UNIVERSITY 0F SOUTHERN CALIFORNIA
PROF. RICHARD DAY
ASSIGNMENT NO. 1
(TO BE SUBMITTED ON 09.13.94)
By SANJEEV SABHLOK.
Q.1. Is the theory of Competitive General Equilibrium a useful theory of a market economy? If so, why? If not, what is missing or what is wrong? If so, does it have limitations, and what are they?
Micro-economics has since long considered general equilibrium as being an important starting point in theory. However, macro-economics was unable to capitalise on this equilibrium approach and therefore there existed for a long time a divide betwee n the two branches of economics. However, there have been attempts to integrate the two branches, with the equilibrium approach as the starting point. In this approach, a set of behavioural relations and a set of equilibrium conditions produ ce an interacting model of the economy.
The theory of Competitive General Equilibrium attempts to show that individual behaviour underlies the famous AS and AD curves. It represents a general equilibrium approach - as contrasted with partial equilibrium approach - to the st udy of the economic system. Millions, even billions (if the global economy is considered to be a purely open system) of consumers - the basic economic decision-making units, who are basically motivated by self-interest (which is of course based on aspects studied by psychology, sociology, etc.), appear to make the economy "run" together in a complicated web of inter-relationships. This models states essentially that demand and supply are both functions of price, and that equilibrium is achieved at the pri ce which equates these two. In other words,all quantities supplied are demanded at that price. We do not describe the details and equations of the model here, which were discussed in class (Day, 1994).
Competition in this theory represents perfect arbitrage, or in other words, that prices of the same commodity cannot continue to remain different in two different markets: these prices shall be moved towards equality by forces of phys ical purchase of the commodity from low price areas and sale to the high price areas.
Walras had the distinction of being the first to understand the fundamentals of this system. Intuitively, we can observe that the constituent partsof the economy (at least in a free market capitalist economy without barriers to trade or barriers to entry) are interdependent. Due to this inter-relation, prices in all markets are simultaneously determined by an "invisible hand". To that extent, as a starting point, the general equilibrium approach appears to be a useful depiction of reality.
i) The general equilibrium model forms part of what is known as comparative-static analysis. It does not consider time as a variable. As Nagatani points out (1981: 3), this model does not concern itself with a knowledge of the actual price-formatio n process. He writes, "In macroeconomics, where it is crucial to understand the dynamic processes of price and quantity variations, this type of equilibrium-price relationship is manifestly inadequate. Actual prices often turn out to be too irresponsive t o important changes in the data (and conversely, too sensitive to false signals) for them to maintain the system close to equilibrium." In this view, this theory overstates the importance of price in determining the general equilibrium. Some of these asp ects are taken into account by considering a dynamic model.
ii) The Keynesian Revolution is a major criciticism of the classical general equilibrium theory. The Keynesians feel that there is often cause for disequilibrium to exist in the goods and other markets. Whereas the classicals view that the economy t ends towards equilibrium, Keynesians think that equilibrium is only one of the many feasible states, and the probability of its existence and continuity are slim Looking at the real world, one would tend to agree with the Keynesians.
iii) Baumol has shown a few interesting outcomes (1977: 484). For example, he shows that in certain situations, it is impossible, using the General Equilibrium theory to have any determinate price level - any price level will do as well as any other because they will all be equally consistent with equilibrium. In general, he shows that monetary theory is made impossible using the classical General Equilibrium theory. One wonders what Friedman has to say to this.
iv) One of the problems I have about the general equilibrium approach is that it is too general. In real life, the output of a particular commodity appears to be determined by the relative prices of its inputs and the expected price of its ou tput in relation to a few competing commodities: not by considering the prices of all commodities. In fact there are considerable possibilities of simplifictation of the thousands (nay, millions) of equations based on the relative strengths of the inter-relationships. How far does the influence of a single commodity reach? Is it useful (or even appropriate) to have equations in prices of endless numbers of commodities, as determining the supply a particular commodity? How much, for example, does th e price of a pin purchased in New York effect the output of an aeroplane produced in Los Angeles, or the output of oil in Kuwait? As the economy becomes more diversified and the number of commodities approaches infinity, the effect a commodity picked at r andom, would have on other commodities would be zero. In fact, the general equilibrium approach almost seems to take on a shape akin to the theory of Chaos in physics, according to which even a butterfly fluttering its wings in the jungles of Africa co uld cause a storm in Iceland.
In reality, therefore, no firm takes into account (or can ever hope to take into account) the prices of all other goods while making its production decisions. What happens is that a very partial view off events is taken. And th at produces fairly good results. The same holds for a consumer: he does not compare the prices of all other goods while deciding on the purchase of a particular good: if he does that he would never be actually able to purchase anything at all, give n that prices of almost all commodities are changing over time.
Samuelson of course makes a point (1963:9) that a system is chosen by the theorist: to be as broad as desired. " A system may be as broad or as narrow as we please depending upon the purpose at hand... The fruitfulness of any theory will hinge upon the degree to which factors relevant to the particular investigation at hand are brought into sharp focus." Therefore, if the purpose of the theory is to enunciate the broadest possible set of inter-relationships, the General Equilibrium theory can be sa id to have succeeded.
v) An interesting criticism of this new approach to macroeconomics is found in Grandmont (1990: 45) "... it is surprising nowadays to see some "New Classical" macroeconomists claim that the distinctive and novel feature of their research strategy - the so-called "equilibrium approach" - is to portray economic units as entities which optimize an objective function under well-defined constraints describing the market or social intitutions through which they interact. I would have thought that understa nding the aggregate behaviour of economic or social systems from sound choice theoretic principles has been, well before 1972 or 1936, one of the goals shared by many microeconomic and macroeconomic theorists of different persuasions, including Friedman, Hicks, Kalecki, Keynes, Modigliani, Patinkin, Samuelson, Solow or Tobin. Proponents of the exclusive use of the "equilibrium approach" to macroeconomic analysis seem moreover to overestimate somewhat the ability of current microeconomic models to pro duce reliable quantitative microeconomic predictions (italics mine)."
vi) Unrealistic assumptions: The general equilibrium approach is based on assumptions which are definitely not very reasonable, e.g., that a producer knows all that there is to know of a particular technology, and that he is producing at the optimum using the best possible technology. We know that it is almost impossible for the average small producer to determine if this is true: he has always a lot more to learn before he reaches the optimum level.
To summarise, briefly, the classical approach to macroeconomics, which is based on the general equilibrium's existence and tendency to continue, has its critics and there is possibly much weight in many of these criticisms. However, the approach is a useful starting point, or a general framework for discussion. It also seems very likely that equilibrium conditions hold over the course of a certain time period: e.g., for a firm, this could be a shorter time period, but for an economy, this could be a fairly longer period. In the intervening period, disequilibrium exists, and processes begin to take shape which bring the system back to equilibrium.
Q.2. Could the theory of Competitive General Equilibrium be a useful theory of a socialist equilibrium? If so, does it have limitations? If not, what is missing?
The book "The Socialist Price System" edited by Alan Abouchar studies various concepts relating to the effecitiveness of the price mechanism in the socialist economy.
According to Seton (1977:10), "In Marxist ideology the final goal of Full Communism is a state of economic bliss where neither scarcity of means of production nor shirking of individual effort will stand in the way of human wants. The role of price relationships as scarcity signals or incentives to effort will thus have withered away and passed into oblivion..."
However, the reality in Socialist systems has always been quite different from the ideology. Even at the very commencement of the socialist system, "after the enforced and ill-conceived flirtation with a moneyless order under War Communism, Lenin j erked the economy back from the brink and restored price and profit incentives with a vengeance." Inspite of this, various attempts to discover "diagnostic" prices continued in the system - prices which hope to eliminate inequality and take distributive a spects into account.
The fundamental feature of the socialist system therefore is its attempt to determine supply and demand through artificially determined prices, in the hope that the "exploitative" nature of "capitalist prices" would be eliminated or reduced.
Two major problems exist with such a system:
i) Administrative impossibilities:- Administered prices cannot "reach into the interstices of economic motivation" (Seton: 12). The administrators of prices become either incapable of optimising the prices in favour of equality, or tend to take adva ntage of this feature of fixing prices, drawing various perquisites/ rents from the system.
ii) Impossible to co-ordinate prices: The more serious problem in such a system is that it will lead to great detail in central decision making which will exceed the planner's capacity for coordinating prices. In fact, this is what happened in the erstwhile Soviet Union: " The price setters' inability to keep all this properly attuned, and to do so in step with constantly changing costs and norms, resulted in a maze of differential profit rates, financial incentives, and well-nigh impenetrable conf usion (Seton)."
The General Equilibrium theory therefore does not allow for a socialist system. Prices have to be determined "naturally" through the interplay of various forces of supply and demand, rather than administratively. Not allowing the general equilibriu m to be determined this way will lead to a permanent inability to achieve equilibrium in the system. Distortions of prices did actually produce such persistent disequilibria in the Soviet economy.
Economics shows that there are many methods of bringing about distributive "justice", without in any way interefering with the price or market system. Socialistic objectives should therefore be attempted by non-price mechanisms, and prices should b e allowed to be determined competitively.
Baumol, W.J. (1977). Economic Theory and Operations Analysis. Prentice-Hall.
Day, R.H. (Fall, 1994) Class discuussions.
Grandmont, Jean-Michel. Keynesian Issues and Economic Theory in Honkapohja, Seppo (1990). The State of Macroeconomics. Basil Blackwell.
Nagatani, Keizo (1981). Macroeconomic Dynamics. Cambridge University Press.
Samuelson, P.A. (1963). Foundations of Economic Analysis. Harvard University Press.
Seton, Francis . The Question of Ideological Obstacles to Rational Price Setting in Communist Countries in .Abouchar, Alan (1977) (ed.), The Socialist Price Mechanism, Duke University Press.