General equilibrium analysis
Previous discussions on market behavior were largely based on partial equilibrium analysis.
When determining the equilibrium prices and quantities in a market using partial market analysis
we assume that activity in one market has little or no effect on other markets. In reality this is not
the case because activity in one market has feedback effect on other markets. To take care of
such effects general equilibrium analysis is usually used. General equilibrium analysis
determines the prices and quantities in all markets simultaneously and it explicitly takes into
account the feedback effects. A feedback effect is a price or quantity adjustment in one market
caused by a price and quantity adjustment in a related market. In practice a complete general
equilibrium analysis which evaluates the effects of a change in one market on all other markets is
not feasible. Usually the analysis is confined to two or three closely related markets.
General equilibrium analysis for two interdependent markets
Consider the competitive market for margarine and butter. The two markets are closely related
because the two are substitutes. Changes in policies that affect one market are likely to affect the
other market which in turn causes feedback effects in the first market. The figures below show
the demand and supply of margarine and butter. In the figure 1 the price of margarine is initially
300 and the market is in equilibrium at the intersection of DM and SM. In figure 2 the butter
market is also in equilibrium with a price of 400. Now suppose the government imposes a tax of
1 shilling on each Kg of margarine purchased, analyze the effect of the tax on the market. Partial
equilibrium analysis is straight forward; imposition of a tax causes the supply curve to shift
upwards and to the left by 1 shilling from SM to SM’. This shift causes the price of margarine to
rise to 310 and the quantity demanded to fall to from QM to QM’. This is the far partial
equilibrium analysis takes us. With general equilibrium analysis we do two things, looking at the
effects of the margarine tax on butter; seeing whether there are feedback effects from the
margarine market to the butter market
Higher price of margarine increases demand for butter shifting the demand for butter from DB to
DB’. This increase in demand causes the price of butter to rise from 400 to 420. The original
demand for margarine assumed that the price of butter remains unchanged at 400. But because
the price of butter is now 420 the demand for margarine shifts upwards from DM to DM”. The new
equilibrium price for margarine is now 317 instead of 310 and the quantity of margarine
purchased has increased from QM’ to QM”. Thus a partial equilibrium analysis would have
underestimated the effect of a tax on the price of margarine. This increase again in the price of
margarine generates a feedback effect on the price of butter which in turn affects the price of
margarine and so on. In the end we must determine the price of both margarine and butter
simultaneously. The equilibrium price margarine is 322 given by the intersection of equilibrium
demand curve and supply curve DM* and SM’. The equilibrium price for butter is 420 given by
the intersection of equilibrium demand and supply curves for butter DB* and SB. These
, equilibrium curves are consistent with prices in related markets and so are not expected to shift
any further. Figure 1: Margarine market
Price SM’
322 SM
317
310
300 DM*
DM”
DM
QM’ QM” QM* QM Number of 1kg margarines
Figure 2: Butter market
Price SB
425
420
400
DB*
DB ’
DB
QB QB’ QB*
Previous discussions on market behavior were largely based on partial equilibrium analysis.
When determining the equilibrium prices and quantities in a market using partial market analysis
we assume that activity in one market has little or no effect on other markets. In reality this is not
the case because activity in one market has feedback effect on other markets. To take care of
such effects general equilibrium analysis is usually used. General equilibrium analysis
determines the prices and quantities in all markets simultaneously and it explicitly takes into
account the feedback effects. A feedback effect is a price or quantity adjustment in one market
caused by a price and quantity adjustment in a related market. In practice a complete general
equilibrium analysis which evaluates the effects of a change in one market on all other markets is
not feasible. Usually the analysis is confined to two or three closely related markets.
General equilibrium analysis for two interdependent markets
Consider the competitive market for margarine and butter. The two markets are closely related
because the two are substitutes. Changes in policies that affect one market are likely to affect the
other market which in turn causes feedback effects in the first market. The figures below show
the demand and supply of margarine and butter. In the figure 1 the price of margarine is initially
300 and the market is in equilibrium at the intersection of DM and SM. In figure 2 the butter
market is also in equilibrium with a price of 400. Now suppose the government imposes a tax of
1 shilling on each Kg of margarine purchased, analyze the effect of the tax on the market. Partial
equilibrium analysis is straight forward; imposition of a tax causes the supply curve to shift
upwards and to the left by 1 shilling from SM to SM’. This shift causes the price of margarine to
rise to 310 and the quantity demanded to fall to from QM to QM’. This is the far partial
equilibrium analysis takes us. With general equilibrium analysis we do two things, looking at the
effects of the margarine tax on butter; seeing whether there are feedback effects from the
margarine market to the butter market
Higher price of margarine increases demand for butter shifting the demand for butter from DB to
DB’. This increase in demand causes the price of butter to rise from 400 to 420. The original
demand for margarine assumed that the price of butter remains unchanged at 400. But because
the price of butter is now 420 the demand for margarine shifts upwards from DM to DM”. The new
equilibrium price for margarine is now 317 instead of 310 and the quantity of margarine
purchased has increased from QM’ to QM”. Thus a partial equilibrium analysis would have
underestimated the effect of a tax on the price of margarine. This increase again in the price of
margarine generates a feedback effect on the price of butter which in turn affects the price of
margarine and so on. In the end we must determine the price of both margarine and butter
simultaneously. The equilibrium price margarine is 322 given by the intersection of equilibrium
demand curve and supply curve DM* and SM’. The equilibrium price for butter is 420 given by
the intersection of equilibrium demand and supply curves for butter DB* and SB. These
, equilibrium curves are consistent with prices in related markets and so are not expected to shift
any further. Figure 1: Margarine market
Price SM’
322 SM
317
310
300 DM*
DM”
DM
QM’ QM” QM* QM Number of 1kg margarines
Figure 2: Butter market
Price SB
425
420
400
DB*
DB ’
DB
QB QB’ QB*
