What purpose does general equilibrium serve in practice?

Question

What purpose does general equilibrium serve in practice?

How is it useful for people (since economics is supposed to assist politics, which is supposed to benefit people)?

Answer 1

Daron Acemoglu, in a paper called Theory, General Equilibrium and Political Economy in Development Economics, discusses the role of economic theory in empirical work in development economics, which investigates the causes of poverty and low incomes. He puts a special emphasis on general equilibrium considerations. He discusses why counterfactual analysis based on microdata that ignores general equilibrium issues may lead to misleading conclusions. In particular, depending on magnitudes of various effects, general equilibrium interactions can offset or even reverse sensible partial equilibrium conclusions.

The importance of general equilibrium effects in theory

Acemoglu considers three important types of general equilibrium effects, which are usually not estimated in partial equilibrium comparisons:

1. In response to large policy interventions or shocks, imperfect substitution between factors and diminishing returns imply that factor productivities and prices will change.
2. The same policy interventions or shocks can lead to endogenous technology responses.
3. There may be composition effects resulting from equilibrium substitution of some factors or products for others.

The importance of general equilibrium effects in practice

• Consider the large increase in the relative supply of college-educated workers in the United States starting in the late 1960s. Given technology, this change in relative supply should have reduced the college premium. As is well known, the opposite happened in practice, and the college premium increased sharply from the late 1970s onwards. This was a consequence of the endogenous response of technology to the relative abundance of more skilled workers.

• A large microeconometric literature shows that healthier individuals are more productive. On this basis, we would expect a greater aggregate productivity if health conditions improve. But one should take general equilibrium effects into account, since an increase in health conditions also increases population and longevity, and because of diminishing returns to capital and land, it may decrease labor productivity and may in fact reduce income per capita.

Other references

• Townsend (2009) for a discussion of the role of general equilibrium analysis in development economics, with special emphasis on credit market issues;
• Heckman, Lochner and Taber (1998) for a discussion of general equilibrium issues in the analysis of the effects of technology on wage inequality.