Definition
General Equilibrium is a concept in economics that refers to a condition in which all markets in an economy are in equilibrium simultaneously. It assumes that all individuals and firms are perfect competitors and are maximizing their utility or profit, respectively. Additionally, this economic state signifies that supply equals demand in each market, causing prices to stabilize and economic resources to be efficiently allocated.
Key Takeaways
- General Equilibrium Theory refers to an economic model that 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 a set of prices exists that will result in an overall equilibrium. It represents the simultaneous interaction of different markets and economic agents.
- General Equilibrium can serve as a useful reference to judge the real-world economy’s efficiency. If real-world conditions divert from the General Equilibrium, it could suggest inefficiencies in the resource allocation process and might need policy interventions for correction.
- The concept of general equilibrium contrasts with the notion of partial equilibrium, which only analyzes single markets in isolation and assumes all other markets remain unchanged. In contrast, General Equilibrium considers the response of markets inter-dependently.
Importance
General Equilibrium is a fundamental concept in finance and economics that is crucial to understanding how markets operate.
It presumes that all economic sectors or markets are interlinked and that a change in one market prompts changes in other related markets until a new equilibrium is established.
It emphasizes the importance of supply and demand and their influence on prices, output, and income distribution in all markets.
This importance underscores the fact that economic decisions should not be made based on isolated markets or sectors, but rather by taking into consideration the entire complex and interconnected economic system.
Hence, for economists, policymakers, and investors, the general equilibrium framework serves as a versatile tool for predicting how changes like new policies, market shocks, or technological advancements will ripple through and impact all parts of the economy.
Explanation
The general equilibrium theory in finance is primarily used to analyze and understand the overall behavior of supply, demand, and prices in an entire economy with many or several interacting markets, rather than focusing singularly on individual markets. It examines how different sectors of an economy relate to each other and adjusts to various changes and disturbances.
The model’s key assumption is that in a competitive market, prices will adjust to achieve overall equilibrium, where demand equals supply in all markets. Thus, the understanding of this theory helps economists predict how changes in one sector will affect other sectors.
In practical terms, general equilibrium models are extensively used for policy evaluation and forecasting in macroeconomics and public finance. Economists use these models to assess the potential impact of changes in fiscal policies, taxation, technology, or external shocks on the distribution of income or wealth and economic welfare.
It is a valuable tool for governments, investment strategists, and economic consultants when formulating economic and fiscal policies or making key strategic decisions. Though the model is abstract and based on several simplifying assumptions, it offers a comprehensive framework for economic analysis.
Examples of General Equilibrium
Forex Market: The Forex or the foreign exchange market is an excellent real-world example of general equilibrium. In this market, countries trade currencies, aiming to balance supply and demand. The value of one currency relative to another depends on demand, which is influenced by factors like political stability, economic performance, interest rates, and more. If there’s a shift in any of these factors, it affects the demand and supply, and therefore the exchange rate, until a new equilibrium is reached.
Real Estate Market: Consider the housing market in a specific region. The price of houses (demand and supply) is determined by a range of factors, such as the interest rates for mortgages, local economy, or the overall quality of life in the region. If a change occurs, like a sudden influx of people moving into the area, the rise in demand for houses may initially outstrip supply, increasing the price of housing. However, over time, as more houses are built to cater to this demand, a new equilibrium price will be set.
Stock Market: The stock market is another arena where the principles of general equilibrium can be observed. When a company report shows increased profits, it can create greater demand for that company’s stock. The increase in demand can drive up the price of the stock. However, if the price gets too high, people will stop buying, or may even start selling the stock, which would increase the supply and decrease the price. This process continues until the market finds an equilibrium price where the quantity of the stock that people are willing to buy equals the quantity that people are willing to sell.
General Equilibrium FAQs
What is General Equilibrium?
General Equilibrium is an economic theory that seeks to understand the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium.
What is the purpose of General Equilibrium?
The purpose of General Equilibrium is to understand the overall functioning of an economy, considering all markets together, rather than looking at individual markets separately. It helps in predicting how changes in one sector will impact other sectors.
What is a General Equilibrium model?
A General Equilibrium model is a kind of economic model that involves numerous economic variables and seeks to describe the relationships between them. These models are used to simulate and analyze the economic processes that might occur if particular conditions hold true.
Who introduced the concept of General Equilibrium?
The concept of General Equilibrium was primarily developed by the economist Lionel Robbins, and further expanded by Kenneth Arrow and Gerard Debreu.
How is General Equilibrium different from Partial Equilibrium?
While partial equilibrium analysis focuses on a reduction in the economy disregarding the effect other markets may have on it, the General Equilibrium analysis is more encompassing and looks at all markets simultaneously. It recognizes that changes in one market will likely affect others, leading to possibly significant shifts in the wider economy.
Related Entrepreneurship Terms
- Welfare Economics
- Pareto Efficiency
- Supply and Demand Equilibrium
- Perfect Competition
- Consumer Surplus and Producer Surplus
Sources for More Information
- Investopedia – A comprehensive source for financial terminologies, and they offer a detailed explanation about General Equilibrium.
- Khan Academy – They provide detailed video and text lessons on a wide range of topics, including finance and economics.
- Econlib (The Library of Economics and Liberty) – It is a unique platform for various economics theories including General Equilibrium.
- Stanford Encyclopedia of Philosophy – They provide a more academically-oriented look into economic terms.
