General Equilibrium: How Markets Connect

Most introductory economics looks at one market at a time, such as the market for apples, assuming other markets stay the same. This is called partial equilibrium analysis. But markets are connected. A change in one can ripple through many others. Analysing all markets together is called general equilibrium analysis.

Connected markets

Consider what happens if the price of oil rises sharply:

• Petrol becomes more expensive, so people drive less.
• Demand for electric cars and public transport rises.
• Airlines raise fares, and tourism may fall.
• Plastics and fertilisers, made from oil and gas, become more expensive, raising costs for farmers and manufacturers.
• Workers in oil-producing regions earn more; workers in oil-using industries may lose jobs.

Each of these changes affects further markets. The final outcome depends on all these interactions.

Walras and general equilibrium

The French economist Léon Walras developed the first mathematical model of general equilibrium in the 1870s, describing an economy where all markets clear at the same time. In the 1950s, Kenneth Arrow and Gérard Debreu proved conditions under which such an equilibrium exists. Both later won Nobel prizes.

Why it matters for policy

Partial equilibrium analysis can miss important effects:

• Taxes: a tax on one industry can affect wages and prices across the economy.
• Trade policy: tariffs protecting one industry may raise costs for industries that use its products.
• Large programmes: research on cash transfers in Kenya by Dennis Egger and colleagues found that transfers raised spending, incomes and prices in surrounding villages, benefits that affected even households that did not receive transfers.

Economists use computable general equilibrium models, detailed computer models of the economy, to estimate such economy-wide effects.