Partial Equilibrium Analysis

1. Partial Equilibrium Analysis • Marshallian Analysis is partial equilibrium analysis • That is, each market/industry is analyzed separately and the interaction between/among markets or industries is not considered • Partial equilibrium analysis is adequate when the first-order effects of a shift in, say, the demand curve do not shift the supply curve

2. Piero Sraffa • "I am trying to find what are the assumptions implicit in Marshall's theory; if Mr. Robertson regards them as extremely unreal, I sympathize with him. We seem to be agreed that the theory cannot be interpreted in a way which makes it logically self-consistent and, at the same time, reconciles it with the facts it sets out to explain. Mr. Robertson's remedy is to discard mathematics, and he suggests that my method is to discard the facts; perhaps I ought to have explained that, in the circumstances, I think it is Marshall’s theory that should be discarded." (Piero Sraffa, 1930, Economic Journal, March, p.93)

3. General Equilibrium Analysis • Economists became more interested in general equilibrium analysis in the late 1920s and 1930s after Piero Sraffa's demonstration that Marshallian economists cannot account for the forces behind an upward-sloping supply curve • But, isn’t that based on diminishing returns/increasing cost???

4. Sraffa’s Criticism • If an industry uses little of a factor of production, a small increase in the output of that industry will not bid the price of that factor up. To a first order approximation, firms in the industry will not experience increasing costs and the industry supply curve will not have an upward slope.

5. Sraffa’s Criticism (continued) • If an industry uses an appreciable amount of that factor of production, an increase in the output of that industry will exhibit increasing costs. • BUT such a factor is likely to be used in substitutes for the industry's product • Therefore, an increased price of that factor will have effects on the supply of those substitutes • Consequently, the first order effects of a shift in the supply curve of the original industry under these assumptions include a shift in the original industry's demand curve

6. General Equilibrium Analysis • So, economists moved on to General Equilibrium Analysis.  • The first general equilibrium analysis was developed by Walras, then refined by Arrow and Debreu.  • They proved that general equilibrium under a market system exist and are Pareto Optimal (no one can be made better off without making someone else worse off).  • But, certain conditions have to hold, including perfect information, rationality and competitive markets.  This is quite unrealistic

7. General Equilibrium Analysis • Modern economic models have been developed that address thelimitations of partial and general equilibrium models  • As an example, the concept of bounded rationality has been applied to economics  • This concept was developed by American psychologist Herbert Simon, and accepts that there are cognitive limits to an individual's knowledge and capacity to act rationally  • For example, there are costs to gathering and processing information.  The concept of bounded rationality beget the notion of "satisficing" which means obtaining an outcome that is "good enough" not necessarily utility maximizing