What is the 'General Equilibrium Theory'

General equilibrium theory, or Walrasian general equilibrium, attempts to explain the functioning of the macroeconomy as a whole, rather than as collections of individual market phenomena. The theory was first developed by the French economist Leon Walras in the late 19th century. It stands in contrast with partial equilibrium theory, or Marshellian partial equilibrium, which only analyzes specific markets or sectors.

BREAKING DOWN 'General Equilibrium Theory'

Walras developed general equilibrium theory to solve a much-debated problem in economics. Up to that point, most economic analyses only demonstrated partial equilibrium — that is, the price at which supply equals demand and markets clear — in individual markets. It was not yet shown that equilibrium could exist for all markets at the same time in aggregate.

Uses of General Equilibrium Theory

General equilibrium theory tried to show how and why all free markets tend toward equilibrium in the long run. The important fact was that markets didn't necessarily reach equilibrium, only that they tended toward it. As Walras wrote in 1889, “The market is like a lake agitated by the wind, where the water is incessantly seeking its level without ever reaching it.”

General equilibrium theory builds on the coordinating processes of a free market price system, first widely popularized by Adam Smith's The Wealth of Nations (1776). This system says traders, in a bidding process with other traders, create transactions by buying and selling goods. Those transaction prices act as signals to other producers and consumers to realign their resources and activities along more profitable lines.

Walras, a talented mathematician, believed he proved that any individual market was necessarily in equilibrium if all other markets were also in equilibrium. This became known as Walras’s Law.

Assumptions

There are many assumptions, realistic and unrealistic, inside the general equilibrium framework. Each economy is considered to have a finite number of goods in a finite number of agents. Each agent has a continuous and strictly concave utility function, along with possession of a single pre-existing good (the “production good”). In order to increase his utility, each agent must trade his production good for other goods to be consumed.

There is a specified and limited set of market prices for the goods in this theoretical economy. Each agent relies on these prices to maximize his utility, thereby creating supply and demand for various goods. Like most equilibrium models, markets lack uncertainty, imperfect knowledge or innovation.

Alternatives to General Equilibrium Theory

Austrian economist Ludwig von Mises developed an alternative to long-run general equilibrium with his so-called Evenly Rotating Economy (ERE). This was another imaginary construct and shared some simplifying assumptions with general equilibrium economics: no uncertainty, no monetary institutions and no disrupting changes in resources or technology. The ERE was designed to illustrate the necessity of entrepreneurship by showing a system where none existed.

Another Austrian economist, Ludwig Lachmann, argued the economy is an ongoing, non-stable process replete with subjective knowledge and subjective expectations. He argued that equilibrium could never be mathematically proven in a general or non-partial market. Those influenced by Lachmann imagine the economy as an open-ended evolutionary process of spontaneous order.

RELATED TERMS
  1. Economic Equilibrium

    Economic equilibrium is a condition or state in which economic ...
  2. Equilibrium

    Equilibrium state in which market supply and demand balance each ...
  3. Above Full-Employment Equilibrium

    Above full-employment equilibrium is an economy operating at ...
  4. Walras' Law

    Walras' law is a theory that the existence of excess supply in ...
  5. Neoclassical Growth Theory

    The neoclassical growth theory is an economic concept where equilibrium ...
  6. Nash Equilibrium

    The Nash Equilibrium is a concept within game theory where the ...
Related Articles
  1. Investing

    Why You Can't Influence Gas Prices

    Neither big oil companies nor consumers are responsible for oil prices: it's basic economics.
  2. Insights

    Fed's Fischer: Aging Population Suppressing Rates

    Federal Reserve Vice Chairman Stanley Fischer said the aging population and slow investment is keeping rates suppressed.
  3. Investing

    Seven Controversial Investing Theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  4. Insights

    The History of Economic Thought

    Economics is a vital part of every day life. Discover the major players who shaped its development.
  5. Investing

    Why It Is Important to Follow Crude Oil Inventories

    Discover what oil inventories are, how they are communicated and what important insights they provide into the state of the oil market.
  6. Trading

    An Introduction To J-Charting

    Learn about a technical tool that's based on the view that markets are energetic systems.
  7. Insights

    The Austrian School of Economics

    If you think economists are only concerned with numbers, check out the Austrian school, which thinks more like economic philosophers.
  8. Insights

    Game Theory And The Greece Bank Crisis

    How can game theory help us understand how the Greece bank crisis will play out? As things come to a head, Greece and the Europeans are trying to hold out.
  9. Insights

    What is Microeconomics?

    Microeconomics deals with individual and small business economic decisions.
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 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 >>
  3. 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 >>
  4. How Does the Law of Supply and Demand Affect Prices?

    Learn how the law of supply and demand affects prices, as when one outweighs the other, prices can rise or fall in response. Read Answer >>
  5. What is the theory of asymmetric information in economics?

    Read a brief overview of asymmetric information theory in economics, the development of its main arguments and why some challenge ... Read Answer >>
Trading Center