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I'm reading a lot on public finance and have been seeing a lot of mentions of measuring "general equilibrium effects".

I know what general equilibrium is, but I don't know what general equilibrium effects are.

What are general equilibrium effects?

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The expression "general equilibrium" refers to the work by Kenneth Arrow, Gerard Debreu, Leon Walras, and many others. In its strictest sense, it is the indirect impact of a policy/event that is due to the reaction of prices to the policy/event. Sometimes but not always this indirect impact offsets the beneficial impacts of the policy or event.

Sounds abstract? Let me give you an example.

An oil field is discovered in a small town in Texas. As the oil exploration company develops the field, that generates jobs and higher incomes. Looks great, because local businesses will enjoy higher revenues and unemployed workers may find employment.

Yet, there can be some substantial general equilibrium effects that partly offset the positive consequences of this beneficial event:

  1. The prices of many products will rise. Housing is going to be more expensive as higher-income workers are going to try to purchase houses in the town. Restaurant meals and haircuts will become more expensive.
  2. A positive consequence: there will be fancier restaurants and hair salons in town. The higher incomes will attract more talented chefs and better hairdressers.
  3. There may be more congestion on the road, as more workers means more cars.

Sometimes the general equilibrium effects are such that the beneficial consequences of the event are almost entirely offset (more expensive, more congestion, more pollution). Sometimes the general equilibrium effects are small and can be ignored. If, for instance, there were already a lot of empty homes in this small town, the additional workforce and income won't drive house prices up. Workers will merely buy the existing stock of houses.

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  • $\begingroup$ The effect produced by the interaction of markets and different sectors in the model. Sometimes this interaction is more like a black box and not clearly interpretable as the accepted answer has explained. While those explanations may be general equilibrium effects, no model can explain that. To trace general equilibrium effects in a model, study how various sectors and markets interact in the model. It is not always easy though. $\endgroup$ Jan 20, 2023 at 9:46

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