General Equilibrium Theory

Published Oct 25, 2023

Definition of General Equilibrium Theory

General Equilibrium Theory is a branch of economic theory that aims to explain the behavior of supply, demand, and prices in a whole economic system. It goes beyond analyzing individual markets and focuses on the interconnectedness of all markets in an economy. This theory assumes that all economic agents, including consumers, producers, and governments, act rationally and have perfect information about the market.

Example

To understand General Equilibrium Theory, let’s consider a simple example. Imagine an economy with two goods, apples and oranges, and two individuals, Adam and Eve. Adam specializes in growing apples, while Eve specializes in growing oranges. Both Adam and Eve consume both apples and oranges.

In this economy, there is a market for apples and a market for oranges. The prices of apples and oranges are determined by the interaction of supply and demand in their respective markets. If the price of apples increases, Adam has an incentive to produce more apples, while Eve may switch from growing oranges to growing apples. This adjustment in production and consumption affects both the supply and demand for apples and oranges, which in turn affects their prices.

The General Equilibrium Theory looks at the equilibrium prices and quantities in all markets simultaneously. It takes into account the interactions between different markets and analyzes how changes in one market can impact prices and quantities in other markets.

Why General Equilibrium Theory Matters

General Equilibrium Theory is important for understanding the overall functioning of an economy. By considering how changes in one market can affect other markets, economists can make more accurate predictions and develop policies that promote economic stability and efficiency.

This theory also highlights the interconnectedness of markets and how changes in one sector can have spillover effects on other sectors. For example, changes in the labor market can impact the prices of goods and services, and vice versa. By studying general equilibrium, economists gain insights into the complex relationships within an economy and can identify potential risks and opportunities for growth.