General Economic Equilibrium
The Invisible Hand of the Market
Many economists identify general economic equilibrium theory with theory tout court, compared to which any other theory can be considered a particular case. This theory, it is said, shows that the ‘invisible hand of the market’ ensures a systematic tendency towards an equilibrium with perfect equality between supply and demand for each commodity (market clearing), even in the presence of many commodities and many economic agents. As a matter of fact, this is not true.
General equilibrium theory was originally developed by the Lausanne school, founded by Leon Walras. Its main constitutive elements are the general interdependence among all the parts that compose an economic system, the idea of the market as an equilibrating mechanism between supply and demand, the view of the economic problem as a problem of optimal allocation of scarce resources and the notion of a perfectly rational and perfectly selfish economic agent (the homo oeconomicus).
The idea of interrelations among the different parts that compose an economic system was already at the centre of Quesnay’s analysis, with his tableau economique; subsequently, we have the simple and expanded reproduction schemes developed by Marx and more recently Leontief’s input-output tables. None of these analytical contributions, however, included a price and quantity adjustment mechanism based on the reactions of agents in the market to disequilibria between supply and demand. Furthermore, these contributions all focussed attention on interdependencies among sectors in production, while interdependence (substitutability) in consumption choices was not considered, or at any rate remained in the background.
The role of demand and supply in determining the price of a good was conversely at the centre of a widespread tradition of economic thinking, which in representing the working of the market took as
ideal reference points first the medieval fairs and then the stock exchanges, both considered institutions that ensure a meeting place, in time and space, for buyers and sellers. However, the idea of a general interrelation among the various parts of the economic system generally remained in the background. Jevons’s utilitarian approach focused on analysis of individual behaviour, with comparison between disutility (labour) and utility (consumption), while interrelations among different economic agents in the market constituted a superstructure in many respects only outlined. Somewhat later Marshall, albeit keeping account of Walras’s work, indicated - as we shall better see in the next chapter - his preference for ‘short causal chains’, hence the method of analysis of partial equilibrium, as compared with general economic equilibrium analysis, considered too abstract.
The grounds to represent the classical economists as precursors of general economic equilibrium theory are even more questionable. There are three aspects to which reference is usually made in doing so: the notions of the invisible hand of the market, of competition and of the convergence of market prices towards natural prices. Briefly returning to the points mentioned previously, it is worth stressing that none of these elements implies a subjective view of value or choice of the medieval fair (or of the stock exchange) as paradigm for representing the working of the economy. In particular, the idea of the convergence of market prices towards natural prices did not imply, for classical economists such as Smith or Ricardo, the idea of market prices as theoretical variables univocally determined by an apparatus of demand and supply curves (nor the idea that it be possible to define sufficiently precise and stable relations connecting quantities demanded and supplied to prices nor indeed the idea that such relations can be deduced as representing the behaviour of rational economic agents). Finally, the notion of the invisible hand was originally used by Smith in different contexts, not to uphold the idea of the optimality of a competitive market based on the demand and supply mechanism.
In conclusion, we must recognise that the idea of an economic system driven by the tendency of all its parts towards equilibrium between supply and demand is simply a specific viewpoint developed by Walras and his followers - one among the various viewpoints that have appeared in the history of economic thought. As we shall see, consolidation of the foundations and extension of the basic model of general equilibrium theory leads not only to dropping the initial idea of an invisible hand of the market but also to pointing out its limitations as an interpretative tool applicable to the real world.