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Interrelation of Markets: General Equilibrium Analysis

When we focus on one market in isolation, we are assuming that events in this market do not have a significant impact on other markets in the economy and that there are no feedback effects from those markets to the one we are considering. This is called partial equilibrium analysis - partial because it deals with only one part of a larger system.

For many markets partial equilibrium analysis is quite satisfactory. What happens in the market for men’s shoes in Decatur, Illinois, or in the fresh cabbage market in West Bend, Wisconsin, is not going to have much effect elsewhere in the economy. But a change in the price of steel or crude oil or labor is going to affect many .markets throughout the economy. When we try to take explicit account of the interrelation of a large number of markets, we are engaged in general equilibrium analysis.

The interdependence of markets was illustrated dramatically in 1973 - 1974 when the price of imported crude oil suddenly increased five-fold and again in 1978 - 1980 when prices tripled. Oil flows, literally, into thousands of different uses. It is a raw material for plastics and petrochemicals, so costs and prices of these products have risen. It goes into fertilizer production, raising farmer’s costs and thus making for higher food prices. It is used by truckers as well as automobile drivers, so transportation costs have risen for everything moving over the nation’s highways. To offset higher fuel costs, cars have become smaller and miles per gallon (mpg) ratings have risen. Many electric power plants are .oil-fired, so utility rates have been raised to cover the higher costs; and since almost everyone uses electricity, these rate increases penetrate every corner of the economy.

But because of the possibilities of economizing on oil, what has hurt some industries has benefited others. Coal is now cheaper than oil for many uses, so coal mining has been stepped up. There has been a rush to drill new oil wells and to extract oil from shale deposits. Homeowners using fuel oil are insulating their houses and putting on storm windows to reduce their heating costs. Some people who used to go everywhere by car are going by train or bus or subway instead. So producers of coal, coal mining machinery, oil drilling equipment, insulating materials, train and subway care, and many other goods have experienced an increase in demand.

Not only does the increased price of petroleum products affect many other markets, but events in these other markets have feedback effects on the petroleum industry. This industry is itself a large user of gasoline and diesel oil for everything from ocean tankers to the tank-wagon trucks that deliver gasoline to filling stations. It is also a large user of electricity, the price of which is closely linked to the price of crude oil. So an increase in the price of petroleum produces means an increase in the cost of producing them, which tends to raise the price still more.

Such feedback effects are common. A rise in the price of steel will eventually raise the price of machinery, some of which is bought by the steel industry. As the demand for labor rises during an economic upswing, wage rates rise, but as wage earners spend their increase earnings at the store, retailers’ order to manufacturers will increase further raising the demand for labor.

It is justified to speak of an economic system. Markets throughout the system are linked by the existence of alternatives and the consequent possibility of choice. A shift in one market is transmitted through these linkages into markets that on the surface seem quite remote from the first. A market economy may be visualized as a kind of a giant computer, constantly receiving information from all parts of the system and working out appropriate adjustments. A shift in one market starts lights flashing all through the machine, and many prices and outputs may have to change before the computer settles down. A major function of economics is to analyze and predict these indirect effects, which the public often overlooks.