General Equilibrium in Production and Exchange

The general equilibrium in production and exchange occurs in an economy when both the allocation of goods in production and their exchange in the market reach a state of general economic equilibrium. With two goods, X and Y, along with two consumers and two firms, general equilibrium is achieved when the marginal rate of substitution (MRS) between the goods for both consumers matches the marginal rate of technical substitution (MRTS) between the goods, as well as the price ratio -p_x/p_y.

MRS^A_X,Y = MRS^B_X,Y = MRTS_X,Y = -p_x/p_y

When consumers decide to trade some quantity of one good (A) to gain more of another good (B), the same ratio applies to the technical process of increasing the production of one good at the expense of the other. In a perfectly competitive market, the price ratio between the goods directly reflects both the consumers' preferences and the technical conditions of producing the two goods. In a general equilibrium of production and exchange, both the trade and production sides of the economy are balanced:

• General Equilibrium of Production: This state of general economic equilibrium occurs when the allocation of productive resources is Pareto-efficient (Pareto optimal in production).
• General Equilibrium of Pure Exchange: This refers to a general economic equilibrium where the distribution of goods is Pareto-efficient (Pareto optimal in exchange).