Abstract
The paper dwells on general equilibrium theory by putting into perspective various critical issues. The origin of the concept of general equilibrium theory is illuminated dating back to neoclassical period. Moreover, various models such as Walras model of pricing and modern equilibrium model is also put into consideration. Finally, the importance and application of general equilibrium has also been discussed at length. General equilibrium theory refers to a concept modeled around theoretical economics. The modern general equilibrium takes into consideration three important interpretations which should be taken into consideration. The idea of general equilibrium theory cannot be complete when there is no enough information in the business. It is used in the determination of pricing through the forces in the market for demand and supply. Price elasticity of demand refers to a proportionate change in the amount of a good required due commensurate change in the value of that good. If the price of the good should increase by, for example, 20% and the amount demanded fall by 10%, the demand for the good is inelastic since elasticity is less than one, that is 10%/20%= 0.5. General equilibrium theory is very good because it helps in the determination of the various measures that should be taken into considerable so that the economy can have positive macroeconomic elements such as positive elements. The state usually utilizes the theory of general equilibrium in order to address macroeconomic problem.
Introduction
General equilibrium theory refers to a concept modeled around theoretical economics. The theory explains the interactions between supply and demand. The interactions between supply and demand are critical because it helps in the determination of prices that offers the trade value for the goods and services which are being offered in exchange for the value in goods and services. In a competitive market structure, the theory of general equilibrium usually has wide applicability across the board.
Origin of the Concept of General Equilibrium Theory
The first interpretation is that the equilibrium is a wide view because it has its applicability in around the international trade. The other important analysis is essential in the sense that it goes a long way to helping emphasize the importance of time when getting the general equilibrium. The modern economics is based on the precept that prices do exist and everyone will always try to engage in trading at particular prices of goods and services than the business will automatically be equated to the supply.
Classical economists including Adam Smith, David Ricardo, Jean-Baptiste Say, and Thomas Malthus made a credible attempt towards putting into perspective the general theory of equilibrium. A general equilibrium dictates that the prices in the economy are flexible to the extent that with accordance with Says law supply creates its own demand in order to generate equilibrium in the society (Malthus & Ricardo 1989). The classical theory goes ahead to post a balance between savings and investment provided that interest rates equilibrium. On the other hand, classical school of thought such as John Hicks and George Stigler gives basic assumptions that include rational preference, maximization of utility, and availability of information.
The idea came into existence during the era of neoclassical that was the first attempt to find the price and quantity that should be supplied for goods and services. The model pricing was brought about by Leon Walras. Walras asserts that each agent in the economy either producer or consumer is bundle with a given amount of goods and service that dictates how the carry out their various operation and how they price such goods and services in exchange for money. In the long run, Walras suggests that the prices of goods and services whether one views them as output or input go a long way to assist in the determination of the prices and output (Friedman, B. M 2005). Since this time of time of the Walras, the idea of general equilibrium theory has evolved to the modern model of a theory of general equilibrium. The modern general equilibrium takes into consideration three important interpretations which should be taken into consideration.
The idea of general equilibrium theory cannot be complete when there is no enough information in the business (Gandolfo 2006). It brings about the idea of incomplete markets that should be addressed in order to establish full markets that can be used for the purposes of maintaining pare to optimal conditions in the business. A consumer should at all the time have enough means through which can be used to facilitate the transfer of wealth to exchange hands.
In order to achieve complete equilibrium in the market which is known as the Walrasian equilibrium, the goods market and the labor market must be taken into consideration several factors such as the Keynesian unemployment, classical unemployment, inflation, and under consumption when all this factors are held at optimal point the concept of general equilibrium is attained in the market.
For an understanding of general equilibrium is of paramount importance that the schools of thought which shaped the theory are put into consideration. These school of thoughts include the classical and the Keynesian school of thought. According to the classical theory, saving is never a problem because according to say’s law, supply can also create its own demand in the market. In short, when the equilibrium level is attained, then it implies that savings does not cause any reduction in the spending within the economy for the simple fact that the business goes back to borrow all the saved money and spend them on investments. The classical school of thought also holds the opinion that the amount that is saved is equal to the amount invested and this is brought about by the interest rates. The interest rate is crucial because it is the demand at equilibrium point in market as a result of the interaction of demand and supply in the money market. On the other hand, Keynesian school of thought predicts that the equilibrium in the market is determined by stability in the economy. Stability in the economic takes into consideration various factors such as price stability, near full employment condition, balance of payments, and stable exchange rates conditions in the market.
Application of General Equilibrium Theory
It is used in the determination of pricing through the forces in the market for demand and supply. The prices of tomatoes are expected to rise because the supply has reduced. The reduction in supply of tomatoes is because frost and floods destroy the crops. It is crucial to take note that tomato is a very delicate plant and can easily be destroyed by frost and flood. The fact that tomatoes have been destroyed means that the supply of tomatoes have dropped significantly. The situation is even made worse by the fact that there was delayed planting.
As a result of the supply reduction, the supply curve will certainly change from S1 to S0 and the demand curve will remain unchanged. The change in supply curve upwards as shown in the diagram below will results to increase in price of tomatoes from P1 to P0. On the other hand, the number supplied will reduce from Q1 to Q0. The equilibrium price and quantity shifts to P0 and Q0 as a result of a change in supply curve upwards. Henderson (2008) claims that the equilibrium price and quantity of tomato are determined by the interactions between demand and supply. There are several factors, which determine changes in an equilibrium position. They include a change in the supply and change in demand curve, which may change the demand curve either upwards or downwards.
When the demand for tomatoes reduces due to increasing in supply the total amount spent on the product is also set to reduce. The justification of this trend is the law of demand, which says that as the prices of a particular good goes up, the demand for the same product is also set to reduce and the reverse is true (Gordon 2007). The reverse condition is that as the prices of goods and services reduce then it implies that the demand for such goods and services is also set to reduce. However, an exception to this law of demand exists. The law is only applicable when the product in question is a normal good. However, does not apply if the good in question is luxury goods, goods of ostentation, basic goods or habit-forming products. The producers of tomatoes will only get a reprieve if the supply of tomatoes is restored since this will automatically lead to a reduction in price.
Elasticity is affected greatly by availability of substitutes in that the more substitutes a good has, the more elastic the commodity is likely to be (Sen Amartya 2010). Also, the proportion of income that the consumer spend on goods determine elasticity in that the goods that take up large amount of the consumer’s income, for example, cars have more elasticity of demand as compared to goods like sugar that uses a small amount of income. Lastly, time affects elasticity as it takes time for consumers to react to the changes in price of goods. It is apparent that the demand for goods in the short run may be inelastic but elastic in the long run due to a price increase.
Market power, on the other hand, refers to the firm’s ability to raise the price of a commodity in the business over the marginal cost of producing the good in order to increase profit. It is majorly done by the monopolists who act as price makers in the market without losing their customers or decreasing their sales. The goods produced in these markets are very essential for people that they do without and that is why they still purchase the goods when their prices increase.
Market power is majorly brought about by barriers to entry to the new firms, hence are dominated by the monopolists. Elasticity is an important factor when one wants to determine market power and this depends on the shape of the demand curve where the price is raised above the marginal cost curve by the firm. For the ratio to be more than one, the price elasticity should be negative. The firm will have more market power if the price/marginal cost ratio is higher. The price elasticity of demand and market potential relate in that if the price of a good is elastic, then there is no market power since any slight increase in the price of a product leads to decrease in sales revenue and the firm will lose many of its customers. An example is a normal good that its demand goes down if its price increases. The only way to increase revenues of the firm is through aggressive advertisements, improving the value of the good and also offering after sales services. On the other hand, if the price inelasticity, market power can exist because any slight increase does not affect the sales revenue and the firm retains its customers (Mills 2006). The sales revenue depends on whether the good obeys the law of demand. The demand for a need good is not affected by price increase as it is a basic need and one cannot do without it. If the price of a luxury good goes up its demand will increase since its snob appeal rises.
Market power and price elasticity of demand affects state control and, therefore, limit government’s ability to enforce its policies. For example, a control on the government to set price ceiling may not work because prices may be pushed above the prices set by the state by the forces of demand and supply. Another regulatory measure by the state is tax policy. A state may impose a tax on certain commodities to reduce their consumption such as alcohol and cigarettes. It will increase their cost of production leading to increased prices of these goods (Mills 2007). The increased prices will not affect consumption of these goods by a large proportion because they are addictive and it is hard for one to do without utilizing this category of goods. The government's aim reduces consumption will not be achieved. Increased prices of alcohol and cigarettes will lead to increased poverty since one will spend more on these goods to maintain the same level of consumption, therefore, saving less. A study conducted in England and Wales showed that only a few people responded to an increase in the price of these products. Some only quit it because once they start seeing their effects.
In many cases, monopoly and oligopoly market structures are bad for the society since they result in dead weight loss to the society. The dead weight loss to the society is as a result of both allocative inefficiency and production inefficiency. The idea of allocative inefficiency is also referred to as X- inefficiency produced by the fact that both monopoly and oligopoly charge their prices above the marginal cost. Allocative efficiency is recommended because the value consumer pays for a product or services is equal to its cost of production, therefore, there is no exploitation to the customers that mean that marginal revenue should equal marginal cost. On the other hand, production inefficiency in monopoly and oligopoly is brought about by the fact that there is wastage of resources such that they are underutilizing their potential. The oligopoly and monopoly market structure usually produces below their output level to exploit consumers through high pricing.
Production efficiency is recommended because it ensures that the firms produce at minimum average cost thereby enabling them to charge competitive prices along the downward sloping demand curve which also represents the average cost. Monopoly and oligopoly market structures are examples of imperfect competition since they do not make economic profits as the case in perfect competition (Mills 2007). They use their market power to act as price makers thereby setting prices above the marginal cost leading to supernormal profits as shown in the graph below. In Oligopoly business structures, the firms are usually engaged in collusion to block other firms from entry into the business. The fact that they are already established in the business they are able to enjoy economies of scale and can easily collude through price fixing to prevent other firms who cannot march the prices they have set in the business since such a move would result to the firm making loss because new firms might not enjoy the economies of scale that the colluding firms enjoy. The graph below shows the allocative inefficiency and production inefficiency exhibited by both monopoly and oligopoly market structures.Importance of General Equilibrium Theory
General equilibrium theory is very good because it helps in the determination of the various measures that should be taken into considerable so that the economy can have positive macroeconomic elements such as positive elements.
The state usually utilizes the theory of general equilibrium in order to address macroeconomic problem of price ceiling. Price ceiling refers to government intervention in which the maximum prices of goods and services are set by the government. (Malthus & Ricardo) 1989 claim that a price ceiling, therefore, suggests that producers and retailers should not sell the products or services beyond a set point. The intervention by the Australian government to set a price ceiling on the prices of tomatoes is appropriate since it assists to prevent the consumers from being exploited by the producers of tomatoes. During shortages, some unscrupulous producers usually resort to arbitrarily increasing the prices of their products at the disadvantage of the consumer who more of the price to access the product in question. The only cure that can be implemented to avert over exploitation of consumers by the tomatoes producers in Australia is through ensuring that a price ceiling is set (Pierson 2006). Once the government sets a price ceiling then it means that it will be illegal for any producer to sell the tomatoes beyond the price ceiling price set by the Australian government.
The idea of price ceiling has its advantages and disadvantages that should be considered when discussing the justification of this tool (Smith 2007. The main advantage of price ceiling is that it protects the consumers from undue exploitation by the producers. The producers are always very crafty and may take advantage of certain occurrences in the business to exploit consumers. For example, with a shortage of tomatoes in place, the producers may decide to increase the prices of tomatoes exorbitantly thereby hurting the consumers who have to pay high prices for tomatoes.
Despite the fact that a price ceiling protects the consumers from exploitation, it is not a healthy practice in the economy because it compromises on the independence of the business. The business should be free from interference by the government ((Malthus & Ricardo 1989). It suggests that the prices of different goods and services be determined by the interactions of supply and demand of the products. If the government sets a price ceiling, then they may scare away potential investors. The potential investors will shy away from investing in the Australian economy since they feel that they may not benefit fully in such a regulated market.
General economic theory also assist to address the issue of unemployment and inflation in the economy. Maintaining low inflation is not an easy fete to achieve. Inflation is measured as the yearly rate of change in the retail price index. In order to achieve price stability the rate of inflation should be zero. It is only theoretical and cannot be practical in the real economy. Small level of inflation is acceptable as it signifies growth in the economic performance besides showing that owners of factors of production are being rewarded for their investment efforts. Mills (112) says that the United Kingdom has over the years had elaborate strategies to counter high inflation. The strategy targets the underlying rate of inflation. This approach is justified because besides helping to control the level of inflation it is also instrumental in checking the interest rate and the retail price index. In a bid to maintain a low level of inflation, the United Kingdom’s government has to contend with the unemployment in the economy.
Currently, the rate of unemployment in the United Kingdom is 7% while the inflation rate is 2.7%. This rate of unemployment is not bad enough as it shows that United Kingdom’s economy is at near full employment. High unemployment levels have adverse social and economic cost to the economy. Unemployed has low purchasing power, therefore, the rate of consumption is low (Gordon 2007). The other characteristic of unemployed is that they lose their skills and morale with time, therefore, they become less productive in the economy. The state is obliged to incur extra public expenditure to provide social benefits to the unemployed population. Finally, the adverse effect of high employment rate is that it results in increased cases of social evils such as crime, prostitution, and vandalism. In order to protect the economy from inflation, the United Kingdom’s government permits some level of inflation in the economy.
Conclusion
General equilibrium theory refers to a concept modeled around theoretical economics. The theory explains the interactions between supply and demand. In a competitive market structure, the theory of general equilibrium usually has wide applicability across the board. The idea of general equilibrium theory cannot be complete when there is no adequate information in the business. It brings about the idea of incomplete markets that should be addressed in order to establish full markets that can be utilized for the purposes of maintaining pare to optimal conditions in the economy.
Bibliography
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Malthus Robert & Ricardo. Thomas Robert Malthus and David Ricardo. Journal of Economic Perspectives, 3(3): 153-164. 1989.
Pierson, John H. G. Full Employment. New Haven: Yale University Press, 2001.
Smith Adam. Wealth of Nations. Cosimo, Inc. 2007.
