Saturday, 3 September 2016

Limits of general equilibrium

In a recent EconLog piece Emily Skarbek writes,
A recent piece by Raphaële Chappe discusses the uses and limitations of general equilibrium theorizing. The post is a long-read, but Chappe briefly summarizes the point when she writes:
...the theory lacks explanatory relevance, providing instead a language through which one can say both too much and too little. The theory's abundance of riches within its own multiverse is to be contrasted with its complete neglect of some important aspects of real-world markets, such as for example the presence of increasing returns to scale, the role of institutions and their effects (including money), and the place of innovation, all of which are difficult to model within the theory.
This neglect of real-world institutions is very well illustrated by current, mainly partial-equilibrium, approach to the theory of the firm. As I have written in chapter 5 of The Theory of the Firm, the current theoretical approaches to the firm highlight a general issue to do with post-1970 microeconomics; namely, the retreat from the use of general equilibrium (GE) models. I argue,
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 GE, as developed in his Elements of Pure Economics, Friedman argued,
Economics not only requires a framework for organizing our ideas [which Walras 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 in so far as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic interaction, asymmetric information and economic institutions.
In fact to model economic institutions like the firm it is necessary to violate basic assumptions of GE theory which suggests that as it stands GE cannot deal easily with firms, or other important economic institutions. Bernard Salanié 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.
(Salanié 2005: 1)
All this would suggest that to make GE 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 GE 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 GE framework.

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