Partial equilibrium theory-the stuff of Part I-focuses on the effects that one change, such as a shift in consumer preferences, has on a one or two markets, disregarding the wider ripples. A partial equilibrium analysis makes sense when the wider ripples are unlikely to be earth-shakingly large. To be precise, when cross-price, cross-income, cross-everything elasticities are at or near zero. For example, with a little imagination you may find a reason why a change in American preference towards low fat food might have in some way or another a effect on the Italian shoe industry or the demand for Dutch tulips. Who knows? Producers of low fat food may like Italian shoes more than the producers of high fat foods. And Italian shoe makers may use their extra earnings to buy more tulips. Ripples can move in funny and unexpected ways. However, the effects on Italian shoes and Dutch tulips will be so small that they are better ignored to keep the analysis simple. Partial equilibrium theory, therefore, asks you to limit the scope of your analysis, reasonably.
Partial equilibrium theory considers the effects of a change on one or a few markets only.
But some problems require a general equilibrium theory. If Saddam Hussein, the deposed ruler of Iraq, had succeeded some years ago in grabbing the oil riches of the Persian Gulf, then the price of oil would have gone up dramatically. In this case the ripple effects would be big and far-reaching. After all, the Persian Gulf counts for enough of production to significantly affect the price of oil. And the price of oil counts for enough in the economy of the world that a rise in its price has big ripple effects. Not ripples; waves. For one, you will pay more at the pump. You also may stay forsake a trip home for Thanksgivings because of a steep rise in the price of a ticket. Your rent may go up as well because a rise in heating expenses. Consequently, an analysis of the effects of Hussein's putative action would have to consider many markets and determine to which new equilibrium all these markets would move. We might even go so far and aspire to include all possible markets to determine the new equilibrium all around, that is, the general equilibrium. In 2005-2006 the price of oil did go up abundantly, rippling across distant foreign markets, so much so that politicians in remote areas of the United States began talking (irrationally, we might add) about price controls.
General equilibrium economics considers all markets in an economy to account for all possible effects of a change.
A general equilibrium model of the economy shows the economy as an interconnected system of numerous markets, in accordance with the vision of one of the great economists, Leon Walras (1834-1910). The economy hangs together as a whole, said Walras. In contemporary economics his vision lives on in the so-called Walrasian general equilibrium theory. The technical workshop below uses diagrams to show you how that theory works.
Concept Check 1: What will happen in the market for big cars when the price of gas goes up?
"Partial" equilibrium analysis by contrast would just look at the curves of demand and supply in the market for oil itself. It would ignore all the other changes. This analysis makes sense when we're interested in the oil market only and there are good reasons to assume that the ripple effects of Hussein's action in other markets won't affect the oil market in any significant way. Such after-effects are conceivable. For example, if wages and salaries were to drop, as indicated in Figures 16.2c and 16.2d, the demand for oil will shift in as the demand for gas goes down in response. Partial equilibrium analysis neglects such secondary effects.
Whenever a curve shifts, a market will be in disequilibrium-temporarily. If the market is perfectly competitive, the response is quick and direct: the price will change to bring about a new equilibrium. Price adjustments occur in all markets that are affected by the initial shock or the subsequent waves. Prices continue to adjust until all markets have reached equilibrium, that is, where quantity demanded equal quantity supplied.