General Equilibrium Analysis of Pure Exchange and Pareto Optimality:
So far we’ve looked at how prices are determined in a single market at a time, now it is time to look at how relative prices are determined in a system of markets so that all markets are in equilibrium at the same time. This situation is called a general equilibrium, and the analysis of systems of markets is called general equilibrium analysis, in contrast to studies of single markets, which is called partial equilibrium analysis. In the latter type of analysis we do not take into account the repercussion effect that a change in a single goods price has on other markets, and that it may trigger price adjustments in these markets which may feed back into our original markets and cause an upset to what we thought was an equilibrium. The repercussion effects on other markets work through (at least) two channels; goods may be substitutes, or complements, and the income (and endowment) effects affect the demand for all goods, not only the goods whose prices changed originally.
A current example is the relationship between the price of gasoline and the demand for cars, and car transports. Gasoline is needed to drive a (conventional) car so if the price of gasoline increases, the quantity demanded of gasoline decreases. Since this means that people will drive less miles each year, the cars will last longer and the demand curve for new cars will shift inwards. Everything else held constant (i.e. a constant supply curve of cars), this will mean a decrease in the price of cars, and of course fewer cars sold and produced. Another market which is affected is the market for train travel. Let’s assume that the supply of train services is not affected directly by the increase in the price of gasoline, but since people are likely to substitute train travel for car travel, the demand for train services increases and the price will increase as well.
Increasing gas prices will increase the cost of transportation and will therefore have an impact on many markets. The total value of consumption of gasoline and oil compared to the value of consumption of all goods and services is about 5%. This is not very much, but high enough so that say a doubling of the price of oil and gasoline will affect the real purchasing power and have a measurable effect on demand for many goods, via the income effect. Hence, an increase in the price of an important good may have repercussion effects on both nearby markets, which are complements and substitutes to gasoline, and more distant markets via the income effect.
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