Chapter 22 General Equilibrium Theory

A. Interdependence in the Economy

 Earlier in this book our concern was with:
Partial Equilibrium Approach- “Under ceteris paribus assumption partial equilibrium
relates to the decisions in particular segment of the society in isolation”
Utility Maximization of Consumer: with assumption that income is given
Production Decisions: with assumption that factor prices, technology, general prices are
given
Cost Minimization of Firm: with assumption that demand of the product is given
Product Market: with assumption that relationship with other markets is ignored
Factor Market: with assumption of isolation
 In summary, the basic characteristic of a partial equilibrium approach 1 is the
determination of the price and quantity in each market by demand and supply
curves drawn on the ceteris paribus clause.
 Interdependence of the Markets: Demand- tastes & incomes → Incomes –
resources and factor prices → Factor prices- demand and supply of factors/inputs
→ Demand for factors- technology & demand of produce → Demand of produce-
 Circular Flow: Real flow and monetary flow, these flows moves in opposite
directions, these flows are linked with commodity prices and factor prices
 The system in a circular flow will be in equilibrium when it attains a set of prices
in such a way that incomes flow from businesses to household is equal to the
expenditures flow from household to the business.
 In Partial equilibrium analysis the interdependence is ignored
 Markets comprise of buyers & sellers, maximizers (utility/satisfaction and profits),
millions of independent and self-interested economic units
 The problem is to find out a consistent behavior of all in such a way that all the
units reach to a general equilibrium
 General Equilibrium:
A state in which all markets and all decision-making units are in simultaneous
equilibrium
A general equilibrium exists if each market is cleared at positive price, each
consumer is maximizing satisfaction and each producer is maximizing profits
 The scope of general equilibrium analysis is the examination of how this state can,
if ever, be reached, that is, “how prices are determined simultaneously in all
markets, so that there is neither excess demand nor excess supply, while at the
same time the individual economic units attain their own goals”
 In mathematics simultaneous equation system will be proved helpful for this
purpose, millions of equations and millions of unknowns (prices and quantities)
Equations are derived from maximization behaviors
 Equations have two types: Behavioural equations and clearing the market
equations
 Mathematically solution of a simultaneous equation system is possible only if
number of equations is equal or greater to the number of unknowns
B. Walrasian System
 French Economist Leon Walras in “Elements of Pure Economics” 1874 use
conception of simultaneous equation system because all prices and quantities
interact with each other simultaneously
 Each equation in the system represents each individual decision-maker
 Each consumer and each firm playing double role in this system
 Important characteristics of such system is interdependence or simultaneity
 Solutions of this system are known as “unknown” of the system
 Number of markets in Walrasian system is equal to the number of commodities
and number of factors of productions
 For each market there are three types of functions: Supply, Demand, Equilibrium
 In each commodity market number of demand equations is equal to number of
consumers and number of supply equations is equal to number of firms
 In each factor market number of demand equations is equal to the number of
firms multiplied by the number of commodities they produce and number of
supply equation is equal to the number of consumers who own factor of
productions
 A necessary (but not sufficient) condition is number of independent equations
should not greater than number of unknows
Example:
 Existence Problem
 In Walrasian system one of the equation is redundant
 Absolute prices are not measured but concept of numeraire is utilized to find out
the relative prices in terms of numeraire
 Numeraire is an economic term that represents a unit in which prices are
measured. A numeraire is usually applied to a single good, which becomes the
base value for the entire index or market. By having a numeraire, or base value, it
allows us to compare the value of goods against each other.
 For determination of absolute price a money market is introduced in the model as
numeraire which could also play the role of medium of exchange and store of
value
 Even if the equality of independent equations and unknown is attained there is no
guarantee to attain the equilibrium
Walras was failed, in 1954 Arrow & Debreu succeed in a competitive market with
no indivisibilities (physical inability to divide) and no increasing returns to scale)
 In 1971 Arrow and Hahn proved general equilibrium with monopolistic
competition, limited increasing returns and without indivisibilities
Even if proofs are available but for specific market structures and restrictive
assumptions
 A real World solution is still not existed
 Problems of Stability and Uniqueness
C. Existence, Uniqueness and Stability of an Equilibrium
 Partial equilibrium example
 Perfectly competitive market: Demand, Supply, Qd=Qs, No excess demand nor
excess supply (negative excess demand)
 An equilibrium price can be defined as the price at which excess demand is zero
 The equilibrium is stable if the demand function cuts the supply function from
above (Fig: 22.2)
 The equilibrium is unstable if the demand function cuts the supply function from
below (Fig: 22.3)
 Multiple equilibria (Fig: 22.4)
 No equilibria (Fig: 22.5)
 Existence----------- whether consumers’ and producers’ behavior ensure that
demand and supply cuts at positive price
 Stability--------- Slope of the demand and supply curves
 Uniquness----------------Slope of the excess demand function-curve showing
difference between Qd and Qs
 Existence, stability and uniqueness could be described in terms of the excess
demand function
E = Qd -Qs
 Redraw Figures 22.2 to 22.5 in terms of Excess Demand Function

D.