In the microeconomic field, general equilibrium is a concept widely used to study and analyze economic variables. It is useful for studying their corresponding functions like interpolations, inter and co-relations, and interdependencies to predict and analyze the functioning of the entire microeconomic system as a whole. General equilibrium provides the roadmap against which the economic the causality and effectiveness of the individual variables and their systematic impact on other variables are evaluated.
For example, consider the case of demand and supply in a microeconomic system. Now a change in the price of a commodity can affect the quantity demanded the same. Consequently, any fluctuation in demand would proportionately impact the supply. Hence general equilibrium helps to blend the effects and causes of the variations in prices and then outline the corresponding fluctuations in demand and supply (other things remaining constant) for the entire economic spectrum under consideration.
One of the most important postulates of general equilibrium is for any economy to remain in balance, all the factors of production and consumption i.e., all the consumers, all firm and services and even all the factor-services are in equilibrium at any given timed and are simultaneously interrelated in a linear or non-linear manner.
In other words, the general equilibrium prevails in microeconomics when every consumer spends his disposable income and assets for the given commodity at a given price in such a manner to deliver maximum satisfaction. The components of production and producing and selling goods at this equilibrium price irrespective of quantity produced and the demand and supply chain interaction also happens at this price only. General equilibrium is linked to consumer satisfaction, and the interaction of demand and supply governed this concept of maximum pleasure.
The concept of general equilibrium is based on certain assumptions and constraints to certain bounding limits. The following are some key assumptions of general equilibrium:
1. There exists perfect competition in the market; it is a commodity market or factor markets. There are no barriers to entry and exit, and as such, any firm faces no losses when it decides to exit a market. Hence, given the low entry threshold, there can be an infinite number of firms in the market at any given time.
2. Another assumption regarding supply is that all the firms have equal access to raw materials, financing needs and would earn the same returns for unit sale of the given product and services. As all the firms operate under the same cost pf production, no firm has the pricing advantage, and hence the unit contribution margin is the same for all the products.
3. On the supply side, general equilibrium assumes that all the firms produce identical homogenous products using the same technology. Hence, none of the firms have any competitive or strategic advantage over the other. As the techniques and cost of production are the same, no firm can influence the consumers in any manner. In the same vein, there is optimum utilization of resources and labor to ensure that the production happens in an optimum manner.
4. On the demand side, general equilibrium assumes that consumer behavior in qualitative aspects i.e., preference of the consumers, tastes, and habits, personal inclining towards consumption remains constant. General equilibrium also outlines that the income level of the consumers and correspondingly the disposable income are constant. Hence all the consumers strive to achieve maximum satisfaction in an optimum manner and are not under any influence by the supply side.
The concept of general equilibrium helps in predicting the dynamics between the product market and the factor market.
1. Product Market: Given that the income levels and the personal preference of the consumers are constant, every consumer tries to spend his income on products to maximize his/her satisfaction levels. Hence the demand for a product depends upon the prices of substitutes. The dynamics of the product market in pricing for delivering optimum satisfaction can be ascertained, thereby predicting the general movement of the supply and demand curve for a particular commodity.
2. Factor Market: Since all the firms have access to similar technology, and the cost of production is the same. Each producer has to deploy resources in such a manner such that marginal revenue and unit contribution are in the given proportion. This proportionality of factor market holds importance in conducting micro economical study.
Given the plethora of assumptions, there are quite a few limitations of the general equilibrium which are discussed as follows:
1. On the supply side, it assumes that the cost pf production is the same for all the firms, and as such, no firm has a competitive advantage. And, this is unrealistic and a hopeful scenario. In a realistic scenario, each firm strives to gain a competitive edge by focusing on innovation, economies of scales, bundling services, etc. Moreover, general equilibrium assumes homogeneity in products and services, which is, again, only a theoretical concept. Since most firms have a diverse product portfolio, such a scenario won't exist in the real world.
2. On the demand side, it considers the consumers as static and homogenous. Most consumers have varying levels of income and even more varying levels of disposable income. Furthermore, each individual has his/her unique propensity to consume a product or service and cannot be bracketed in one group. Given the evolving consumer preference across all economies, this assumption is bound to fall flat. Most of the consumers are influenced by marketing strategies and, as such, under the influence of external stimuli might, for instant gratification rather than optimum satisfaction.
The concept of general equilibrium provides a framework using which an ideal scenario can be proposed. Using this ideal scenario as a benchmark, firm, consumers, and policymakers can strive to alter or innovate in the product or factor market to maximize unit contribution. Hence general equilibrium should be used as a model to analyze the dynamics of various economic variables.
Sep 16, 2020