General Equilibrium Theory - Explained
What is General Equilibrium Theory?
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What is General Equilibrium Theory?
General equilibrium theory refers to a theory which tries to explain how demand, supply, and price functions in an economy as a whole and not just in a single or specific market. In other words, the general equilibrium analyzes the whole economy. This is contrary to partial equilibrium which analyzes individual markets only. General equilibrium theory is also known as the Walrasian general equilibrium.
- General equilibrium theory refers to a theory which tries to explain how demand, supply, and price functions in an economy as a whole and not just in a single or specific market.
- General equilibrium is only in existence when every single products supply equals demand.
How does the General Equilibrium Theory Work?
The general equilibrium is the same as economic equilibrium. Both theories use the equilibrium price model to study economies. The main objective of these theories is to determine the situation in which the general equilibrium will hold using assumptions. For instance, the theories seek to prove that both demand and supply interaction will lead to a whole general equilibrium. In economics, general equilibrium refers to where demand and supply have equal status (are equal to each other).
The History of General Equilibrium Theory
The general equilibrium theory can be traced back to 1874 where a French economist known as Leon Walras, invented it during his very first work, Elements of Pure Economics. Being a talented mathematician, Walras proved that for a single market to be in equilibrium, the rest of the markets have to also be in equilibrium. This is where the theory of general equilibrium originated and was named Walras's Law hence the term, Walrasian equilibrium theory.
Why the General Equilibrium Theory was Developed
Back then before general equilibrium theory was developed, there were many problems relating to economics. Following this, Walras developed this theory so as to address the economic problems that were much debated. Take note that before the emergence of this theory, the analysis of economics could only demonstrate the function of demand, supply, and price in single markets (partial equilibrium). It could not demonstrate the existence of all markets simultaneously as a whole. So, the theory was, therefore, developed to help in demonstrating how all markets tend to move toward equilibrium and also the reason why they move. Importantly, note that markets didnt, and still do not reach equilibrium, rather, they only tend to move close to it. Because of this, economists believe that there is no existence of general equilibrium. The best you can do is to try and move towards it as close as you possibly can. Generally, this theory builds on a market price system that is free. The system demonstrates how traders through the process of bidding with fellow traders can through buying and selling of goods, build a transaction. It is through these transaction prices that producers and consumers are able to adjust their resources to business lines that are more profitable. However, this assumption has been under criticism. Typically, general equilibrium theory sees the economy as interdependent markets network, which strives to show that free markets as a whole, in the end, do move close to general equilibrium.
General Equilibrium Assumptions
Since general equilibrium is a theory, therefore, based on several assumptions as highlighted below: There exists perfect competition in goods and services as well as in other factor markets.
- All productive services units are similar.
- The income of the consumers is constant and given.
- tastes as well as habits of the consumers are constant and given
- The productions techniques have no change.
- The production factors go through mobility between different occupations and places.
- Return to scale are constant
- All firms operate their business under similar cost conditions
- There exist full resource employment including services such as labor
Generally, using the above assumptions, general equilibrium is only attainable when every single products supply equals demand. Also, the decision of the consumer regarding each product as well as the decision of the producers for each items production should work out harmoniously.
- Total Utility (Economics)
- Efficiency Principle
- Indifference Curve
- Time Preference Theory of Interest
- Diminishing Marginal Utility
- Sunk Costs
- Production Possibilities Frontier
- Law of Diminishing Returns
- Economic Efficiency
- Efficiency Theory
- Productive Efficiency
- Capacity Utilization Rate
- Pareto Efficient
- Comparative Advantage
- Criticisms of the Economic Approach
- Behavioral Economics
- Normative Economics
- Positive Economics
- Invisible Hand
- Sunk cost