# Understanding General Equilibrium Theory & Its Alternatives

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*Businessman looking at bar graph.*

## What Is General Equilibrium Theory?

General equilibrium theory, or [Walrasian](https://www.investopedia.com/terms/w/walras-law.asp) general equilibrium, attempts to explain the functioning of the macroeconomy as a whole, rather than as collections of individual market phenomena.

The theory was first developed by the French economist Leon Walras in the late 19th century. It stands in contrast with partial equilibrium theory, or Marshallian partial equilibrium, which only analyzes specific markets or sectors.

### Key Takeaways

*   General equilibrium analyzes the economy as a whole, rather than analyzing single markets like with partial equilibrium analysis.
*   General equilibrium shows how supply and demand interact and tend toward a balance in an economy of multiple markets working at once.
*   The balance of competing levels of supply and demand in different markets ultimately creates a price equilibrium.
*   French economist Leon Walras introduced and developed the theory in the late 19th century.

## Understanding General Equilibrium Theory

Walras [developed the general equilibrium theory](https://www.investopedia.com/ask/answers/012615/what-general-equilibrium-theory-macroeconomics.asp) to solve a much-debated problem in economics. Up to that point, most economic analyses only demonstrated partial equilibrium—that is, the price at which supply equals demand and markets clear—in individual markets. It was not yet shown that equilibrium could exist for all markets at the same time in aggregate.

General equilibrium theory tried to show how and why all free markets tend toward equilibrium in the long run. The important fact was that markets didn't necessarily reach [equilibrium](https://www.investopedia.com/terms/e/equilibrium.asp), only that they tended toward it.

Around 1900, Walras wrote, “The market is like a lake agitated by the wind, where the water is incessantly seeking its level without ever reaching it.”

General equilibrium theory builds on the coordinating processes of a free market price system, first widely popularized by Adam Smith's "The Wealth of Nations" (1776). This system says traders, in a bidding process with other traders, create transactions by buying and selling goods.

Those transaction prices act as signals to other producers and consumers to realign their resources and activities along more profitable lines.

Walras, a talented mathematician, believed he proved that any individual market was necessarily in equilibrium if all other markets were also in equilibrium. This became known as Walras’s Law.

## Special Considerations

There are many assumptions, realistic and unrealistic, inside the general equilibrium framework. Each economy has a finite number of goods in a finite number of agents. Each agent has a continuous and strictly concave [utility function](https://www.investopedia.com/ask/answers/072915/what-utility-function-and-how-it-calculated.asp), along with possession of a single pre-existing good (the “production good”).

To increase their utility, each agent must trade their production good for other goods to be consumed.

There is a specified and limited set of market prices for the goods in this theoretical economy. Each agent relies on these prices to maximize their utility, thereby creating supply and demand for various goods. Like most equilibrium models, markets lack uncertainty, imperfect knowledge, or innovation.

## Alternatives to General Equilibrium Theory

[Austrian](https://www.investopedia.com/terms/a/austrian_school.asp) economist Ludwig von Mises developed an alternative to long-run general equilibrium with his so-called Evenly Rotating Economy (ERE).

This was another imaginary construct and shared some simplifying assumptions with general equilibrium economics: no uncertainty, no monetary institutions, and no disrupting changes in resources or technology. The ERE illustrates the necessity of entrepreneurship by showing a system where none existed.

Another Austrian economist, Ludwig Lachmann, argued the economy is an ongoing, non-stable process replete with subjective knowledge and subjective expectations. He argued that equilibrium could never be mathematically proven in a general or non-partial market.

Those influenced by Lachmann imagine the economy as an open-ended evolutionary process of spontaneous order.

## What Does Equilibrium Theory Tell Us?

General equilibrium theory tells us that in all the markets of an economy, supply and demand interact actively, resulting in price equilibrium. The markets in an economy are all interconnected, and as such, supply and demand decisions in one market will affect the supply and demand decisions in another.

## What Are the Limitations of General Equilibrium?

The limitations of general equilibrium theory are found in its assumptions, which are (1) markets are perfectly competitive, (2) all participants have perfect knowledge and therefore optimize behavior, and (3) there are no externalities. None of these assumptions are true in the real world.

## What Is the 2 x 2 x 2 General Equilibrium Model?

The 2 x 2 x 2 general equilibrium model seeks to illustrate the theory by assuming there are two factors of production, two commodities, and two consumers.

## The Bottom Line

Leon Walras developed the general equilibrium theory which shows how all markets in an economy interact with one another and tend toward a balance. Though the theory has been influential, it relies on certain assumptions that have been challenged by detractors. These assumptions include perfect knowledge and no uncertainty in an economy, which are not realistic factors in actual economies.

> **Article Sources**
>
> 1.  The Library of Economics and Liberty. "[Leon Walras, 1834-1910](https://www.econlib.org/library/Enc/bios/Walras.html)."
>     
> 2.  Humphrey, Thomas M. "[Marshallian Cross Diagrams and Their Uses Before Alfred Marshall: The Origins of Supply and Demand Geometry](https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_review/1992/pdf/er780201.pdf)." _Federal Reserve Bank of Richmond, Economic Review_, March/April 1992, pp. 3-23.
>     
> 3.  Mary S. Morgan. "[Chapter 5 - Metaphors and Analogies: Choosing the World of the Model](https://www.cambridge.org/core/books/abs/world-in-the-model/metaphors-and-analogies-choosing-the-world-of-the-model/3B4953CCC10CE56C4221790CE46D7794)." _The World in the Model: How Economists Work and Think_. Cambridge University Press, 2012.
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> 4.  Levin, Jonathan. "[General Equilibrium](https://web.stanford.edu/~jdlevin/Econ%20202/General%20Equilibrium.pdf)." _Microeconomic Notes (Stanford University)_, November 2006, pp. 1-50.
>     
> 5.  Hülsmann, Jörg Guido. "[A Realist Approach to Equilibrium Analysis](https://mises.org/quarterly-journal-austrian-economics/realist-approach-equilibrium-analysis)." _Quarterly Journal of Austrian Economics_, vol. 3, no. 4, Winter 2000, pp. 3-51.
>     
> 6.  Manish, G.P. "[Subjective Expectations and the Process of Equilibration: the Views of Lachmann and Mises](https://cdn.mises.org/Subjective%20Expectations%20and%20the%20Process%20of%20Equilibration%20The%20Views%20of%20Lachmann%20and%20Mises.pdf)." _The Quarterly Journal of Austrian Economics_, vol. 20, no. 3, Fall 2017, pp. 201-223.