Saturday, 9 April 2016

Is general equilibrium dead?

As early as 1955 Milton Friedman was suggesting that to deal with "substantive hypotheses about economic phenomena" a move away from Walrasian towards Marshallian analysis was required. When reviewing Walras's contribution to general equilibrium, as developed in his Elements of Pure Economics, Friedman argued,
"[e]conomics not only requires a framework for organizing our ideas [which provides], it requires also ideas to be organized. We need the right kind of language; we also need something to say. Substantive hypotheses about economic phenomena of the kind that were the goal of Cournot are an essential ingredient of a fruitful and meaningful economic theory. Walras has little to contribute in this direction; for this we must turn to other economists, notably, of course, to Alfred Marshall" (Friedman 1955: 908).
By the mid-1970s microeconomic theorists had largely turned away from Walras and back to Marshall, at least insofar as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic interaction, asymmetric information and economic institutions.

If one takes the theory of the firm as an example (see here for an overview of this literature), all the models considered in the contemporary literature are partial equilibrium models. but in this regard the theory of the firm is no different from most of the microeconomic theory developed since the 1970s. Microeconomics such as incentive theory, incomplete contract theory, game theory, industrial organisation, organisational economics etc, has largely turned its back on general equilibrium theory and has worked almost exclusively within a partial equilibrium framework.

One major path of influence from the mainstream of modern economics to the development of the theory of the firm has been via contract theory. But contract theory is an example of the mainstream’s increasing reliance on partial equilibrium modelling. Contract theory grew out of the failures of general equilibrium. As Salanie (2005: 2) has argued,
“[t]he theory of contracts has evolved from the failures of general equilibrium theory. In the 1970s several economists settled on a new way to study economic relationships. The idea was to turn away temporarily from general equilibrium models, whose description of the economy is consistent but not realistic enough, and to focus on necessarily partial models that take into account the full complexity of strategic interactions between privately informed agents in well-defined institutional settings”.
When surveying theory of the firm literature Foss, Lando and Thomsen (2000) use a classification scheme which clearly illustrates the movement of the current theory of the firm literature away from general equilibrium towards partial equilibrium analysis. The scheme divides the contemporary theory into two groups based on which of the standard assumptions of general equilibrium theory is violated when modelling issues to do with the firm. The theories are divided into either a principal-agent group, based on violating the ‘symmetric information’ assumption, or an incomplete contracts group, based on the violation of the ‘complete contracts’ assumption.

Another recent challenge to standard general equilibrium as come from the introduction of the entrepreneur in the theory of the firm since, as William Baumol noted more than 40 years ago, the entrepreneur has no place in formal neoclassical theory.
“Contrast all this with the entrepreneur’s place in the formal theory. Look for him in the index of some of the most noted of recent writings on value theory, in neoclassical or activity analysis models of the firm. The references are scanty and more often they are totally absent. The theoretical firm is entrepreneurless−the Prince of Denmark has been expunged from the discussion of Hamlet” (Baumol 1968: 66).
The reasons for this are not hard to find. Within the formal model the ‘firm’ is a production function or production possibilities set, it is simply a means of creating outputs from inputs. Given input prices, technology and demand, the firm maximises profits subject to its production plan being technologically feasible. The firm is modelled as a single agent who faces a set of relatively uncomplicated decisions, e.g. what level of output to produce, how much of each input to utilise etc. Such ‘decisions’ are not decisions at all, they are simple mathematical calculations, implicit in the given conditions. The ‘firm’ can be seen as a set of cost curves and the ‘theory of the firm’ as little more than a calculus problem. In such a world there is a role for a ‘decision maker’ (manager) but no role for an entrepreneur.

The necessity of having to violate basic assumptions of general equilibrium theory so that we can model the firm, suggests that as it stands GE can not deal easily with firms, or other important economic institutions. Bernard Salanie has noted that,
“[ ...] the organization of the many institutions that govern economic relationships is entirely absent from these [GE] models. This is particularly striking in the case of firms, which are modeled as a production set. This makes the very existence of firms difficult to justify in the context of general equilibrium models, since all interactions are expected to take place through the price system in these
models” (Salanie 2005: 1).
This would suggest that to make general equilibrium models a ubiquitous tool of microeconomic analysis - including the analysis of issues to do with non-market organisations such as the firm - developing models which can account for information asymmetries, contractual incompleteness, strategic interaction, the existence of institutions and the like is not so much desirable as essential. One catalyst for the development of such a new approach to general equilibrium is that partial equilibrium models can obscure the importance of the theory of the firm for overall resource allocation, a point which is more easily appreciated in a general equilibrium framework.

General equilibrium is dead. Long live general equilibrium? We will see.

  • Baumol, William J. (1968). `Entrepreneurship in Economic Theory', American Economic Review, 58(2) May: 64-71.
  • Foss, Nicolai J., Henrik Lando and Steen Thomsen (2000). ‘The Theory of the Firm’. In Boudewijn Bouckaert and Gerrit De Geest (eds.), Encyclopedia of Law and Economics (vol. III, pp. 631-58), Cheltenham U.K.: Edward Elgar Publishing Ltd.
  • Friedman, Milton (1955). ‘Leon Walras and His Economic System’, American Economic Review, 45(5) December: 900-09.
  • Salanie, Bernard (2005). The Economics of Contracts: A Primer, 2nd edn., Cambridge, Mass.: The MIT Press.

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