General Equilibrium Theory is a macroeconomic theory that explains how supply and demand in an economy with many markets interact dynamically and eventually culminate in an equilibrium of prices. The theory assumes that there is a gap between actual prices and equilibrium prices.

The goal of the theory is to identify the precise set of circumstances under which the equilibrium price is likely to achieve stability.

Key Takeaways

  • General Equilibrium Theory in macroeconomics shows how supply and demand in a multi-market economy interact and create an equilibrium of prices.
  • French economist Léon Walras is credited with developing and expanding upon the general equilibrium theory in the late 19th century.
  • Walras applied the theory to multi-market settings by introducing a third good into his model, which then allowed him to calculate price ratios.
  • Walras' contributions to the theory helped economics evolve into a study that includes mathematical analysis at its core.

Léon Walras and General Equilibrium Theory

The theory is most closely associated with Léon Walras, who wrote "Elements of Pure Economics" in 1874. While the idea had been vaguely hinted at by earlier economists, he was the first one to articulate the idea thoroughly.

Walras started his explanation of General Equilibrium Theory by describing the simplest economy imaginable. In this economy, there were only two goods that could be exchanged, referred to as x and y. Everyone in the economy was presumed to be a buyer of one of these products and a seller of the other. Under this model, supply and demand would be interdependent, because the consumption of each of the goods would be dependent on the wages derived from selling each of the goods.

The price of each of the goods would be decided by a bidding process, which Walras referred to as "tâtonnement" (or "groping" in English). He described this in terms of an individual seller calling out the price of a good in the market and consumers responding by either buying or declining to pay. Through a trial and error process, the seller would adjust the price to suit demand—thus, establishing the equilibrium price. Walras believed that there would be no exchange of goods until the equilibrium price was reached, an assumption that has been criticized by others.

Multi-Market Settings

When describing equilibrium on a grander scale, Walras applied this principle to multi-market settings, which are much more intricate. He introduced a third good to his model, referred to as z. From this, three price ratios could be determined, one of which would be redundant as it would not give any information that could not be identified from the others. This redundant good could be identified as the standard by which all other price ratios could be expressed. The standard would provide a guide to currency rates.

The Bottom Line

Theoretically, Walras's theory had transformational effects. Economics, formerly a literary and philosophical discipline, was now viewed as a determinist science. His insistence that economics could be reduced to disciplined mathematical analysis persists today.

In more recent terms, it can also be said that Walras' equilibrium theory has long-lasting effects. It blurs the lines between microeconomics and macroeconomics, as the economics that relates to individual households and companies cannot be viewed as existing separately from the macroeconomy.