In this article we will discuss about the general equilibrium of the ecomomy.
In microeconomics we discuss the roles of consumer preferences and firms’ behaviour in the determination of the prices of commodities and inputs. All our analyses so far have been partial, i.e., the analysis has been confined to analysing only some of the effects of the behaviour of economic agents.
But, in reality, if demand for good X changes and its price alters, this will have the effect of changing the demand for substitutes and compliments. Changes in the prices of all these goods, thus, altering input prices, and so on. Thus, the interdependence between the prices and quantities of commodities and inputs is an important fact of life.
In the language of Ryan and Pearce, “it is this fact of interdependence that leads many economists to feel that purely partial analyses convey only limited, and possibly misleading, information about the consequences of economic events. Because of this they argue that the proper mode of analysis should be general. General analysis attempts to take into account the existence of interdependencies between prices.”
The determination of price of a single commodity in a single market falls under the purview of the partial equilibrium analysis. The same exercise is conducted in case of a particular factor. These prices, be it commodity price or factor price, are equilibrium prices. There is no tendency for them to change unless one of other things have been held equal.
In other words, interdependence is ignored in the analysis of partial equilibrium. However, in reality it is quite reasonable to suppose that it must be possible for a complete set of prices to exist such that all the plans of households and firms-or of buyers and sellers-are mutually consistent. Such a situation it existed, would be one of general equilibrium.
Microeconomics is the study of the behaviour of isolated economic entitles, such as individual consumers or firms or industries. Contrarily macroeconomics, as we have seen, is the study of the behaviour of the economy as a whole; as measured by the aggregate value of such variables as the volume of output, the price level, and the level of employment General equilibrium theory actually forms a bridge between these two branches of economic theory and uses the tools of microeconomics to analyse the behaviour of the entire economy.
“In common with macroeconomics, general equilibrium theory is concerned with inter-relationships that exist among the markets for goods and services in the economy in common with microeconomics, the analysis in general equilibrium theory is carried out in terms of individual decision makers and commodities rather than in terms of aggregates. The fundamental questions that general equilibrium theory attempts to answer are the same as those posed in macroeconomic theory: given different economic environments, what goods will the economy produce, how will these be produced, and who will obtain them? But, whereas macroeconomics provides answers in terms of aggregates, general equilibrium theory provides answers in terms of individual consumers, producers, and commodities making up these aggregates.”
In fact, microeconomics may be regarded as a simple form of general equilibrium theory in which the decision-makers in the economy are the consumer, the producer, and the government. The consumer has to make decisions with respect to the allocation of his income between consumption and saving, the amount of labour he is to supply, and the form in which he will hold his wealth (holdings of money versus securities).
The producer in his him has to take decisions on the number of units of labour to hire to produce a particular commodity which may be used either as a consumption or as a capital good. He has also to determine the number of units of output to set aside for further investment.
“The resulting interactions among these consumption, wealth- holding, and production decisions then determine such magnitudes as the price of the commodity, the interest rate (the inverse of the price of securities), the number of units of labour employed and the number and distribution of units of output of the commodity given exogenous decisions on government purchases and determination of the size of the money supply.”
Macroeconomics provides straightforward and simple answers to such questions as which goods will be produced and how as also who will acquire them. General equilibrium theory has a much more ambitious goal—that of analysing the options of the economy, explicitly taking account of such things as the diversity of consumption and capital goods, and the varying tastes and preferences and wealth and income positions of consumers as well as the differences in technological possibilities available to firms. The analytic framework of general equilibrium analysis is that of microeconomics.
The essential theme of general equilibrium analysis is that all markets are interrelated: it deals with inter-connected markets and emphasises the mutual interrelationships of prices and output of various goods and factors of production. Consumers spend their incomes on all commodities, and the demand for each community depends upon all prices.
If the goods A and B are gross substitutes, an increase in the price of A will induce consumers, as a whole to substitute B for A. The opposite would be the case if A and B were complements. Likewise, pairs of inputs may also be defined as substitutes or complements. Furthermore, production and consumption are not independent.
Consumers earn their incomes from the sale of labour services and other productive factors to the firms. Similarly, business firms earn their income from the expenditure made by consumers. Consequently, equilibrium for all product and factor markets must be determined simultaneously in order to find out a consistent set of commodity and prices.
The data for the determination of a general equilibrium (for all markets) are the utility and production functions of all producers and consumers and their initial endowments of factors and/or commodities. The variables are the prices of all factors and commodities and the quantities purchased and sold by each consumer and producer. The behavioural assumptions require utility and profit maximisation together with the condition that every market be cleared.
The general equilibrium system is based on three assumptions:
1. Decision-making units like consumers and firms can maximise their objectives in their own way.
2. The equality between price and average cost represents nothing but long-run competitive equilibrium situation.
3. Under capitalism, means of production are privately owned.
Use of General Equilibrium Analysis:
The general equilibrium analysis has focused attention on how government policy changes in external environment might influence behaviour of individual firms, industries, consumers and suppliers of factors. It also tries to show how the behaviour of these economic agents interact so as to reach a solution which could be deemed more nearly ‘optimal’.
General equilibrium theory and welfare economics is a special branch of microeconomics which concerns itself with the performance of whole interdependent economic systems composed of such entities. It gives special attention to the characteristics of the equilibrium of such systems, the state they could reach if all exogenous variables (overall income, consumer demand patterns, and technological possibilities in production) remained unchanged.
If it can be executed, a general analysis will be more realistic than a partial analysis. It is because general analysis enables us to trace out all the effects of an independent economic event such as a change in the demand for a product caused by a change in preferences. However, the most important, if not all, effects of an individual event may well be detected by partial analysis.
Secondly, general equilibrium analysis enables us to study the interdependence of economic events. For example, it enables us to predict the detailed effects of a particular tax or tariff.