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General equilibrium

General equilibrium theory is a branch of theoretical microeconomics. It seeks to explain production, consumption and prices in a whole economy.

General equilibrium tries to give an understanding of the whole economy using a bottom-up approach, starting with individual markets and agents. Traditional macroeconomics uses a top-down approach where the analysis starts with larger aggregates. Since modern macroeconomics has emphasized microeconomic foundations, this distinction has been slighly blurred. However, many macroeconomic models simply have a 'goods market' and study its interaction with for instance the financial market. General equilibrium models typically model a multitude of different goods markets. Modern general equilibrium models are typically complex and require computers to help with numerical solutions.

In a free market economy, the prices and production of all goods are interrelated. If you are considering the price of one good, say bread, this may affect another price, for example the wages of bakers. In return the wages of bakers will affect the price of bread. Determining the price of just one good in real economy would in theory require an analysis that took into account all of the millions of different goods that are available.

In partial equilibrium analysis, the determination of the price of a good is simplified by just looking at the price of one good, and assuming that the prices of all other goods remain constant. The theory of supply and demand is an example of partial equilibrium analysis. Partial equilibrium analysis will usually be considered adequate when the item to be analysed is fairly insignificant when compared to the economy as a whole. However, if partial equilibrium analysis is used to analyse macroeconomic variables such as the level of interest rates or wage rates[?], partial equilibrium analysis could potentially be misleading as it would ignore feedback effects.

The first attempt to show how prices for a whole economy could be determined was attempted by Leon Walras, who showed that under certain very restrictive assumptions the prices for all goods in an economy could be determined as the solution to a series of simultaneous equations.

Subsequent work on general equilibrium theory, such as that by Kenneth Arrow and Gerald Debreu[?] has shown how a free market system might arrive at prices under less restrictive assumptions. Nevertheless, there are many arguments to suggest that general equilibrium theory may be a long way from describing the workings of real economies.

Concepts of general equilibrium in economics

Different schools of economic thought use different concepts of equilibrium in their models of the economy. The two main types of equilibrium are:

  • Static equilibrium - the situation in which an economy is in a steady state. Every year, the same goods are produced, and just enough capital goods, such as machinery, are produced to keep the economy producing at the same level. Static equilibrium can also be used to mean a situation in which there are no capital goods, so all goods are traded at the same time and none are carried over to later time periods. In a static equilibrium, prices will be such that the steady state is maintained, with the wages and profits accruing to each individual matching the cost of the goods bought each year. This concept of equilibrium is similar to that used in, for example, physics.

  • Dynamic equilibrium. In these models, the economy is not in a steady state, and might for example be growing through time, with different goods being introduced through innovation. Here, the economy being in equilibrium means that prices are adjusted so that supply and demand are equated for all goods in the economy. In these models, goods often need to be identified by when they are to be delivered, and under what circumstances, as well as by their intrinsic nature, so there would be a complete set of prices for contracts such as "1 tonne of wheat, delivered on 3rd of January, if there is a hurricane in Florida".

Static equilibrium was used in the analysis of classical economists, such as David Ricardo, and forms the basis of marxist theories of value. Early neoclassical economics, such as the work of Leon Walras, was also based on static equilibrium, but was later developed into a full dynamic equilibrium model by Kenneth Arrow and Gerard Debreu[?]. Some modern schools of economic thought, such as post Keynesian economics, continue to use static equilibrium models.

Validity of static and dynamic equilibrium concepts

Proponents of dynamic equilibrium models would contest that static equilibrium is totally unrealistic for the modern world, where the economy is clearly not in a steady state. There are new innovations, economic growth, and wide swings in prices happening all the time. In this view, static equilbrium is totally unsuited for modelling real economies, apart perhaps from traditional societies which have remained stable for centuries.

Critics of dynamic equilibrium contest that this concept of equilibrium is fundamentally invalid. Because it is not a steady state, the equilibrium remains a "moving target" - if prices are not at equilibrium, there is no guarantee that the forces of supply and demand will return the economy to equilibrium.

Although modern models in general equilibrium theory demonstrate that under certain circumstances prices will indeed converge to the dynamic equilibrium, critics hold that the assumptions necessary for these results are completely unrealistic. The necessary assumptions include perfect rationality of individuals; complete infomation about all prices both now and in the future; and the conditions necessary for perfect competition.

Some economists reject equilibrium theory outright in favour of more pragmatic models based more closely on observation of the economy.

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