Partial Equilibrium vs. General Equilibrium

If someone was to ask me what the one biggest difference is between the Economics one studies at A-level or in High School, versus the Economics one would study at university; and also to some extent the difference between the more rudimentary/abstracted models of Economics built on just a few key simplifying assumptions, versus what Economics is more likely to look like in the real world; then, after some thinking, I might settle on the distinction between 'Partial Equilibrium' and 'General Equilibrium'.

The reason for this is that Economics is founded on simplifying assumptions, we try to reduce real-world behaviour down to factors and determinants that might influence the demand and supply of goods in all kinds of markets. And to the extent that 'money makes the world go round' within some all-encompassing framework analogous to some kind of 'circular flow' with goods markets, service industries, meta-goods/meta-services (nothing to do with 'Meta'; more the idea of goods based on/off other goods and services based on/off other services), labour markets, and other factor markets, including various capital markets (such as forex/stock exchanges/venture capital/block-chain based exchanges), and what-not; when one is initially introduced to Economics, all analysis stops at one-step 'ceteris paribus' reasoning.

What I mean by that is #ceteris paribus (with all else held constant), we only consider how a change in price of coffee beans (say) might affect the demand for coffee, or tea even (as a substitute product), or maybe the profitability for a business like Starbuck's. Even when we sequence more than one step to our chain of economic reasoning, each step is still limited by this very 'ceteris #paribus' (with all else held constant) restriction; e.g. should the price of coffee beans fall, then well, the demand that Starbuck's enjoys might fall, which might hurt their profitability, and in response, it might make sense for Starbuck's to diversify into offering a wider array of distinctive and attractive products (artisan teas, freshly-pressed fruit juices, I don't know, you name it).

The concept of 'equilibrium' is fundamental to Economics in the sense that pretty much all economic behaviour is considered by conventional mainstream economists in terms of some 'balancing', most typically a 'balance' or 'equilibrium' to the 'demand and supply' for a good/service that equilibrates to some #equilbrium market price'.

#Partial equilibrium economic analysis considers only a partial/isolated/single market, with everything else/all other economic forces/influences held constant, for each step of economic reasoning that's applied.

But in the real world, everything is changing all at the same time: currency fluctuations, political dynamics, countless markets (really beyond any sensible countability, with substitute and complementary products interacting through cross-price, cross-demand and cross-supply effects), labour conditions, terms of trade, credit markets, consumer/business sentiments, regulatory changes...

And this is the very crux of the idea of general equilibrium: how do we answer a real and genuine question that pertains to Economics, if all of these things are changing at the same time? #General equilibrium seeks to factor in all kinds of market conditions changing simultaneously with complex interaction and feedback effects. We want to paint a picture of some 'overall equilibrium/balance' to markets that cross-interact with each other in the real economy.

Let me try and think of some plausible examples to illustrate this.

1. If fuel prices start to go up, possibly due to conflicts (hot or cold), decisions by OPEC, and all other kinds of factors; intrinsic market demand is potentially a relatively minor determinant of fuel prices. A simple partial equilbrium analysis might suggest that the demand for EV vehicles might rise (this was an idea I mentioned in my EV blog post, where I talked about this in terms of first-order and second-order effects).

   But once everything starts changing in the market all at the same time, how quickly can consumers and suppliers keep up with the changes to other energy prices (electricity/natural gas and other fossil fuels/renewable/nuclear); and what if we consider the demand for fuel as a derived demand (i.e. it's not demanded in and of itself, but for the purpose it serves, i.e. fuelling cars or warming houses); in which case, surely we ought to at least consider various substitutes, such as various forms of public transport, solar panel home installations, and so on.

   Very soon what might have appeared to be sensible 'partial equilibrium' economic analysis might soon yield predictions that stray far from what precipitates in the real world.

2. Pork prices started to really rise in China, quite a few years ago now. And the typical economist looking back in hindsight would now tell us, "oh yeah, really predictable", farmers start trying to farm strategically by rearing more swines, and place their confidence on selling pork meat a year or two down the line for a premium price, above and beyond that of day-to-day vegetables, eggs or chicken. But wait, what if all farmers think the same thing? And that's exactly what game theoretic reasoning is all about. How does one party's strategic decision making affect the outcomes for themselves as well as for the other parties involved? Yeah, the smug economist with hindsight to their favour tells us, it's what we would have predicted all along, farmers would have done better to keep to organic eggs instead.

3. PS5s (Sony's Play-Station-5) were all the hype when they hit the market towards the end of 2020 (12 Nov 2020 for the markets in the US/Japan/Canada/Oceania/South Korea to be specific; and a week later by 19 Nov 2020 for Europe, including the UK).

   But ironically, for a good couple of years it became a profitable opportunity for hustlers who were able to get their hands on a console, they could sell it off to someone with effective demand for a PS5 unit at a premium to the RRP (recommended retail price). This premium centred on a value somewhere in the region of $200/£200 (per unit), give or take, for really a good 2 years or so.

   So what about our conventional analysis on a business responding to inelastic demand by raising the market price to increase its sales revenue. I can't think of a better example to illustrate this, that tells us yes, it actually shouts in our face and says, "Increase the price, profitiability and sales have to rise!". But alas, we don't even need to worry too much about the markets for micro-chips, semi-conductors or rare/precious metals, or the actual underlying reasons for all of this in a time when COVID severely, really severely, disrupted global markets; unfortunately when a large blue-chip firm like Sony announces its RRP for a product like the PS5, it simply doesn't have the available choice of hiking that RRP up as a short-term adjustment; it would immediately face severe implications with regulatory bodies such as the CMA (Competition and Markets Authority) in the UK.

I hope that these 3 examples I've chosen offer some interesting illustrations of how all kinds of things changing simultaneously in the real world can influence and shape real markets for real goods, ones we can all connect to in our lives to differing degrees.

Once economists start to try and get serious with modelling these complications, some mathematical solutions might start to take shape, and this is exactly why Economics-majors at various global institutions all study Linear Algebra, together with Calculus and Econometrics (Quantitative Methods encompassing Probability and Statistics); and for all fairness probably not much or really any other bits of Mathematics.

Models such as some kind of GVAR (Global Vector Auto-regression), the very kind that my 3rd-year undergrad Director of Studies had already been building more than 10-years ago, where a whole array of independent variables are integrated into a model with all kinds of cross-effects. Don't underestimate the importance of a process such as 'partial differentiation', for in essence, the very idea of it is a mathematical process to allow us to capture how one variable affects another, whilst holding/keeping all of the other variables constant.

This blog post is as much personal musing, as it is intellectual sharing. And for what it's worth, the note I'm ending on seems to beg the question: 'if that's what 'partial differentiation' is doing, then surely the very analysis of general equilibrium is again built up from something that's inherently just a 'partial equilibrium' idea anyway?