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67-479: General equilibrium theory both studies economies using the model of equilibrium pricing and seeks to determine in which circumstances the assumptions of general equilibrium will hold. The theory dates to the 1870s, particularly the work of French economist Léon Walras in his pioneering 1874 work Elements of Pure Economics . The theory reached its modern form with the work of Lionel W. McKenzie (Walrasian theory), Kenneth Arrow and Gérard Debreu (Hicksian theory) in

134-559: A 1979 article, Nicholas Georgescu-Roegen complains: "There are endeavors that now pass for the most desirable kind of economic contributions although they are just plain mathematical exercises, not only without any economic substance but also without any mathematical value." He cites as an example a paper that assumes more traders in existence than there are points in the set of real numbers. Although modern models in general equilibrium theory demonstrate that under certain circumstances prices will indeed converge to equilibria, critics hold that

201-530: 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". A general equilibrium model with complete markets of this sort seems to be a long way from describing the workings of real economies, however, its proponents argue that it is still useful as a simplified guide as to how real economies function. Some of

268-450: A consumer better off without leaving another consumer worse off. In a pure exchange economy, a sufficient condition for the first welfare theorem to hold is that preferences be locally nonsatiated . The first welfare theorem also holds for economies with production regardless of the properties of the production function. Implicitly, the theorem assumes complete markets and perfect information. In an economy with externalities , for example, it

335-494: A contract specifies, for example, a good to be delivered and the date at which it is to be delivered. The Arrow–Debreu model of intertemporal equilibrium contains forward markets for all goods at all dates. No markets exist at any future dates. Third, suppose contracts specify states of nature which affect whether a commodity is to be delivered: "A contract for the transfer of a commodity now specifies, in addition to its physical properties, its location and its date, an event on

402-535: A deeper result than proving the two Fundamental Theorems. Another method of proof of existence, global analysis , uses Sard's lemma and the Baire category theorem ; this method was pioneered by Gérard Debreu and Stephen Smale . Starr (1969) applied the Shapley–Folkman–Starr theorem to prove that even without convex preferences there exists an approximate equilibrium. The Shapley–Folkman–Starr results bound

469-429: A good is simplified by just looking at the price of one good, and assuming that the prices of all other goods remain constant. The Marshallian theory of supply and demand is an example of partial equilibrium analysis. Partial equilibrium analysis is adequate when the first-order effects of a shift in the demand curve do not shift the supply curve. Anglo-American economists became more interested in general equilibrium in

536-429: A large consumption side, nonconvexities in preferences do not destroy the standard results of, say Debreu's theory of value. In the same way, if indivisibilities in the production sector are small with respect to the size of the economy, [ . . . ] then standard results are affected in only a minor way. To this text, Guesnerie appended the following footnote: The derivation of these results in general form has been one of

603-543: A method for solving the Arrow–Debreu General Equilibrium system in a numerical fashion. This was first implemented by John Shoven and John Whalley (students of Scarf at Yale) in 1972 and 1973, and were a popular method up through the 1970s. In the 1980s however, AGE models faded from popularity due to their inability to provide a precise solution and its high cost of computation. Computable general equilibrium (CGE) models surpassed and replaced AGE models in

670-412: A real economy (two commodities, many commodities, production, growth, money). Some think Walras was unsuccessful and that the later models in this series are inconsistent. In particular, Walras's model was a long-run model in which prices of capital goods are the same whether they appear as inputs or outputs and in which the same rate of profits is earned in all lines of industry. This is inconsistent with

737-453: A shift in the demand curve of the original industry under these assumptions includes a shift in the supply curve of substitutes for that industry's product, and consequent shifts in the original industry's supply curve. General equilibrium is designed to investigate such interactions between markets. Continental European economists made important advances in the 1930s. Walras' arguments for the existence of general equilibrium often were based on

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804-456: A simplified structure that only incorporates a few markets, like a "goods market" and a "financial market". In contrast, general equilibrium models in the microeconomic tradition typically involve a multitude of different goods markets. They are usually complex and require computers to calculate numerical solutions . In a market system the prices and production of all goods, including the price of money and interest , are interrelated. A change in

871-413: A single individual) or the gross substitute property then likewise the equilibrium will be unique. All methods of establishing uniqueness can be thought of as establishing that each equilibrium has the same positive local index, in which case by the index theorem there can be but one such equilibrium. Given that equilibria may not be unique, it is of some interest to ask whether any particular equilibrium

938-442: Is A model organized around the tâtonnement process has been said to be a model of a centrally planned economy , not a decentralized market economy. Some research has tried to develop general equilibrium models with other processes. In particular, some economists have developed models in which agents can trade at out-of-equilibrium prices and such trades can affect the equilibria to which the economy tends. Particularly noteworthy are

1005-419: Is a condition of economic equilibrium which analyzes only a single market , ceteris paribus (everything else remaining constant) except for the one change at a time being analyzed. In general equilibrium analysis, on the other hand, the prices and quantities of all markets in the economy are considered simultaneously, including feedback effects from one to another, though the assumption of ceteris paribus

1072-415: Is a model for investigating stability of equilibria. Prices are announced (perhaps by an "auctioneer"), and agents state how much of each good they would like to offer (supply) or purchase (demand). No transactions and no production take place at disequilibrium prices. Instead, prices are lowered for goods with positive prices and excess supply . Prices are raised for goods with excess demand. The question for

1139-598: Is at least locally unique. If so, then comparative statics can be applied as long as the shocks to the system are not too large. As stated above, in a regular economy equilibria will be finite, hence locally unique. One reassuring result, due to Debreu, is that "most" economies are regular. Work by Michael Mandler (1999) has challenged this claim. The Arrow–Debreu–McKenzie model is neutral between models of production functions as continuously differentiable and as formed from (linear combinations of) fixed coefficient processes. Mandler accepts that, under either model of production,

1206-451: Is efficient, it may not be that every efficient allocation of resources can be part of an equilibrium. However, the second theorem states that every Pareto efficient allocation can be supported as an equilibrium by some set of prices. 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. This suggests that

1273-465: Is efficient, neither of the above two theorems say anything about the equilibrium existing in the first place. To guarantee that an equilibrium exists, it suffices that consumer preferences be strictly convex . With enough consumers, the convexity assumption can be relaxed both for existence and the second welfare theorem. Similarly, but less plausibly, convex feasible production sets suffice for existence; convexity excludes economies of scale . Proofs of

1340-404: Is maintained with respect to such things as constancy of tastes and technology. Mas-Colell, Whinston & Green's widely used graduate textbook says, "Partial equilibrium models of markets, or of systems of related markets, determine prices, profits, productions, and the other variables of interest adhering to the assumption that there are no feedback effects from these endogenous magnitudes to

1407-440: Is often assumed that agents are price takers , and under that assumption two common notions of equilibrium exist: Walrasian, or competitive equilibrium , and its generalization: a price equilibrium with transfers. The first attempt in neoclassical economics to model prices for a whole economy was made by Léon Walras . Walras' Elements of Pure Economics provides a succession of models, each taking into account more aspects of

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1474-423: Is possible for equilibria to arise that are not efficient. The first welfare theorem is informative in the sense that it points to the sources of inefficiency in markets. Under the assumptions above, any market equilibrium is tautologically efficient. Therefore, when equilibria arise that are not efficient, the market system itself is not to blame, but rather some sort of market failure . Even if every equilibrium

1541-557: Is provided by the Arrow–Debreu– McKenzie model, developed jointly by Kenneth Arrow , Gérard Debreu , and Lionel W. McKenzie in the 1950s. Debreu presents this model in Theory of Value (1959) as an axiomatic model, following the style of mathematics promoted by Nicolas Bourbaki . In such an approach, the interpretation of the terms in the theory (e.g., goods, prices) are not fixed by the axioms. Three important interpretations of

1608-406: 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. Under some conditions the economy may still be constrained Pareto optimal , meaning that a central authority limited to

1675-530: Is today referred to as AGE models, are based on static, simultaneously solved, macro balancing equations (from the standard Keynesian macro model), giving a precise and explicitly computable result. Lionel W. McKenzie Lionel Wilfred McKenzie (January 26, 1919 – October 12, 2010 ) was an American economist. He was the Wilson Professor Emeritus of Economics at the University of Rochester . He

1742-695: 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. However, stability depends not only on the number of equilibria but also on the type of the process that guides price changes (for a specific type of price adjustment process see Walrasian auction ). Consequently, some researchers have focused on plausible adjustment processes that guarantee system stability, i.e., that guarantee convergence of prices and allocations to some equilibrium. When more than one stable equilibrium exists, where one ends up will depend on where one begins. The theorems that have been mostly conclusive when related to

1809-541: The 1950s. Broadly speaking, general equilibrium tries to give an understanding of the whole economy using a "bottom-up" approach, starting with individual markets and agents. Therefore, general equilibrium theory has traditionally been classified as part of microeconomics . The difference is not as clear as it used to be, since much of modern macroeconomics has emphasized microeconomic foundations , and has constructed general equilibrium models of macroeconomic fluctuations . General equilibrium macroeconomic models usually have

1876-405: The 1970s general equilibrium analysis remained theoretical. With advances in computing power and the development of input–output tables, it became possible to model national economies, or even the world economy, and attempts were made to solve for general equilibrium prices and quantities empirically. Applied general equilibrium (AGE) models were pioneered by Herbert Scarf in 1967, and offered

1943-508: The 1970s, states that the aggregate excess demand function inherits only certain properties of individual's demand functions, and that these ( continuity , homogeneity of degree zero , Walras' law and boundary behavior when prices are near zero) are the only real restriction one can expect from an aggregate excess demand function. Any such function can represent the excess demand of an economy populated with rational utility-maximizing individuals. There has been much research on conditions when

2010-492: The Arrow-Debreu-McKenzie model is thus fully subject to the dilemmas of factor price theory. 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. But this raises

2077-547: The Hahn process, the Edgeworth process and the Fisher process. The data determining Arrow-Debreu equilibria include initial endowments of capital goods. If production and trade occur out of equilibrium, these endowments will be changed further complicating the picture. In a real economy, however, trading, as well as production and consumption, goes on out of equilibrium. It follows that, in

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2144-460: The assumptions necessary for these results are extremely strong. As well as stringent restrictions on excess demand functions, the necessary assumptions include perfect rationality of individuals; complete information about all prices both now and in the future; and the conditions necessary for perfect competition . However, some results from experimental economics suggest that even in circumstances where there are few, imperfectly informed agents,

2211-408: The conditions under which an equilibrium will be efficient, which efficient equilibria can be achieved, when an equilibrium is guaranteed to exist and when the equilibrium will be unique and stable. The First Fundamental Welfare Theorem asserts that market equilibria are Pareto efficient . In other words, the allocation of goods in the equilibria is such that there is no reallocation which would leave

2278-403: The counting of equations and variables. 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 replacement of certain equations by inequalities and the use of more rigorous mathematics improved general equilibrium modeling. The modern conception of general equilibrium

2345-420: The course of convergence to equilibrium (assuming that occurs), endowments change. In turn this changes the set of equilibria. Put more succinctly, the set of equilibria is path dependent ... [This path dependence] makes the calculation of equilibria corresponding to the initial state of the system essentially irrelevant. What matters is the equilibrium that the economy will reach from given initial endowments, not

2412-552: The distance from an "approximate" economic equilibrium to an equilibrium of a "convexified" economy, when the number of agents exceeds the dimension of the goods. Following Starr's paper, the Shapley–Folkman–Starr results were "much exploited in the theoretical literature", according to Guesnerie, who wrote the following: some key results obtained under the convexity assumption remain (approximately) relevant in circumstances where convexity fails. For example, in economies with

2479-629: The entire sequence of prices clears all markets at all times. A generalization of the sequential market arrangement is the temporary equilibrium structure, where market clearing at a point in time is conditional on expectations of future prices which need not be market clearing ones. Although the Arrow–Debreu–McKenzie model is set out in terms of some arbitrary numéraire , the model does not encompass money. Frank Hahn , for example, has investigated whether general equilibrium models can be developed in which money enters in some essential way. One of

2546-502: The equilibrium that it would have been in, given initial endowments, had prices happened to be just right. – ( Franklin Fisher ). The Arrow–Debreu model in which all trade occurs in futures contracts at time zero requires a very large number of markets to exist. It is equivalent under complete markets to a sequential equilibrium concept in which spot markets for goods and assets open at each date-state event (they are not equivalent under incomplete markets); market clearing then requires that

2613-428: The equilibrium will be unique, or which at least will limit the number of equilibria. One result states that under mild assumptions the number of equilibria will be finite (see regular economy ) and odd (see index theorem ). Furthermore, if an economy as a whole, as characterized by an aggregate excess demand function, has the revealed preference property (which is a much stronger condition than revealed preferences for

2680-530: The essential questions he introduces, often referred to as the Hahn's problem is: "Can one construct an equilibrium where money has value?" 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. Some critics of general equilibrium modeling contend that much research in these models constitutes exercises in pure mathematics with no connection to actual economies. In

2747-716: The establishment of the graduate program in economics. McKenzie has been the recipient of numerous professional awards, including the Guggenheim Fellowship in 1973, election to the United States National Academy of Sciences in 1978, the Order of the Rising Sun in 1995 and honorary doctorates from Keio University in 1998 and Kyoto University in 2004. The latter three reflect the success of his many Japanese students. McKenzie has been referred to as "the father of

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2814-618: The existence of equilibrium traditionally rely on fixed-point theorems such as Brouwer fixed-point theorem for functions (or, more generally, the Kakutani fixed-point theorem for set-valued functions ). See Competitive equilibrium#Existence of a competitive equilibrium . The proof was first due to Lionel McKenzie , and Kenneth Arrow and Gérard Debreu . In fact, the converse also holds, according to Uzawa 's derivation of Brouwer's fixed point theorem from Walras's law. Following Uzawa's theorem, many mathematical economists consider proving existence

2881-406: The feedback would increase, resulting in an infinite cycle that would eventually dampen out and converge. The importance of these feedback effects might or might not be worth the extra calculations necessary. They will generally affect the exact amount of the original good's price change, but not the direction. Partial equilibrium analysis examines the effects of policy action only for one good at

2948-421: The industry supply curves will not slope up. If an industry uses an appreciable amount of that factor of production, an increase in the output of that industry will exhibit increasing costs. But such a factor is likely to be used in substitutes for the industry's product, and an increased price of that factor will have effects on the supply of those substitutes. Consequently, Sraffa argued, the first-order effects of

3015-421: The initial endowments will not be consistent with a continuum of equilibria, except for a set of Lebesgue measure zero. However, endowments change with time in the model and this evolution of endowments is determined by the decisions of agents (e.g., firms) in the model. Agents in the model have an interest in equilibria being indeterminate: Indeterminacy, moreover, is not just a technical nuisance; it undermines

3082-442: The issues of efficiency and equity can be separated and need not involve a trade-off. The conditions for the second theorem are stronger than those for the first, as consumers' preferences and production sets now need to be convex (convexity roughly corresponds to the idea of diminishing marginal rates of substitution i.e. "the average of two equally good bundles is better than either of the two bundles"). Even though every equilibrium

3149-436: The late 1920s and 1930s after Piero Sraffa 's demonstration that Marshallian economists cannot account for the forces thought to account for the upward-slope of the supply curve for a consumer good. If an industry uses little of a factor of production, a small increase in the output of that industry will not bid the price of that factor up. To a first-order approximation, firms in the industry will experience constant costs, and

3216-503: The major achievements of postwar economic theory. In particular, the Shapley-Folkman-Starr results were incorporated in the theory of general economic equilibria and in the theory of market failures and of public economics . Although generally (assuming convexity) an equilibrium will exist and will be efficient, the conditions under which it will be unique are much stronger. The Sonnenschein–Mantel–Debreu theorem , proven in

3283-498: The market for some specific goods is obtained independently from prices and quantities in other markets. In other words, the prices of all substitute goods and complement goods , as well as income levels of consumers , are taken as given. This makes analysis much simpler than in a general equilibrium model, which includes an entire economy . Consider, for example, the effect of a tariff on imported French wine. Partial equilibrium would look at just that market, and show that

3350-546: The mathematical economists in Japan". His research focused on general equilibrium and capital theory. Although most widely known as a co-creator of the Arrow–Debreu–McKenzie model , he also published a book and numerous research papers, including: The 1954 paper provided the first proof of the existence of a general equilibrium , using Kakutani's fixed point theorem . Another proof, by Kenneth Arrow and Gérard Debreu ,

3417-472: The mathematician is under what conditions such a process will terminate in equilibrium where demand equates to supply for goods with positive prices and demand does not exceed supply for goods with a price of zero. Walras was not able to provide a definitive answer to this question (see Unresolved Problems in General Equilibrium below). In partial equilibrium analysis, the determination of the price of

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3484-602: The mid-1980s, as the CGE model was able to provide relatively quick and large computable models for a whole economy, and was the preferred method of governments and the World Bank . CGE models are heavily used today, and while 'AGE' and 'CGE' is used inter-changeably in the literature, Scarf-type AGE models have not been constructed since the mid-1980s, and the CGE literature at current is not based on Arrow-Debreu and General Equilibrium Theory as discussed in this article. CGE models, and what

3551-461: The occurrence of which the transfer is conditional. This new definition of a commodity allows one to obtain a theory of [risk] free from any probability concept..." These interpretations can be combined. So the complete Arrow–Debreu model can be said to apply when goods are identified by when they are to be delivered, where they are to be delivered and under what circumstances they are to be delivered, as well as their intrinsic nature. So there would be

3618-409: The price of one good, say bread, may affect another price, such as bakers' wages. If bakers don't differ in tastes from others, the demand for bread might be affected by a change in bakers' wages, with a consequent effect on the price of bread. Calculating the equilibrium price of just one good, in theory, requires an analysis that accounts for all of the millions of different goods that are available. It

3685-427: The price would rise. It would ignore the fact that if French wine became more expensive, demand for domestic wine would rise, pushing up the price of domestic wine, which would feed back into the market for French wine. If the feedback were included, the higher domestic price would shift out the demand curve for French wine, further increasing its price. This further increase would again raise demand for domestic wine, and

3752-490: The price-taking assumption of competitive models. Since arbitrary small manipulations of factor supplies can dramatically increase a factor's price, factor owners will not take prices to be parametric. 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;

3819-438: The quantities of capital goods being taken as data. But when Walras introduced capital goods in his later models, he took their quantities as given, in arbitrary ratios. (In contrast, Kenneth Arrow and Gérard Debreu continued to take the initial quantities of capital goods as given, but adopted a short run model in which the prices of capital goods vary with time and the own rate of interest varies across capital goods.) Walras

3886-428: The question of how these prices and allocations have been arrived at, and whether any (temporary) shock to the economy will cause it to converge back to the same outcome that prevailed before the shock. This is the question of stability of the equilibrium, and it can be readily seen that it is related to the question of uniqueness. If there are multiple equilibria, then some of them will be unstable. Then, if an equilibrium

3953-474: 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. While it has been shown that such economies will generally still have an equilibrium, the outcome may no longer be Pareto optimal . The basic intuition for this result

4020-406: The resulting prices and allocations may wind up resembling those of a perfectly competitive market (although certainly not a stable general equilibrium in all markets). Frank Hahn defends general equilibrium modeling on the grounds that it provides a negative function. General equilibrium models show what the economy would have to be like for an unregulated economy to be Pareto efficient . Until

4087-485: The same type and number of contracts as the individual agents may not be able to improve upon the outcome, what is needed is the introduction of a full set of possible contracts. 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. Research still continues in this area. Basic questions in general equilibrium analysis are concerned with

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4154-506: The stability of a typical general equilibrium model are closed related to that of the most local stability. Research building on the Arrow–Debreu–McKenzie model has revealed some problems with the model. The Sonnenschein–Mantel–Debreu results show that, essentially, any restrictions on the shape of excess demand functions are stringent. Some think this implies that the Arrow–Debreu model lacks empirical content. Therefore, an unsolved problem

4221-478: The terms of the theory have been often cited. First, suppose commodities are distinguished by the location where they are delivered. Then the Arrow-Debreu model is a spatial model of, for example, international trade. Second, suppose commodities are distinguished by when they are delivered. That is, suppose all markets equilibrate at some initial instant of time. Agents in the model purchase and sell contracts, where

4288-420: The underlying demand or cost curves that are specified in advance." General equilibrium analysis, in contrast, begins with tastes, endowments, and technology being fixed, but takes into account feedback effects between the prices and quantities of all goods in the economy. The supply and demand model originated by Alfred Marshall is the paradigmatic example of a partial equilibrium model . The clearance of

4355-576: Was born in Montezuma, Georgia . He completed undergraduate studies at Duke University in 1939 and subsequently moved to Oxford that year as a Rhodes Scholar . McKenzie worked with the Cowles Commission while it was in Chicago and served as an assistant professor at Duke from 1948 to 1957. Having received his Ph.D. at Princeton University in 1956, McKenzie moved to Rochester where he was responsible for

4422-491: Was published in the next issue of the same journal. The 1957 paper appears to include the first derivation of Shephard's lemma in the context of consumer theory. In 2014, Till Düppe and E. Roy Weintraub published a book arguing that McKenzie was unfairly excluded from the Nobel Prizes which both Arrow and Debreu won for work on general equilibrium theory. Partial equilibrium In economics , partial equilibrium

4489-513: Was the first to lay down a research program widely followed by 20th-century economists. In particular, the Walrasian agenda included the investigation of when equilibria are unique and stable— Walras' Lesson 7 shows neither uniqueness, nor stability, nor even existence of an equilibrium is guaranteed. Walras also proposed a dynamic process by which general equilibrium might be reached, that of the tâtonnement or groping process. The tâtonnement process

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