Understanding General Equilibrium Theory & Its Alternatives

What Is General Equilibrium Theory?

General equilibrium theory, or Walrasian general equilibrium, explains the functioning of the macroeconomy as a whole, rather than as individual market phenomena.

The theory was developed by the French economist Leon Walras in the late 19th century. It contrasts with partial equilibrium theory, or Marshallian partial equilibrium, which analyzes specific markets or sectors.

Key Takeaways

• General equilibrium analyzes the economy as a whole, instead of single markets like with partial equilibrium analysis.
• General equilibrium shows how supply and demand interact and tend toward a balance in an economy with multiple markets.
• The balance of supply and demand in different markets creates a price equilibrium.
• Leon Walras introduced and developed the theory in the late 19th century.

Understanding General Equilibrium Theory

Walras developed the general equilibrium theory to solve a debated problem in economics. Previously, economic analyses only demonstrated partial equilibrium—the price at which supply equals demand and markets clear—in individual markets. It had not been shown that equilibrium could exist for all markets at the same time in aggregate.

General equilibrium theory shows how and why free markets tend toward equilibrium in the long run. Markets don’t necessarily reach equilibrium, only tend 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 popularized by Adam Smith’s "The Wealth of Nations" (1776). Traders, in a bidding process, create transactions by buying and selling goods. These transaction prices act as signals to other producers and consumers to realign their resources and activities along profitable lines.

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

The general equilibrium theory considers the economy as a network of interdependent markets and seeks to prove that all free markets eventually move towards general equilibrium.

Special Considerations

There are many assumptions, realistic and unrealistic, inside the general equilibrium framework. Each economy has a finite number of goods and agents. Each agent has a continuous and strictly concave utility function and a single pre-existing good (the "production good"). Each agent must trade their production good for other goods to increase their utility.

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 their utility, creating supply and demand for various goods. 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 Evenly Rotating Economy (ERE). This is another imaginary construct and shares simplifying assumptions with general equilibrium economics: no uncertainty, no monetary institutions, and no disrupting changes in resources or technology. The ERE illustrates the necessity of entrepreneurship by showing a system where none existed.

Another Austrian economist, Ludwig Lachmann, argued that the economy is an ongoing, non-stable process with subjective knowledge and 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.