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General Equilibrium 15

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In the mid-2010s, China, India, and other emerging market countries in Asia grew dramatically. With that growth came an unquenchable demand for all sorts of commodities like oil and natural gas. Just as the price of oil skyrocketed, oil companies in North America found new ways to extract petroleum by “fracking,” and the oil-producing regions of Canada and the United States began booming as they sold increasing amounts of oil for increasing amounts of money.

Yet even as cities like Midland, Texas, and Williston, North Dakota, became rich from the resources, they began to experience other problems. While companies and workers in the oil sector reaped a big windfall as demand rose for the fuel exports, this drove up the cost of living for everyone else. Housing was in short supply and prices rose dramatically. Services became scarce and expensive as all sorts of businesses had to raise wages to keep from losing their workers to the mining sector. Firms like Walmart and FedEx had to pay truck drivers more or they would start driving trucks for the oil companies.

The high cost of living in oil boomtowns is a perfect example of the ways in which one market can have an impact on a completely different market. Throughout most of this textbook, we’ve examined how markets function in isolation. Each market has its own demand side that reflects consumers’ tastes and its own supply side that is driven by producers’ input costs, production technologies, and market power. These two sides of the market combine in a self-contained unit to determine an equilibrium price and quantity primarily for that one market.

In earlier chapters, we’ve talked about substitutes and complements, the cross-price elasticity of demand, and other topics that have involved the interaction of markets for different goods, but we have largely ignored how other markets can indirectly affect the ones we’re dealing with. Ignoring cross-market effects simplifies our analysis, but at a cost. Most markets in the real world are interconnected. What happens in one (such as oil in Texas) can affect outcomes in another (such as Texan trucking). In some cases, across-market spillover effects can be so large that ignoring them means we miss an important part of the picture.

In this chapter, we stop ignoring these across-market effects and think explicitly about how the market-clearing process in one market affects the same process in other markets (and vice versa). Economists refer to this as general equilibrium analysis, the study of markets that takes into account all cross-market influences to arrive at a set of prices that simultaneously equates supply and demand in many markets.

General equilibrium holds when all markets are in equilibrium at the same time. Taking explicit account of the way each market operates on its own while recognizing the influences of market spillovers is the key to understanding general equilibrium effects. What we’ve been doing up to this point is called partial equilibrium analysis, the determination of equilibrium in a particular market while assuming that it is not affected by spillovers from any other market. General equilibrium analysis is more complicated because there are more “moving parts” to keep track of. You might think it’s unlikely that all those markets would manage to achieve equilibrium at the same time, but one of the most fundamental results of microeconomic theory proves that it will all come together under the right circumstances.

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General equilibrium analysis also deals with conceptual questions about how well markets allocate goods. It asks whether market outcomes in general equilibrium are desirable. Of course, defining “desirable” can be a sticky issue, so economists are a little more specific about the standards that well-functioning markets are held to. We discuss in this chapter what these standards are and investigate what must be true for markets to meet them.