We know that markets are constantly in flux and prices constantly change. The question is will there always be a price vector where all markets for different goods clear?
Being that one of the principle focus of economics is understanding the determination of price, if equilibrium does not occur then we have a serious problem in our understanding of economics. Therefore, we must be specific in our definition of equilibrium, aggregate supply and demand. Walras’s Law helps us in bringing this picture together.
Walras’ law is an economic theory that the existence of excess supply in one market must be matched by excess demand in another market so that it balances out. It asserts that an examined market must be in equilibrium if all other markets are in equilibrium.
It was formulated by French economist Leon Walras from the University of Lausanne in 1874.
Implications of Walras’ Law:
1) A market for a particular commodity is in equilibrium if, at the current prices of all commodities, the quantity of the commodity demanded by potential buyers equals the quantity supplied by potential sellers. For example, suppose the current market price of cherries is $1 per pound. If all cherry farmers summed together are willing to sell a total of 500 pounds of cherries per week at $1 per pound, and if all potential customers summed together are willing to buy 500 pounds of cherries in total per week when faced with a price of $1 per pound, then the market for cherries is in equilibrium because neither shortages nor surpluses of cherries exist.
2) Walras’ law assumes that the invisible hand is at work to settle markets into equilibrium. Where there is excess demand, the invisible hand will raise prices; where there is excess supply, the hand will lower prices for consumers to drive markets into a state of balance.
3) An economy is in general equilibrium if every market in the economy is in partial equilibrium. Not only must the market for cherries clear, but so too must all markets for all commodities (apples, automobiles, etc.) and for all resources (labor and economic capital) and for all financial assets, including stocks, bonds, and money.
4) Walras’ Law implies that sum of values of excess demands across all markets must equal zero whether or not the economy is in a general equilibrium. This implies that if positive excess demand exists in one market, negative excess demand must exist in some other market. Thus, if all markets but one are in equilibrium, then that last market must also be in equilibrium. Thus, to demonstrate that a situation of general equilibrium holds, it suffices to show that n – 1 markets are in equilibrium. This implication of Walras’ law plays an important role in models of markets and models of asset portfolios.
Limitations of Walras’ Law:
1) It has been observed that even if all other markets were in equilibrium, an excess of supply or demand was observed in one market meaning that equilibrium was disturbed.
2) Economists who studied and built on Walras’ law hypothesized that the challenge of quantifying units of so-called “utility,” a subjective concept, made it difficult to formulate the law in mathematical equations, which Walras sought to do. Measuring utility for each individual, not to mention aggregating across a population to form a utility function, was not a practical exercise, critics of Walras’ law argued, and if it could not be done, the law would not hold.