Applying general equilibrium analysis to policy requires a basic understanding of general equilibrium theory. A general equilibrium model of an economy can be best understood as one in which there are markets for each of N commodities, and consistent optimization occurs as part of equilibrium. Consumers who maximize utility are subject to their budget constraints, leading to the demand-side specification. In equilibrium, market prices are such that the required equilibrium conditions hold. Demand equals supply for all commodities, and in the constant-returns-to-scale case zero-profit conditions are satisfied for each industry.
A number of basic elements can be identified in general equilibrium models. In a pure exchange economy, consumers have endowments and demand functions (usually derived from utility maximization). In the two-consumer-two-good case, this leads to the well-known Edgeworth Box analysis of general equilibrium of exchange. In the case of an economy with production, endowments and demands are once again specified, but production sets also need to be incorporated into the analysis.
