General Equilibrium Theory: An Overview

General Equilibrium Theory: An Overview

By
The Investopedia Team
Investopedia logo
Full Bio
Investopedia contributors come from a range of backgrounds, and over 24 years there have been thousands of expert writers and editors who have contributed.
Learn about our editorial policies
Updated October 30, 2023
Reviewed by Charles Potters
Fact checked by
Katrina Munichiello
Katrina Avila Munichiello
Fact checked by Katrina Munichiello
Full Bio

Katrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications.

Learn about our editorial policies

In macroeconomics, General Equilibrium Theory explains how supply and demand interact dynamically, culminating in an equilibrium of prices in an economy with many markets. The theory assumes a gap between actual and equilibrium prices and identifies the circumstances under which the equilibrium price achieves stability.

Key Takeaways

  • General Equilibrium Theory shows how supply and demand in a multi-market economy interact and create an equilibrium of prices.
  • French economist Léon Walras is credited with developing and expanding the theory in the late 19th century.
  • Walras applied the theory to calculate price ratios and helped economics evolve into a study that includes mathematical analysis.

Léon Walras and General Equilibrium Theory

General Equilibrium Theory is most closely associated with Léon Walras, who wrote "Elements of Pure Economics" in 1874. While the idea had been hinted at by earlier economists, Walras articulated it thoroughly.

Walras used the example of a simple economy to hone his theory. If only two goods could be exchanged, referred to as x and y, everyone in the economy would be either a buyer or a seller. Under this model, supply and demand are interdependent since the consumption of each good relies on the wages derived from selling each of the goods.

Determining Equilibrium

Through a bidding process, the price of each good is decided. Leon Walras referred to this as "tâtonnement" or "groping" in English. An individual seller calls out the price of a good in the market, and consumers respond by either buying or declining to pay.

Through trial and error, the seller adjusts the price to suit demand, establishing the equilibrium price. Walras believed there would be no exchange of goods until the equilibrium price was reached. His assumption has been criticized.

General Equilibrium Theory assumes an exchange economy without production and a finite number of trading partners and goods.

The Walrasian Market

A Walrasian market is an economic model of a market process where orders are collected into batches of buys and sells to determine the market price. This is also referred to as a call market. Orders are grouped together and then carried out at specific times instead of executed one by one continuously. The New York Stock Exchange (NYSE) uses a similar process to a Walrasian market before the opening bell to determine opening prices.

Multi-Market Settings

When describing equilibrium on a grander scale, Walras applied this principle to multi-market settings by introducing a third good to his model, referred to as z.

From this, three price ratios could be determined, one of which would be redundant as it would not give any information that could not be identified from the others.This redundant good could be the standard by which all other price ratios could be expressed and provide a guide to currency rates.

What Are the Assumptions of the General Equilibrium Theory?

The general equilibrium theory assumes there is perfect competition in goods and services, the income of consumers is constant and given, production techniques have no change, all firms operate under the same cost conditions, and full employment.

What Is the 2*2*2 General Equilibrium Model?

The 2*2*2 general equilibrium model assumes there are two of three separate components. Two consumers, two factors, and two firms. Each firm produces a separate commodity, each consumer buys both commodities, and each consumer provides a certain quantity of both factors. This model would determine the quantities and prices of all variables.

How Important is Price in General Equilibrium Theory?

Price helps to equilibrate demand and supply so that buyers can buy at the going price, and sellers who want to sell can do so at the going price, with no excess or shortages on either side. 

The Bottom Line

Walras' theory showed that economics could incorporate disciplined mathematical analysis. General Equilibrium Theory blurred the lines between microeconomics and macroeconomics, as the economics for individual households and companies expanded to show how supply and demand in a multi-market economy interact and create an equilibrium of prices.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

  1. Gianni Vaggi and Peter Groenewegen. "Léon Walras, 1834–1910: the Notion of General Equilibrium. In: A Concise History of Economic Thought." Palgrave Macmillan, 2003.

  2. Uzawa, H. "Walras' Tâtonnement in Theory of Exchange." The Review of Economic Studies, vol. 27, no 27, Summer 1960, pp 182-194.

  3. Stanford University. "General Equilibrium," Page 3.

  4. New World Encyclopedia. "Leon Walras."

  5. Stanford University. "General Equilibrium," Page 2.

Open a New Bank Account
×
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.
Sponsor
Name
Description