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Leon Walras and General Equilibrium

Leon Walras (1834-1910) was born in France where his father was also an economist. Walras was influenced by the work of Cournot an early French pre-cursor of neo-classical economics. Walras was appointed Professor of Economics at the University of Lausanne in Switzerland where he founded what is known as the Lausanne School (He was succeeded by the Italian Vilfredo Pareto) which emphasized th application of mathematics to economics. He independently arrived at the same marginal principle as Jevons & Menger, but his approach was towards the determination of a general equilibrium in the economy rather than the partial equilibrium approach of Marshall. Elements of Pure Economics (published in French in 1874; not translated into English until 1954) In Marshallian economics, . a consumer with a given income & fixed tastes will maximize his utility with respect to the prevailing prices of available goods by equating the MU divided by the prices in various goods. . At the same time, producers minimize their costs by employing factors of production so that the MP divided by the price of the factor was the same for each factor.

. Further the producers in the long run build plants of optimal size and produce the quantity that will maximize profits by equating MR and MC. When we sum up all markets, the market demand prices must equal, in equilibrium, the market supply prices . while at the same time, the factor payments in all industries must equal the revenues while the income earned by all households (which was assumed when we set up individual demand curves) must equal the total value of production The question that Walras asked was "Does all this hang together?" Does the market mechanism guarantee that all these parts of the economy will be compatible? If so is the solution unique or might there be several combinations of prices that might work? Even if a unique general equilibrium exists, is it this general equilibrium if it departs from it?
In other words, we have n partial equilibrium equations with n parameters, which is necessary but not sufficient to solve for all the n's.

stable? - i.e. are there forces that will return the economy to

This issue had been anticipated by Cournot who realized that: "for a complete and precise solution of the partial problems of the economic system, it is inevitable that one must consider the system as a whole." That is what Walras set out to do. He did not have as good mathematical skills as Cournot, but he did pose the problem correctly and demonstrated that it could in principle be solved although his own approach was (to quote Mark Blaug) "not only mathematically clumsy but ambiguous and unfinished".

The idea of a general equilibrium is not always easy to grasp since it tends to undermine our ideas of causality. People often ask if higher input prices cause higher output prices, or if high demand causes higher input prices. But in a general equilibrium model, they are all jointly-determined. This struck many people as a kind of circular argument but it is inherent in the set-up of the partial equilibrium equations since: A firm cannot decide how much labour to hire without knowing what demand will be and the price of labour is partly determined by the quantity demanded and the income they earn will partly determine the amount of demand for the product!
..

In Marshallian partial economics, there are a lot of ceteris paribus assumptions while in Walrasian economics all factors are interdependent.

In addition, in Marshall, the variable that adjusts is quantity:

1.e.

Dpx = f (qx) Spx = f (qx)

while Walras saw price as the variable that adjusts, i.e.

Qdx = f (Px) Qsx = f (Px)

both of these are functions since one variable is a "function" of another. In Walras's case, the left side represents the quantity demand and supplied of good x and this varies as the price of x changes (on the right side) In Marshall, the demand and supply price are related to the quantities. We can see this more clearly on the diagram reproduced in the text (fig. 15-1 and 15-2) and by looking at Excess Demand Functions (ED = Qd - Qs) In Walrasian terms, it is the price that changes to equilibrate S & D [i.e. ED = f(P)] - e.g. when ED > 0, prices are bid up by consumers reducing ED

In Marshall, it is the quantity that changes to reach equilibrium [i.e. ED = f(Q)] e.g. when ED < 0, higher profits will lead firms to produce more and quantity increase towards equilibrium

Both systems are stable given downward-sloping demand and upward-sloping supply curves
However, if we encounter backward-bending supply curves (see fig. 15 - 3) then with a supply curve with a negative slope, it is stable in Walrasian terms and unstable in Marshallian terms

To see this, consider any quantity below the equilibrium quantity. Then in the Walrasian system, Qd < Qs and prices will tend to fall leading us back to equilibrium. But in the Marshallian system, supply price> demand price which will tend to lead firms to reduce production and thus move away from equilibrium
(However, if the supply is backward bending but has a flatter slope than the demand curve, the opposite is true!!!)

Why would this matter?

. we believe that there are some backward bending supply curves in the real world such as labour supply curves and supply curves for foreign exchange . there are examples of markets which have a "cobweb" style of adjustment and these cannot be successfully modeled using Marshallian approach
. modem economic theory has been quite interested in stability

conditions - that is as to how the market adjusts rather than what the new equilibrium is - Walras's view of adjustment
involved "tatonnement" - a groping or search for equilibrium which involved a sort of auctioneer crying out different prices and then the parties observed the results - the issue of how markets move to equilibrium has been of considerable interest in the 20th century

The Walrasian System Basically a series of equations in a number of different areas:

1. Technical coefficients of production which are fixed - tells how much of various inputs are needed to produce a given output

2. The raret or marginal utility function of each individual product or service where MU = f (q) It is assumed that there are a fixed number of inputs which are owned by various individuals and who will supply various amounts as the prices change. So each individual has a demand function for goods equal to the total value of productive services which they sell

pf

==

pc

Where f= factor supplies and c = consumer goods Values are handled by the use of a single good which has a price = 1 and is called the numeraire Each consumer has a demand curve for goods which takes all goods ) into account at once so Da = fa(Pa, Pb, Pc Also each individual has a supply function for his/her factor services which also depends on all prices We then sum all the individual supply and demand functions and we get market clearing conditions in all factor and consumer good markets One of the interesting problems that Walras had to confront was where prices come from given that all agents are price-takers in his model. Walrass answer was that of tatonnement = groping. Either an auctioneer (crieur) or the buyer and seller would call out a price. If they were not the same, no exchange would occur; this would be repeated until a common price was called out which allowed the trade.

Pareto and Welfare Economics

Vilfredo Pareto, 1848 - 1923, was the successor to Walras at Lausanne and developed the theory along the lines of general equilibrium welfare analysis.
Cours d'conomie politique, 1896-97 Mauel d'conomie politique, 1906

In Marshallian economics, welfare economics is partial equilibrium & is largely done through consumer surplus. Pareto used the idea of indifference curves developed by F. Y. Edgeworth in 1881 to derive the optimal conditions in exchange and consumption. He showed that a welfare optimum exists when no one person can be made better off without making at least one person worse off and this is usually called "Pareto optimal". In other words, in a general exchange economy, we cannot by transforming or transferring goods improve the welfare of any individual A (in the sense of giving him a combination he prefers) without also moving at least one individual B to a position of less welfare. It fits into the marginal system very well, since once we agree that utility comparisons are intra-personal and not inter-personal, then it can be rigorously shown that in a competitive exchange economy, the Pareto optimum always occurs where the marginal rates of utility for the individuals are equal. There are typically many such situations (they are collectively called the contract curve) but we cannot distinguish between them since they represent different distributions of the total utility but we always know that they are superior to any points not on the contract curve.

He was attempting to derive a value-free welfare economics. The idea of Pareto optimality is a necessary although not sufficient condition for a general welfare optimum. His system is limited however because it is based on an assumption of a fixed supply of inputs and outputs and is a static equilibrium. It does not include any cardinal utility, only ordinal, and implicitly assumes that there are no externalities or uncertainties in the system. This is part of a long-running attempt by economists to separate efficiency and equity as J. S. Mill described the immutable laws of production versus the culturally-determined laws of distribution. So most economics policy arguments, like the abolition of the Corn Laws for example, usually proceeded by arguing the effects of a change in allocative efficiency with 1. a fixed initial distribution of income and 2. to import some kind of value judgment on the resulting changes in the distribution of income (i.e. that the gains of workers would offset the losses of farmers). So the value of Paretos approach is to clearly separate the efficiency from the equity though at the cost of assuming away all comparisons between individuals and at the cost of having a large number of potential Pareto optimal outcomes depending on the initial distribution of income. Modern welfare economics has not really been able to solve these problems. We still have no clear-cut way of evaluating policies that help some people and harm others except through the political process or by imposing a preferred distribution of income on the problem. Once the question of the distribution of income/utility has been settled, by a social welfare function or whatever, then it is fairly easy to demonstrate that a long-run perfectly competitive economy will produce a Pareto equilibrium and that a Pareto equilibrium allocation of resources must be a long-run competitive

economy (given the allocation of income). This is not the same thing as a capitalist economy since there was a literature from the 1930s onwards that demonstrated that a socialist planner could impose the marginal pricing rules on firms and order them to act as if they were profit maximizers and thus to obtain the Pareto outcome.

General Equilibrium & Pareto Optimality since WW II

The study of general equilibria and Paretian welfare economics has been considerably extended in the 20th C. The first major accomplishment was to prove the existence of a general equilibrium under certain circumstances which was accomplished in the 1950s by the work of Kenneth Arrow & Gerard Debreu and is usually called the ArrowDebreu theorem. The actual model is highly mathematical, starting with a number of axioms, and not really defining what the commodities are. There are 3 possible interpretations of the model: 1. commodities differ by being in different places in which case the model is a spatial model of general equilibrium similar to a description of international trade 2. commodities differ by being delivered at different times in which case it is an inter-temporal model

3.

commodities differ by the probability that they will be

delivered at a certain time and place - this is a description of a riskfree general equilibrium All of these can be combined into a single model of when, where and under what circumstances a good would be delivered. This would require that we have prices for the delivery of 1 tonne of hard wheat in Saskatoon at 12 noon on Feb. 1, 2056 if there is no major snow storm. Obviously such complete markets to cover all these contingencies do not exist in the real economy. If we allow that there are incomplete markets, then equilibrium may still exist but it will not be Pareto optimum. It is not entirely clear to most observers what the practical significance of these proofs is especially since we know that the world has externalities, imperfect information, transaction costs, imperfect competition, increasing returns to scale, convex preference functions and a tendency to believe our utility is inter-twined. As the British economist Frank Hahn put it: (referring to Arrow & Debreus proof) Now that we have got there we find it less enlightening than we had expected. Still it does give us some insights. The fact that some of the markets needed in an Arrow-Debreu world do not exist has led us to think more clearly about why they do not. The work on asymmetric information and transaction costs can help us in this respect. Game theory is another way to approach some of these problems. It is also useful to remember the theory of the second-best which tells us that when some impediment to achieving the Pareto optimum exists, sometimes another distortion will make things better. So is the economy in a general equilibrium and what are its

characteristics? This is something that we are not completely sure about. Some of the issues that the critics of neo-classical economics including the work of J M Keynes will be concerned with these issues.

Assessment of Neo-classical Economics The neo-classical system had its benefits and costs when compared to the other possible paradigms.
On the positive side, it produced a consistent, precise and elegant simplicity of analysis permitted by the use of the marginal technique. It allowed economists to treat capital as a factor of production much like labour and with a methodology much like consumption. Under Marshall in particular, the partial equilibrium analysis lent itself to the analysis of many real-world problems and most of modern applied economics rests on this foundation. Finally many observers would argue that the it moved economics away from the rather fruitless search for the underlying value of commodities and provided a more useful measurement (although at the cost of introducing an unmeasurable cardinal activity; the latter problem was somewhat solved by the elaboration of indifference curves with an ordinal utility) On the other hand, neo-classical theory narrowed the scope of both value theory and economics in general. Most notable was the absence of a real theory of the functional distribution of income; in neo-classical economics, given the existing distribution of income, the system can demonstrate the optimal allocation of resources but it really doesnt have a good explanation for the existing distribution. It also has problems with the heterogeneity of both capital and labour (which Ricardo and Marx struggled with as well). In particular, there is still a problem with

the source of profits. For Marshall they are a combination of rewards to waiting, risk-bearing, entrepreneurial skill, etc, but he never clearly distinguished between profit and interest. Someone who inherits capital and invests it is hardly engaged in abstinence and this lower the range of capital which is a necessary payment. There is also not much growth theory embedded in neo-classical economics and the return of growth theory in the 1970s under Robert Solow returns to the classical model for its inspiration. So to sum up, Ricardo and his colleagues were interested in trying to explain the share of profits (which he regarded as the engine of economics growth) in national product while the neo-classicals were content to let the answer come out as a logical by-product of their assumptions about the prices of factors in the long-term competitive equilibrium.