From the Perfect to the Imperfect
1. "General" versus "partial" equilibrium

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Partial equilibrium theory-the stuff of Part I-focuses on the effects that one change, such as a shift in consumer preferences, has on a one or two markets, disregarding the wider ripples. A partial equilibrium analysis makes sense when the wider ripples are unlikely to be earth-shakingly large. To be precise, when cross-price, cross-income, cross-everything elasticities are at or near zero. For example, with a little imagination you may find a reason why a change in American preference towards low fat food might have in some way or another a effect on the Italian shoe industry or the demand for Dutch tulips. Who knows? Producers of low fat food may like Italian shoes more than the producers of high fat foods. And Italian shoe makers may use their extra earnings to buy more tulips. Ripples can move in funny and unexpected ways. However, the effects on Italian shoes and Dutch tulips will be so small that they are better ignored to keep the analysis simple. Partial equilibrium theory, therefore, asks you to limit the scope of your analysis, reasonably.

Partial equilibrium theory considers the effects of a change on one or a few markets only.

But some problems require a general equilibrium theory. If Saddam Hussein, the deposed ruler of Iraq, had succeeded some years ago in grabbing the oil riches of the Persian Gulf, then the price of oil would have gone up dramatically. In this case the ripple effects would be big and far-reaching. After all, the Persian Gulf counts for enough of production to significantly affect the price of oil. And the price of oil counts for enough in the economy of the world that a rise in its price has big ripple effects. Not ripples; waves. For one, you will pay more at the pump. You also may stay forsake a trip home for Thanksgivings because of a steep rise in the price of a ticket. Your rent may go up as well because a rise in heating expenses. Consequently, an analysis of the effects of Hussein's putative action would have to consider many markets and determine to which new equilibrium all these markets would move. We might even go so far and aspire to include all possible markets to determine the new equilibrium all around, that is, the general equilibrium. In 2005-2006 the price of oil did go up abundantly, rippling across distant foreign markets, so much so that politicians in remote areas of the United States began talking (irrationally, we might add) about price controls.

General equilibrium economics considers all markets in an economy to account for all possible effects of a change.

A general equilibrium model of the economy shows the economy as an interconnected system of numerous markets, in accordance with the vision of one of the great economists, Leon Walras (1834-1910). The economy hangs together as a whole, said Walras. In contemporary economics his vision lives on in the so-called Walrasian general equilibrium theory. The technical workshop below uses diagrams to show you how that theory works.

Léon Walras

The great French/Swiss economist Leon Walras (1834-1910, usually pronounced "Vall-rah" but better pronounced "Vall-rahs") is thought of as the master of general equilibrium. Born in 1834 in France, Walras was not the success he wished to be in his native land. He twice failed the examinations to get into the most prestigious university in France, and had to settle (as he saw it) for training as an engineer, in which he in fact failed to graduate. (It is noteworthy that all the French mathematizers of economics down to the present have had training as engineers.) He read at age 19 a book on engineering "statics" that he kept by his bedside for decades afterwards. Its mathematics provided him with the inspiration for his work on economics. His father was his only teacher of economics and was himself an amateur economist - a high school administrator by profession and a teacher of rhetoric and philosophy. The son wrote in the 1850s and 1860s novels that did not sell and ran businesses that went bankrupt. He could not get the job in France as a professor that he believed his brilliance justified. (He complained with some justice that the ten professors of economics in France passed their jobs on to their relatives.)

His success began in 1870, at the age of 36, as the first professor of economics at the law school of the Academy of Lausanne, in the French-speaking part of Switzerland. Fame arrived slowly. As a biographer says, "The Walrasian theory did not make its appearance as 'a flash of light illuminating a dark and confused landscape', but rather as a penetrating pencil of esoteric rays serviceable only to specialists to whom it gradually revealed a clear design of organic unity inherent in socio-economic phenomena" (Jaffé, ed., p. 5).

Technical workshop: General equilibrium in a few graphs
Economists prefer to articulate the Walrasian theory of general equilibrium in the form of equations. The basic idea can also be shown in a few graphs. To keep matters simple we assume that all markets are perfectly competitive. That allows us to draw demand and supply curves for each market. The change is in this case a shift in the supply of oil due to a war in the Middle East. This will increase the price of oil, as you see in Figure 16.2a.
Figure 16.2 The Walrasian general equilibrium

The economy hangs together, Walras showed. An increase in the price of oil causes curves to shift in markets throughout the economy. The shifting and price-adjustments will continue until a new equilibrium is reached in all markets. This equilibrium is called general equilibirum.

The increase in the price of oil has repercussions for the transportation industry, among many others. The supply for transportation services shifts to the left, as in Figure 16-2b. The price for transportation goes up. But that's not all. The demand for truck drivers is derived from the conditions in the market for transportation services. With the quantity of transport miles down, the demand for truck drivers will shift to the left as well, as in Figure 16-2c. The result is lower wages for truck drivers. So some drivers will seek employment elsewhere. They may seek jobs at their local university-driving forklifts, fixing windows, checking furnaces-thus causing the supply of university employees to shift to the right, as in Figure 16.2d. And so on. One big change in a curve causes curves to shift throughout the market system.

Concept Check 1: What will happen in the market for big cars when the price of gas goes up?

"Partial" equilibrium analysis by contrast would just look at the curves of demand and supply in the market for oil itself. It would ignore all the other changes. This analysis makes sense when we're interested in the oil market only and there are good reasons to assume that the ripple effects of Hussein's action in other markets won't affect the oil market in any significant way. Such after-effects are conceivable. For example, if wages and salaries were to drop, as indicated in Figures 16.2c and 16.2d, the demand for oil will shift in as the demand for gas goes down in response. Partial equilibrium analysis neglects such secondary effects.

Whenever a curve shifts, a market will be in disequilibrium-temporarily. If the market is perfectly competitive, the response is quick and direct: the price will change to bring about a new equilibrium. Price adjustments occur in all markets that are affected by the initial shock or the subsequent waves. Prices continue to adjust until all markets have reached equilibrium, that is, where quantity demanded equal quantity supplied.