Updated Apr 5, 2024 The Arrow–Debreu model, named after economists Kenneth Arrow and Gerard Debreu, is a theoretical framework for understanding the workings of a complete market system. It’s a model of general equilibrium in which prices for all goods and services in the economy are determined such that supply equals demand in every market. This model assumes that every commodity is distinctly different, even if the difference is only in location or time of delivery, leading to the existence of a very large number of markets. Consider an economy that produces only two goods: apples and oranges. In this simplified scenario, the Arrow–Debreu model would designate a market for apples and a separate market for oranges, each with its own supply and demand conditions. If consumers and firms have different preferences and technologies, the model would determine the price for apples and for oranges such that the amount of apples producers want to sell exactly matches the amount of apples consumers want to buy, and the same for oranges. The model extends this basic idea to cover the entire economy, including all possible goods and services, and incorporates time and uncertainty. It introduces ‘state prices’ that allow for goods to be priced differently in different states of the world or at different times, illustrating how the economy can reach an equilibrium that accounts for future events and risks. The Arrow–Debreu model is crucial in economic theory because it establishes the conditions under which a general equilibrium exists in the market. It shows how a complex web of interdependent markets can, in theory, function smoothly to allocate resources efficiently without any waste. By doing so, it lays the groundwork for understanding how economic systems can potentially self-regulate through the price mechanism, coordinating all economic activities and optimizing resource allocation. This model also provides a baseline against which to judge real-world markets. It highlights the importance of complete markets, perfect competition, and the absence of externalities for achieving economic efficiency. Thus, it helps economists identify market failures and explore potential interventions to address these failures. The Arrow–Debreu model is highly theoretical and relies on assumptions that are rarely met in the real world, such as perfect competition, no transaction costs, and complete markets. However, it provides a useful benchmark for analysing how real markets deviate from the theoretical ideal. It helps economists understand the importance of complete information, efficient markets, and the role of institutions in facilitating economic transactions. One of the main limitations of the Arrow–Debreu model is its reliance on very strict assumptions, such as perfect information, no externalities, and a complete set of markets, which do not hold in the real world. Moreover, the model does not account for dynamic processes like technological progress or changes in preferences over time. It’s also criticized for its abstract nature, making it difficult to apply directly to policy analysis without significant modifications. The Arrow–Debreu model incorporates uncertainty and future states through the concept of “state prices”. It distinguishes goods not only by their physical characteristics but also by when they are delivered and under what circumstances. This allows the model to cover situations where the outcome is uncertain, assigning prices to goods in different future states of the world. Consumers and firms can then make decisions that reflect their preferences for risk and their expectations about the future, leading the market toward an equilibrium that encompasses all possible future states. According to the Arrow–Debreu model, if all its assumptions are fulfilled, the market equilibrium it predicts is Pareto efficient. This means that no one can be made better off without making someone else worse off. The model demonstrates how, in a world of complete markets and perfect competition, the market can achieve an allocation of resources that maximizes societal welfare. However, it also implies that when these conditions are not met, such as in the presence of externalities or market power, the market may fail to achieve such efficiency without intervention.Definition of Arrow–Debreu Model
Example
Why Arrow–Debreu Model Matters
Frequently Asked Questions (FAQ)
Can the Arrow–Debreu model be applied to real-world markets?
What are some limitations of the Arrow–Debreu model?
How does the Arrow–Debreu model handle uncertainty and future states?
What does the Arrow–Debreu model say about welfare and efficiency?
Economics