A:

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 general equilibrium theory is to identify the precise set of circumstances under which the equilibrium price is likely to achieve stability. 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 – the equilibrium price. Walras believed that there would be no exchange of goods until the equilibrium price was reached, an assumption which has been criticized by others.

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.

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' general equilibrium theory has long-lasting effects. It blurs the lines between microeconomics and macroeconomics, as the economics that relate to individual households and companies cannot be viewed as existing separately from the macroeconomy.

RELATED FAQS
  1. What is the difference between a dominant strategy solution and a Nash equilibrium ...

    Dive into game theory and the Nash equilibrium, and learn why the equilibrium assumptions about information are less important ... Read Answer >>
  2. Why is game theory useful in business?

    The concepts of game theory became a revolutionary interdisciplinary phenomenon, but they are still relevant for business ... Read Answer >>
  3. How do I differentiate between micro and macro economics?

    Differentiating between microeconomics and macroeconomics is primarily concerned with the difference of the scales of the ... Read Answer >>
  4. How does a monopoly contribute to market failure?

    Read a simple overview of the theory of market monopoly, where it originated and some contemporary challenges to the classical ... Read Answer >>
  5. Why are there no profits in a perfectly competitive market?

    See why economic profits are theoretically impossible in a perfectly competitive market and why some economists use perfect ... Read Answer >>
  6. How Is a Market Failure Corrected?

    Market failures are corrected through reallocation of resources or changes in incentive structure. Economists have different ... Read Answer >>
Related Articles
  1. Insights

    What Is Equilibrium?

    Equilibrium is a state of balanced supply and demand.
  2. Trading

    The Nash Equilibrium

    Nash Equilibrium is a key concept of game theory, which helps explain how people and groups approach complex decisions. Named after renowned mathematician John Nash, the idea of Nash Equilibrium ...
  3. Investing

    Why You Can't Influence Gas Prices

    Neither big oil companies nor consumers are responsible for oil prices: it's basic economics. Find out why you can't influence the price of gas.
  4. Investing

    Game Theory: Beyond the Basics

    Take your game theory knowledge to the next level by learning about the Nash Equilibrium.
  5. Investing

    Nobel Winners Are Economic Prizes

    Before you try to profit from their theories, you should learn about the creators themselves.
  6. Investing

    Oil As An Asset: Hotelling's Theory On Price

    Not sure where oil prices are headed? This theory provides some insight.
  7. Insights

    Macroeconomics

    Find out everything you need to know about macroeconomics.
RELATED TERMS
  1. Economic Equilibrium

    Economic equilibrium is a condition or state in which economic ...
  2. Neoclassical Growth Theory

    The neoclassical growth theory is an economic concept where equilibrium ...
  3. Radner Equilibrium

    The Radner Equilibrium is a theory regarding economic decision ...
  4. Intertemporal Equilibrium

    An intertemporal equilibrium is an economic concept that holds ...
  5. Below Full Employment Equilibrium

    Below full employment equilibrium occurs when an economy's short-run ...
  6. Lindahl Equilibrium

    Lindahl equilibrium is the price paid by an individual for his ...
Trading Center