Wednesday, May 18, 2011

General Equilibrium Theory - Overview

Micro-economics is the study of the behaviour of isolated economic entities as individual consumers, firms or industries. It deals with the division of the total output among individuals, industries, products, and firms and the allocation of resources among competing users. It looks at the whole thing with a singular point of view.

Contrarily, macro-economics is the study of the behaviour of the economy as a whole, as measured by the aggregate value of such variables like the aggregate volume of output of an economy (GNP), the extent to which its resources are employed, the size of the national income, the price level (i.e. whether there is inflation, deflation or price stability), and the level of employment. It is concerned with the overall dimension of economic life. It looks at the size, shape and functioning of the whole economic system.

General equilibrium theory actually forms a bridge between these two branches of economic theory and uses the tools of micro-economics to analyze the behaviour of the entire economy.
In common with macro-economics, general equilibrium theory is concerned with inter-relationships that exist among the markets for goods and services in the economy.
In common with micro-economics, the analysis in general equilibrium theory is carried out in terms of individual decision-makers and commodities, rather than in terms of aggregates.
The fundamental questions that general equilibrium theory attempts to answer are the same as those posed in macro-economic theory. Given different economic environments, what goods will the economy produce, how will these be produced, and who will obtain them? But, whereas macro-economics provides answers in terms of aggregates, general equilibrium theory provides answers in terms of the individual consumers, producers and commodities making up these aggregates.

Micro-economics may be regarded as a simple form of general equilibrium theory in which the decision makers in the economy are the consumers, the producers and the government. The consumer has to make decisions with respect to the allocation of his income between consumption and saving, the amount of labour he is to supply, and the form in which he will hold his wealth (money or security). The producer, in his turn, has to take decisions on the number of units of labour to hire to produce a particular commodity, which may be used either as a consumption or as a capital item. The producer has also to determine how much units to set aside for production in future. The resulting interaction among these consumption, wealth-holding, and production decisions determine such variables as the price of a commodity, the interest rate, the number of units of labour and capital employed, the number of units of output, their distribution cost etc. within a framework of government policies, namely fiscal and monetary.

Macro-economics provides simple and straightforward answer to such questions like which goods will be produced and how, and also who will acquire them. General equilibrium theory has a much more ambitious goal - that of analyzing the operations of the economy, explicitly taking into account of such things as the diversity of consumption and capital goods, and the varying tastes and preferences and wealth and income positions of consumers, as well as the differences in technological possibilities available to production firms. To quote J. K. Galbraith: "There is also the world of farmers, repairmen, retailer, small manufacturer, plumber, television repairmen, service station operator, medical practitioner, artist, actress, photographer..... In economics, as in anatomy, the whole is much more than the sum of the parts." The analytical framework of general equilibrium analysis is that of micro-economics.

The essential theme of general equilibrium analysis is that all markets are interrelated (commodity market, labour market, money market, capital market, stock market etc). It deals with interconnected markets and emphasizes the inter-relationship of prices and output of various goods and factors of production. Consumers spend their incomes on all commodities, and the demand for each commodity depends upon all prices. If the goods A and B are gross substitutes, an increase in the price of A will induce consumers as a whole to substitute B for A. The opposite would be the case if A and B were compliments. Likewise pairs of inputs may also be defined as substitutes and compliments. Furthermore, production and consumption are not independent. Consumers earn their incomes from the sale of labour, services, and other productive factors to producers. Similarly they spend their incomes on goods and services produced by the firms. Thus business firms earn their income from the expenditure made by consumers. As a consequence, equilibrium from all commodity markets and factor (land, labour and capital) markets must be determined simultaneously in order to secure a consistent set of prices.

The general equilibrium theory uses utility and production function of consumers and producers, prices of all factors of production and commodities, and quantities purchased by each consumer and producer. Consumers and producers behave in a manner to maximize their utility and profit correspondingly, and there exists a set of equilibrium prices, with which all the markets will be cleared. Existence of a competitive economy is assumed, and the general equilibrium analysis is done with a relative price concept in view. Absolute prices are nor relevant.

General equilibrium theory deals with the fundamentals of supply and demand within an economy where there are a group of markets. It considers all markets in totality. Its objective is to prove that all input and output prices are at equilibrium. It was initially done by Leon Walras, a French economist in the year 1870. The concept was revised by Gustav Cassel in 1932. It is popularly known as the Walras-Cassel Model.

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