Let us make an in-depth study of General Equilibrium Analysis:- 1. Meaning of General Equilibrium Analysis 2. Objectives of General Equilibrium Analysis 3. Uses.
Meaning of General Equilibrium Analysis:
As against partial equilibrium analysis, general equilibrium analysis is concerned with economic system as a whole.
It recognises the fact that economic system is a network in which all the parts are mutually dependent on one another and in mutual interaction with one another.
Goods are either competitive or substitutes. Some goods are used in the manufacture of other goods. Factors of production are complementary to each other to the extent they can be substituted for each other, they are competitive also. Resources also face competitive demand from producers.
Therefore, change in the demand or supply of any commodity or factor of production sets in motion a chain reaction. A disturbance in one sector of the economy produces its repercussions on all sides. General equilibrium analysis is concerned with the overall effects of a disturbance.
Instead of taking only a few variables at a time, we take into consideration all the relevant variables which may affect the particular phenomenon in hand. In this type of analysis, all the side-affects of an economic disturbance are analysed in full.
An example will make the concept of general equilibrium clearer. Suppose the demand for India-manufactured consumer goods suddenly increases in Western Europe. Indian exports will increase thereby increasing output, employment and profits in the export industries. Resources will be diverted from other industries to the export industries.
The demand and prices of the substitute commodities will also increase. The increased demand for exports will have economy-wide effects. An all-round analysis of the repercussions of the economic disturbance increased demand for manufactured consumer goods for export can be done only through general equilibrium theory.
General equilibrium analysis deals with the equilibrium of the whole organisation in the economy consumers, producers, resource-owners, firms and industries. Not only should individual consumers and firms be in equilibrium in themselves but also in relation to each other.
Business firms enter product markets as suppliers, but they enter factor markets as buyers. Households, on the other hand, are buyers in product markets but suppliers in factor markets. General equilibrium prevails when both the product and factor markets are in equilibrium in relation to each other.
Objectives of General Equilibrium Analysis:
General equilibrium analysis serves many important purposes.
Firstly, it provides us with a theoretical tool to understand the economy in its entirely the mechanics of its working, it structure, and the major forces making it work. The theory is analysis of the interrelationships of the various sectors of an economy. As such, it helps us in knowing clearly the economy-wide implications of an economic change.
Secondly, we can apply general equilibrium theory to determine the primary, secondary and tertiary effects of an economic disturbance which has an intersectoral impact. Whenever there is an economic disturbance say, like the defence programmes in the wake of Chinese aggression in 1962 it has some immediate effects in one sector of the economy.
Gradually, the impact of such a disturbance is felt in other sectors. The whole economy goes into disequilibrium. Process of adjustment to the economic disturbances starts to establish a new equilibrium.
As Richard Leftwich put it, “First comes the big splash from the disturbance. Particular equilibrium analysis handles the splash. But waves and then ripples are set up from it, affecting one another and affecting the area of the splash. The ripples run farther and farther, becoming smaller and smaller, until eventually they dwindle away. The tools of general equilibrium are required for analysis of the entire series of readjustments.”
Thus, general equilibrium theory is of great value in stressing the interdependence of various parts of the economic system, which is easily lost sight of in the use of partial equilibrium theory in micro-economic analysis.
Failure to recognise this interdependence is responsible for many errors in popular reasoning on economic policy.
Uses of General Equilibrium Analysis:
The practical importance of general equilibrium analysis cannot be questioned.
Recently, it has proved extremely useful in different forms:
1. The general equilibrium theory is being put to extensive use in the study of the development and other major programmes of modern economics to ascertain their feasibility, their impact and requirements. Take, for example, the effect of defence preparations to meet the Chinese threat.
It meant a rearrangement of all the priorities. There was heavier demand for steel and other construction materials, as also the demand for woolens.
It also meant heavier imports. Prices of all these commodities increased, diverting resources to these industries and away from some others. Eventually, effects were felt over the entire economy. An assessment of the full impact of such a programme in advance could be possible only through general equilibrium analysis.
2. Professor Wassily Leontief accomplished the task of bringing general equilibrium theory to the practical level by building his input-output analysis. The use of computers and other high speed calculating machines has made it possible for us to solve hundreds of equations to find out a solution.
Thus, input-output analysis has been put to a variety of uses. Since this analysis can throw light on the structure of an economy and the interdependence between its different parts, it has been extensively used in planning for smooth growth of the national and international economy.
3. General equilibrium analysis has found its most extensive use in welfare economics. In this branch of economics, we study the ‘best’ allocation of resources, given the objectives of society. The search for such an organization of the economy leads us to apply the methods of general equilibrium.
4. Monetary theory and policy have been revolutionised by the introduction of general equilibrium analysis. It is now widely recognized that a meaningful monetary policy must apply to all the assets in the economy which are related to all the goods, capital and labour markets. Such a monetary policy is nothing but a study of general equilibrium effects of government policy.