I’d say that government, by redistributing endowments, is the visible hand. While prices offer a mechanism for democracy, we need a view on opportunity and the such as well – allocative inefficiency is preferable to segregation of opportunity 😉

Indeed. Although, the use of DSGE models in macro is something that can’t be forgotten here – they don’t allow for the same number of firms, but they capture something important to the question … namely expectations and monopolistic competition.

Having GE models with strategic elements would be nice, very nice, and that is definitely a way forward in time!

I’m not saying that all econ is PE but by far most is, A footnote that is missing from the above reads:

“This is not to say there has been no work at all on GE within these areas. For an example of work on a GE approach to firms see Zame (2007). For a discussion of the Arrow-Debreu model when faced with moral hazard and adverse section see Guesnerie (1992). For a look at effects to provide strategic foundations for GE see Gale (2000). On the GE approach to tax and to international trade see, for example, Shoven and Whalley (1984), Creedy (1997), Jones (2011) and Woodland (2011). There has also been much work on computable general equilibrium analysis, see Boehringer, Rutherford and Wiegard (2003) and Sue Wing (2004) for overviews.”

But this is a small part of micro these days. And certainly the use of the Arrow-Debreu framework is limited to very small areas of micro. The problem is that GE as we know it can’t handle things like information asymmetries, contractual incompleteness, strategic interaction, the existence of institutions etc which lie at the base of almost all micro issues. Hence the reduced use of GE.

How far these issues are important for macro is another question. But insofar as they are important then GE in macro will be of limited use until a “better” GE is developed.

Interesting stuff!

“Basically I would argue that GE, as it is, is seen as being too limited
to be able to be used to do the things that economists want to do.”

From reading your post I think this conclusion is a bit too broad – GE, as it is, is seen as being too limited for SOME questions of economic analysis. Such as the description of the firm. And the “cost” in terms of the loss of GE effects is sufficiently small in those areas. It doesn’t make too much sense for me to apply this to all of economics – for example with macroeconomics moving towards GE models from large empirical models over the same timeframe!

However, if we wanted to look at issues of general macroeconomics or associated public economics – where viewing the set of prices as a form of voting would fit in – the loss from ignoring GE effects is huge.

This is why I believe that macro is usually “a few decades behind” micro – macroeconomists have to find a way to fit the tools and knowledge embedded in partial equilibrium models to fit questions where there are important GE effects.

I’d also note here why I think AD management by a central bank is so popular. By having this, we ensure that other policies can generally be looked at in a partial equilibirum sense! Of course, this has led to a situation with more active governments using broader policies where we do need a broader GE understanding to properly analyse them (eg the introduction of working for families … and how this may end up in a situation where the real exchange rate is higher).

A final point about the models of the firm discussed in this essay is that they highlight a general issue to do with post-1970 microeconomics, that is, the retreat from the use of general equilibrium (GE) models.Footnote[When discussing the influence of Gerard Debreu on economics Duppe (2010: 2-3) nicely sums up the fate of GE as well. “From the point of view of today Debreu’s influence on the body of economics could be called zero, in that general equilibrium theory (GET) is the economics of yesterday. While GET had mirrored most analytic advances in economic theory before Debreu, after Debreu most theoretical innovations came as alternatives to GET (from game theory to complexity theory)”. Historian of economic thought Roger Backhouse writes that “[i]n the 1940s and 1950s general-equilibrium theory [ dots ] became seen as the central theoretical framework around which economics was based” (Backhouse 2002: 254) and that by the “[ dots ] early 1960s, confidence in general-equilibrium theory, and with it economics as a whole, as at its height, with Debreu’s {em Theory of Value} being widely seen as providing a rigorous, axiomatic framework at the centre of the discipline” (Backhouse 2002: 261), but “[…] there were problems that could not be tackled within the Arrow-Debreu framework. These include money (attempts were made to develop a general-equilibrium theory of money, but they failed), information, and imperfect competition. In order to tackle such problems, economists were forced to use less general models, often dealing only with a specific part of the economy or with a particular problem. The search for ever more general models of general competitive equilibrium, that culminated in {em Theory of Value}, was over”. (Backhouse 2002: 262). One set of particularly problematic results for general equilibrium are the Sonnenschein-Mantel-Debreu (SMD) theorems. “In part because of a conviction that progress could not be made in general equilibrium theory, there was a substantial redirection in economic theory. As the results in SMD theory became well known, for example through Wayne Shafer and Hugo Sonnenschein’s survey (1982), economists began to question the centrality of general equilibrium theory and put forward alternatives to it. Thus in the ten years following the Shafer-Sonnenschein survey, we find a number of new directions in economic theory”. (Rizvi 2006: 230).]

As early as 1955 Milton Friedman was suggesting that to deal with “substantive hypotheses about economic phenomena” a move away from Walrasian towards Marshallian analysis was required. When reviewing Walras’s contribution to GE, as developed in his “Elements of Pure Economics”, Friedman argued,

“[e]conomics not only requires a framework for organizing our ideas [which Walras provided], it requires also ideas to be organized. We need the right kind of language; we also need something to say. Substantive hypotheses about economic phenomena of the kind that were the goal of Cournot are an essential ingredient of a fruitful and meaningful economic theory. Walras has little to contribute in this direction; for this we must turn to other economists, notably, of course, to Alfred Marshall”. (Friedman 1955: 908).

By the mid-1970s microeconomic theorists had largely turned away from Walras and back to Marshall, at least insofar as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic interaction, asymmetric information and economic institutions.

All the models considered above are partial equilibrium models, but in this regard the theory of the firm is no different from most of the microeconomic theory developed since the 1970s. Microeconomics such as incentive theory, incomplete contract theory, game theory, industrial organisation, organisational economics etc, has largely turned its back, presumably temporarily, on GE theory and has worked almost exclusively within a partial equilibrium framework. This illustrates the point made at the beginning of the paper that there is a close relationship between the economic mainstream and the theory of the firm; when the mainstream forgoes general equilibrium, so does the theory of the firm.

One major path of influence from the mainstream of modern economics to the development of the theory of the firm has been via contract theory. But contract theory is an example of the mainstream’s increasing reliance on partial equilibrium modelling. Contract theory grew out of the failures of GE. As Salanie (2005: 2) has argued,

“[t]he theory of contracts has evolved from the failures of general equilibrium theory. In the 1970s several economists settled on a new way to study economic relationships. The idea was to turn away temporarily from general equilibrium models, whose description of the economy is consistent but not realistic enough, and to focus on necessarily partial models that take into account the full complexity of strategic interactions between privately informed agents in well-defined institutional settings”.

As was noted in the previous section the Foss, Lando and Thomsen classification scheme divides the current literature on the theory of the firm into two general groups based on which of two of the standard assumptions of GE theory, namely symmetric information and complete contracts, is violated when modelling the firm. In contract theoretic terms the former gives rise to principal-agent type models and the latter to incomplete contract type theories.

The necessity of having to violate basic assumptions of GE theory so that we can model the firm, suggests that as it stands GE can not deal easily with firms, or other important economic institutions. Bernard Salanie has noted that,

“[ … ] the organization of the many institutions that govern economic relationships is entirely absent from these [GE] models. This is particularly striking in the case of firms, which are modeled as a production set. This makes the very existence of firms difficult to justify in the context of general equilibrium models, since all interactions are expected to take place through the price system in these models”. (Salanie 2005: 1).

This would suggest that to make GE models a ubiquitous tool of microeconomic analysis – including the analysis of issues to do with the firm – developing models which can account for information asymmetries, contractual incompleteness, strategic interaction, the existence of institutions and the like is not so much desirable as a necessity.

Basically I would argue that GE, as it is, is seen as being too limited to be able to be used to do the things that economists want to do.