Empirical methods Prescriptive and policy In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an overall general equilibrium.
Broadly speaking, general equilibrium tries to give an understanding of the whole economy using a "bottom-up" approach, starting with individual markets and agents.
In contrast, general equilibrium models in the microeconomic tradition typically involve a multitude of different goods markets.
Prices are announced (perhaps by an "auctioneer"), and agents state how much of each good they would like to offer (supply) or purchase (demand).
Such arguments are inadequate for non-linear systems of equations and do not imply that equilibrium prices and quantities cannot be negative, a meaningless solution for his models.
The modern conception of general equilibrium is provided by the Arrow–Debreu–McKenzie model, developed jointly by Kenneth Arrow, Gérard Debreu, and Lionel W. McKenzie in the 1950s.
So there would be a complete set of prices for contracts such as "1 ton of Winter red wheat, delivered on 3rd of January in Minneapolis, if there is a hurricane in Florida during December".
Some of the recent work in general equilibrium has in fact explored the implications of incomplete markets, which is to say an intertemporal economy with uncertainty, where there do not exist sufficiently detailed contracts that would allow agents to fully allocate their consumption and resources through time.
The basic intuition for this result is that if consumers lack adequate means to transfer their wealth from one time period to another and the future is risky, there is nothing to necessarily tie any price ratio down to the relevant marginal rate of substitution, which is the standard requirement for Pareto optimality.
Hence, one implication of the theory of incomplete markets is that inefficiency may be a result of underdeveloped financial institutions or credit constraints faced by some members of the public.
In a pure exchange economy, a sufficient condition for the first welfare theorem to hold is that preferences be locally nonsatiated.
In other words, all that is required to reach a particular Pareto efficient outcome is a redistribution of initial endowments of the agents after which the market can be left alone to do its work.
[9] In fact, the converse also holds, according to Uzawa's derivation of Brouwer's fixed point theorem from Walras's law.
For example, in economies with a large consumption side, nonconvexities in preferences do not destroy the standard results of, say Debreu's theory of value.
[12]: 99 To this text, Guesnerie appended the following footnote: The derivation of these results in general form has been one of the major achievements of postwar economic theory.
One result states that under mild assumptions the number of equilibria will be finite (see regular economy) and odd (see index theorem).
Mandler accepts that, under either model of production, the initial endowments will not be consistent with a continuum of equilibria, except for a set of Lebesgue measure zero.
[18]: 17 When technology is modeled by (linear combinations) of fixed coefficient processes, optimizing agents will drive endowments to be such that a continuum of equilibria exist: The endowments where indeterminacy occurs systematically arise through time and therefore cannot be dismissed; the Arrow-Debreu-McKenzie model is thus fully subject to the dilemmas of factor price theory.
[18]: 19 Some have questioned the practical applicability of the general equilibrium approach based on the possibility of non-uniqueness of equilibria.
In a typical general equilibrium model the prices that prevail "when the dust settles" are simply those that coordinate the demands of various consumers for various goods.
Then, if an equilibrium is unstable and there is a shock, the economy will wind up at a different set of allocations and prices once the convergence process terminates.
[20]The Arrow–Debreu model in which all trade occurs in futures contracts at time zero requires a very large number of markets to exist.
Frank Hahn, for example, has investigated whether general equilibrium models can be developed in which money enters in some essential way.
The goal is to find models in which existence of money can alter the equilibrium solutions, perhaps because the initial position of agents depends on monetary prices.
Although modern models in general equilibrium theory demonstrate that under certain circumstances prices will indeed converge to equilibria, critics hold that the assumptions necessary for these results are extremely strong.
[citation needed] Frank Hahn defends general equilibrium modeling on the grounds that it provides a negative function.
[22][23] In the 1980s however, AGE models faded from popularity due to their inability to provide a precise solution and its high cost of computation.
Some, such as the Keynesian and Post-Keynesian schools, strongly reject general equilibrium theory as "misleading" and "useless".
Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.Robert Clower and others have argued for a reformulation of theory toward disequilibrium analysis to incorporate how monetary exchange fundamentally alters the representation of an economy as though a barter system.
Within socialist economics, a sustained critique of general equilibrium theory (and neoclassical economics generally) is given in Anti-Equilibrium,[28] based on the experiences of János Kornai with the failures of Communist central planning, although Michael Albert and Robin Hahnel later based their Parecon model on the same theory.