplifying assumptions with general equilibrium economics: no uncertainty, no monetary institutions, and no disruptive resource or technological shifts. An empty system in the ERE shows the need for entrepreneurship.
Ludwig Lachmann, another Austrian economist, believed the economy was a dynamic process with subjective knowledge and expectations. A comprehensive or non-partial market cannot mathematically show equilibrium, he said. Lachmann-influenced economists see the economy as a spontaneous, orderly progression.
- Partial equilibrium analysis investigates individual markets, but general equilibrium analyzes the economy.
- In a multi-market system, general equilibrium explains how supply and demand balance.
- Different market marketplaces and demand balances establish a price equilibrium.
- French economist Leon Walras created the hypothesis in the late 19th century.