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General Equilibrium

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The General Equilibrium is a state of equilibrium between supply and demand in the market. In comparison to the Partial Equilibrium in economics, the general equilibrium does not analyze the optimal price and quantity in the economical equilibrium on one isolated market - independent of any influences form other markets -, but determines the prices and quantities in the equilibrium on all relevant markets at the same time while observing the interaction and influences of other markets.

Partial vs General EquilibriumEdit

On any market, aggregated (market) supply and aggregated (market) demand interact with each other and will eventually constitute a market equilibrium, which can be analyzed concerning the optimal price of this equilibrium and the optimal quantities traded in that situation. While doing so, the market is viewed as being isolated, i.e. no influences of other markets and the absence of interaction between markets is assumed. This concept is called partial equilibrium analysis.

The partial equilibrium analysis is adequate, if the observed market has no strong connections to any other markets in the economy. In this case the observed market does not influence much the behaviour on those other markets and vice versa.

Generally, however, markets are known to interact and to influence each other.

Example: A rise of the petrol price will

  • reduce the household demand for car drives, which will
    • reduce the demand for cars, which will in turn
      • reduce the demand for aluminium, etc.
    • raise the demand household demand for bikes, which will
      • reduce the household demand for health protection, etc.
  • raise the company demand for electricity, which will
    • raise the demand for water power turbines, which will
      • raise the demand for stainless steel, etc.
    • will raise the demand for cables, which will
      • raise the demand for rubber, etc.

It is not necessary to treat all these changes at the same time, but sometimes it is impossible to analyze specific markets isolated. This is because of

  • macroeconomic question concerning big markets and their interactions with other big markets;
  • interactions of strongly interconnected and interdependent special markets, like e.g. financial markets.

In such cases it is necessary to analyze both demand and supply simultaneously on several markets, which is called the general equilibrium analysis.

Formal General Equilibrium AnalysisEdit

The formal analysis of the general equilibrium consists first of the analysis of the partial equilibrium, followed by the analysis of the general equilibrium.

If S0a is the supply curve for good a in a specific market and D0a is the demand curve for the same good on the same market, the market equilibrium on this market is given at the point where the quantity offered matches the quanitity consumed:

  • S0a = D0a

Now, if you assume that the demand curve for good a moves for some reason - e.g. a decrease in the foreign demand for good a and therefore a fall in the aggregated demand for good a - a new equilibrium will be reached. Considering the case of a demand curve falling from D0a to D1a (with D0a > D1a), a new equilibrium is reached:

  • S0a = D1a

However, as mentioned above, markets are rarely isolated and it is well probable that the market for good a is linked to other markets, i.e. the market for good b. This link is particularly close if both consumers and producers have to possibility to substitute between both goods.

Therefore, the falling demand for good a has to somehow affect the market for good b. This effect is given by the substitution from good b to a by consumers (because good a has become relatively less expensive, some persons who consumed good b before will now consume good a), which leads to a falling demand curve for good b, D2b, which settles at a lower level becoming D1b; this movement means that the consumers consume more of good b for a given price or they consume the same quantity of good b as before at a much lower price. Furthermore the firms produce relatively more of good b, so the supply curve S0b falls too, becoming S2b; this movement means that the firms produce a much higher quantity at the same price like before or they produce the same quantity at a much lower price.

This necessarily affects the equilibrium price for good b, which lowers from p0b, derived from D0b(p0b) = S0b(p0b), to p2b, derived from D2b(p2b) = S2b(p2b).

As the result on the market for good b is that a lower quantity than before at a lower price than before are achieved in the equilibrium, some producers who cannot sell their products anymore on the market for good b, will substitute good b for good a and enter the market for good a, thus letting the supply curve become S3a.

Such movements may continue for some time until the market price and the market quantities traded in the equilibrium settle on both markets in a long-term general equilibrium.

LiteratureEdit

  • Pindyck, Robert S.; Rubinfeld, Daniel L.: Microeconomics, 7th edition, Prentice Hall, 2009.

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