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MCXXXX10.1177/00977004211054844Modern ChinaGao

Article
Modern China

A Reflection on Postwar
2022, Vol. 48(1) 29­–52
© The Author(s) 2021
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DOI: 10.1177/00977004211054844
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The Shift from General journals.sagepub.com/home/mcx

Equilibrium Theory to
the New Microeconomic
Theories

Yuan Gao1,2

Abstract
The theoretical focus of neoclassical economics experienced a significant
change in the 1970s–1980s. General equilibrium theory lost its dominant
position in theoretical economic studies, with its role of setting the research
agenda taken over by what this article calls the “new microeconomic
theories,” principally decision theory, game theory, and mechanism design.
Mainstream economists, post-Keynesians, and historians of economic
thought each give a different explanation of the hows and whys of that
change, but all miss some critical methodological implications. That change,
as this article discusses, shows that neoclassical economics has turned from
“grand theory” toward “small models” with empirically delimited utility
and that the ideology of marketism lacks a valid scientific foundation. This
interpretation can help illuminate the deeper dynamics of the postwar
development of neoclassical economics and provide insights for a new
political economy that can come to grips with political-economic practices
that cannot be fully grasped by the neoclassical tradition.

1
School of Agricultural Economics and Rural Development, Renmin University of China,
Beijing, China
2
Institute of Agrarian History, Renmin University of China, Beijing, China

Corresponding Author:
Yuan Gao, School of Agricultural Economics and Rural Development, Renmin University of
China, 59 Zhongguancun Street, Beijing 100872, China.
Email: hlbbk@163.com
30 Modern China 48(1)

Keywords
postwar neoclassical economics, general equilibrium theory, the new
microeconomic theories, social science methodology, a new political
economy

After World War II, general equilibrium theory, exemplified by the seminal
work of Kenneth Arrow and Gerard Debreu (1954), became the most impor-
tant theoretical topic in neoclassical economics and was deemed a landmark
in economic studies for its rigor and logical consistency. However, thirty
years later, general equilibrium theory lost its momentum. Its preeminence as
the crown of neoclassical economic theory was overshadowed in the 1980s
by new theoretical branches of neoclassical economics: decision theory,
game theory, and mechanism design in the main.1 Though the idea of general
equilibrium itself is still a key ingredient in modeling in mainstream econom-
ics—which is embedded in the practice of requiring “all markets must clear”
in building concrete economic models—for economists who consider them-
selves theorists, theoretical studies essentially mean studies in the three fields
of decision theory, game theory, and mechanism design. Rare is the scholar
in the neoclassical school who still engages in theoretical studies in the vein
of general equilibrium theory of the 1950–1970s.
What accounts for this fundamental shift in the theoretical focus of neo-
classical economics? And what explains the rise of the new microeconomic
theories to the point where they have come to dominate theoretical economic
studies? Different academic traditions have different answers to these ques-
tions. Below, we consider the responses of scholars in three traditions: main-
stream neoclassical economics, post-Keynesianism, and the history of
economic thought.
Mainstream neoclassical economists attribute the decline of general equi-
librium theory to its inability to deal with the issue of asymmetric informa-
tion,2 and the rise of the new microeconomic theories, especially game theory,
to their power to provide a workable framework for analyzing economic
realities replete with asymmetric information.
Post-Keynesians, the best-known opponents of neoclassical economics in
the Anglo-American economic academy, consider the fall of general equilib-
rium theory to be a result of its failure to deal with the famous “aggregation
problem”—the problem of how to construct meaningful macroeconomic
concepts from microeconomic primitives.3 By turning to game theory, a field
that is little concerned with the relations between microeconomic and macro-
economic concepts but instead focuses on studying in a general and formal-
ized way how decision-makers interact strategically with each other in
Gao 31

idealized contexts, neoclassical economists can avoid the difficult task of

tackling aggregation problems head-on. These problems are still there, but
they have been simply shunted aside.
Finally, historians of economic thought look upon the rise of decision
theory, game theory, and mechanism design as an exemplification of
the accelerated mathematization in postwar neoclassical economics.
Particularly, in their view the rise of these approaches reflects the further
triumph of Bourbakism,4 the most influential school of mathematical phi-
losophy in the twentieth century, in defining how theoretical economic
studies should be done. The key idea behind Bourbakism is that the entire
architecture of mathematics should be rebuilt into a highly formalized,
axiomatized structure. Influenced by Bourbakism, postwar neoclassical
economists also began to reconstruct economic knowledge in an axioma-
tized “definition-proposition-proof” style. That is, the definition of eco-
nomic concepts must be formulated in rigorous mathematical language,
and economic propositions must be articulated mathematically and then
proved. The Arrow-Debreu general equilibrium theory was the first suc-
cessful example of conducting and expressing theoretical economic stud-
ies in a Bourbakist manner. But the momentum of mathematization and
formalization generated by general equilibrium theory began to dissipate
in the 1970s–1980s. Decision theory, game theory, and mechanism design
came to the rescue and pushed neoclassical economics into the next stage
of mathematization and formalization.
Although all three of these answers provide some insights, they miss some
crucial implications of the change in the theoretical focus of neoclassical
economics. First, general equilibrium theory, deemed by its founding fathers
to be a comprehensive system that explains universal operations and basic
laws of the economy, in fact is beset by fundamental intrinsic flaws, as shown
by both mainstream economists and the post-Keynesians, and thus failed to
work as a scientific grand theory. Consequently, it lost its theoretical central-
ity in neoclassical economics.
The failure of general equilibrium theory as a grand theory suggests that
marketism—the belief that the market acting as a spontaneous mechanism
free of intervention can solve most socioeconomic problems—is not viable.5
At the very core of general equilibrium theory is the conviction that the mar-
ket is the most efficient mechanism for resource allocation. Built around this
assumption is a systematic discourse of how values are formed, how produc-
tion factors are provided, and how incomes are distributed through markets,
all written in a rigorous, logically precise manner using mathematized defini-
tions, theorems, and proofs. This gives marketism the appearance of “scien-
tific” knowledge. However, the intrinsic inconsistency that proponents of
32 Modern China 48(1)

general equilibrium theory encounter when trying to incorporate some impor-

tant economic concepts reveals that the scientific cover of marketism is in
fact not scientific but just a cover.
Second, what has taken the place of general equilibrium theory is not
another grand theory, but instead a collection of small models. These models
are not overarching law-like explanations for the whole economic system but
instead are fully specified and small scale, and come with empirically delim-
ited utility. Such models are intended to formalize stylized facts about human
decision-making and strategic interaction. Decision theory, game theory, and
mechanism design are the most successful examples of this new path of
research using small models. Past studies, especially in the history of eco-
nomic thought, have correctly identified the rise of the new microeconomic
theories and the deepening of mathematization in neoclassical economics but
have failed to note this more fundamental dynamic—that is, what replaced a
grand theory were small theories.
Furthermore, by turning to small theories, neoclassical economists, incon-
testably the mainstream in Anglo-American economic studies, have lost the
ability to engage in substantial conceptualization of political-social-economic
practices. Decision theory, game theory, and mechanism design are good at
creating small models that target particular aspects of empirical objects, but
the more these models are empirically meaningful, the narrower their scope
of application. In fields where the new microeconomic theories can provide a
basis for good inferences about the properties of empirical objects and for
comparatively precise predictions about the evolution of empirical phenom-
ena, economic research has become increasingly indistinguishable from
operations research or applied computer science.
Thus, with the decline of general equilibrium theory, the neoclassical tra-
dition lost the vision of eighteenth- and nineteenth-century political econo-
mists such as Adam Smith, David Ricardo, and Karl Marx, all of whom
emphasized that the foremost task in economics research is to grasp the
essence of the political-economic system. Moreover, their practice of analyz-
ing the relations between state and economy, of explaining the whys and
hows of the development of nations, has also faded from the core of theoreti-
cal economic studies. Of course, today there remains a large group of econo-
mists interested in these issues, but what must be emphasized here is that
their interests and concerns are no longer a source of theoretical innovations
and creations on the frontier of neoclassical economics. This trend, however,
has created an avenue toward a new political economy (Huang, 2021), one
that shares the vision of classical political economy but emphasizes grasping
actual political-economic practices.
Gao 33

The Change in the Theoretical Focus of

Neoclassical Economics: Past Explanations
The fall of general equilibrium theory and the rise of decision theory, game
theory, and mechanism design as the new theoretical workhorses in postwar
neoclassical economics has drawn the interest of scholars in many different
camps. Mainstream neoclassical economists, post-Keynesians, and historians
of economic thought have all offered their own explanations for this
transition.

Mainstream Neoclassical Economists: Asymmetric Information

French microeconomic theorist Jean-Jacques Laffont, a mainstream econo-
mist, considered the fall of general equilibrium theory to be the result of its
inability to deal with the issue of asymmetric information, so pervasive and
significant in the real world that it calls for an effective analytical framework,
which in Laffont’s view was game theory. According to Laffont and his coau-
thor David Martimort,

general equilibrium theory was capable of producing powerful generalizations

and able to deal with uncertainty, time, externalities, and extending the validity
of the invisible hand as long as the appropriate competitive markets could be
set up. However, at the beginning of the seventies, works by Akerlof (1970),
Spence (1974), and Rothschild and Stiglitz (1976) showed in various ways that
asymmetric information was posing a much greater challenge and could not be
satisfactorily imbedded in a proper generalization of the Arrow-Debreu theory.
The problems encountered were so serious that a whole generation of general
equilibrium theorists momentarily gave up the grandiose framework of GE to
reconsider the problem of exchange under asymmetric information in its
simplest form, i.e., between two traders. In a sense, the theorists went back to
basics. They joined another group trained in game theory and in the theory of
organizations, and together they built the theory of incentives, which we take
as encompassing contract theory and mechanism design. (Laffont and
Martimort, 2002: 4)

This “much greater challenge” mentioned by Laffont and Martimort is that,

when one assumes that different participants in the market—especially trad-
ers from different sides of the market, such as buyers and sellers—are privy
to asymmetric information, an equilibrium solution according to the Arrow-
Debreu model may not exist. If equilibrium cannot be guaranteed, the gen-
eral equilibrium framework will collapse since all the possible implications
of the theory depend on the existence of equilibria. If economists become
34 Modern China 48(1)

increasingly concerned with the issue of asymmetric information—which

was in fact the case in the 1970s–1980s—they will no doubt be inclined to
abandon any theory that cannot provide an effective way to model informa-
tion asymmetry. From this perspective, Laffont and Martimort’s point makes
good sense.
But is it really the case that general equilibrium theory and asymmetric
information are doomed to be mutually exclusive, as Laffont and Martimort
suggest? Is there any chance of creating an extended framework of general
equilibrium that can incorporate at least to some extent asymmetric informa-
tion? In fact, there is indeed a small circle of economists who have been
working toward this goal since the 1980s, which is exactly the time when the
tide of general equilibrium theory ebbed so low that most theorists left that
field. Representative works in this vein of studies are the two Cowles
Foundation working papers of Dubey, Geanakoplos, and Shubik (1989, 2000)
and the published paper in Econometrica by the same authors (Dubey,
Geanakoplos, and Shubik, 2005). Through a long academic journey, the
authors found a way to incorporate asymmetric information into general
equilibrium theory. They did so by introducing a new concept: “default.”
They show that two typical phenomena of asymmetric information—adverse
selection and moral hazard—can be interpreted as special cases of their new
version of the general equilibrium model.6 They also prove that their model
in general has solutions, thus showing that, at least in some cases, general
equilibrium models with certain forms of asymmetric information can have
solutions. Inspired by these pioneering works, Alberto Bisin and Piero
Gottardi (1999) accomplished a similar extension of general equilibrium
theory in a dynamic setting, unlike Dubey, Geanakoplos, and Shubik’s static
setting. Urai, Yoshimachi, and Shiozawa (2018) have gone further by extend-
ing Dubey, Geanakoplos, and Shubik’s idea from an exchange economy into
a production economy.
Nonetheless, all these studies since the 1980s have generated few responses
from mainstream economists. Neoclassical scholars in the past three decades
by and large have ignored these works. This is because, first, all the works
that incorporate asymmetric information in general equilibrium theory have
only made limited progress in dealing with the complexity of the phenome-
non of asymmetric information in reality. If one insists on working within the
framework of general equilibrium, only a few basic cases of asymmetric
information can be formalized. Second, as Laffont and Martimort pointed
out, game theory is a more flexible and powerful tool for dealing with the
complexities of real-world cases of asymmetric information. This has to
some extent induced some noted neoclassical theorists to give up general
equilibrium theory as their central pursuit and turn to game theory. Aside
Gao 35

from asymmetric information, there are also other reasons why neoclassical
theorists have abandoned general equilibrium theory, a subject to which we
turn below.

Post-Keynesians: The Aggregation Problem

The fall of general equilibrium theory and the rise of decision theory, game
theory, and mechanism design have also drawn the attention of the post-
Keynesians, the most influential “heterodox” camp of economists in the
Anglo-American world. Unlike mainstream neoclassical economists, post-
Keynesians do not believe that it is solely the inability of general equilibrium
theory to deal with asymmetric information that led to its decline. They argue
instead that the so-called aggregation problem caused general equilibrium
theory to lose its momentum.
The aggregation problem in economics refers to the issues of how to for-
mulate macroeconomic concepts and/or quantities from microeconomic
primitives—such as preferences, production techniques, endowments, and so
forth—and of how to constitute logically valid relations among macroeco-
nomic concepts/quantities, usually in the form of mathematical functions.
Even in the heyday of general equilibrium theory, the aggregation problem
had already drawn the attention of both neoclassical economists and post-
Keynesians. Early in the 1950s–1960s, in the famous “capital controversy,”7
post-Keynesians and neoclassical economists heatedly debated the aggregate
production function,8 which is the first remarkable aggregation problem that
touches on the core question of whether the basis of neoclassical economics
is valid. That debate led to the conclusion that the neoclassical assumption of
the existence of a well-defined aggregate production function is logically
inconsistent and will produce incorrect predictions about many important
macroeconomic activities.
In the 1980s, the post-Keynesians perceptively observed that it was
another aggregation problem—the aggregate excess demand function9—that
was responsible for the decline of general equilibrium theory. Precisely
because the aggregate excess demand function is not a well-defined macro-
economic construct, as they argued, general equilibrium theory was finally
abandoned by neoclassical economists as their core theoretical agenda.
In 1973–1974, three economic theorists—Hugo Sonnenschein, Rolf
Mantel, and Gerard Debreu—separately analyzed the properties of the aggre-
gate excess demand function (Sonnenschein, 1973; Mantel, 1974; Debreu,
1974). They found that if one proceeded from ordinary microeconomic set-
tings, one can at most construct an aggregate excess demand function satisfy-
ing some rather unrestricted properties,10 which renders that function almost
36 Modern China 48(1)

meaningless. In other words, aggregate excess demand functions cannot be

used to make substantial inferences about how aggregate demand reacts to
changes in prices, and about where possible equilibria of the economy might
be. Their findings were later summarized as the Sonnenschein-Mantel-
Debreu theorem (or, the SMD theorem).
The SMD theorem had three immediate impacts on the study of general
equilibrium theory. First, according to the SMD theorem, the textbook exam-
ple of a market demand curve monotonically decreasing from the upper left
to the bottom right corner, showing that a rising price will lead to reduction
in demand—also known as the famous “law of demand”—does not always
apply. In contrast to the “common sense” endlessly preached in introductory
textbooks on economics, the SMD theorem holds that a market demand curve
is not in general monotonically decreasing, and in reality, there may be mul-
tiple equilibria with rather irregular behavior. Hence general equilibrium
theory’s great difficulty in predicting the outcomes of the economy.
Second, the SMD theorem implies that, aside from noting the existence
of equilibria, one can hardly say anything more about the outcomes of the
economy if one proceeds from the standard assumptions of general equilib-
rium theory. In other words, unless one makes in addition some rather unre-
alistic assumptions about microeconomic agents, such as assuming all
consumers and firms are homogeneous or can be reduced to a couple of
representative consumers and firms,11 one cannot make substantial infer-
ences about how the economy behaves at the macro level. This arbitrariness
in macro-level outcomes implied by general equilibrium theory is so signifi-
cant that in Andreu Mas-Colell, Michael Whinston, and Jerry Green’s
Microeconomic Theory, known as the bible of advanced microeconomic
textbooks, the section discussing the main results of the SMD theorem is
titled “Anything Goes: The Sonnenschein-Mantel-Debreu Theorem” (Mas-
Colell, Whinston, and Green, 1995).
Finally, the SMD theorem can be used to show that there cannot be a gen-
eral equilibrium framework that incorporates monopolistic competition, an
important topic in economics since the 1930s. Monopolistic competition is a
kind of market structure that lies in between the two extremes of perfect com-
petition and monopoly. It refers to a situation where many firms in the market
compete with each other although their products are slightly different and are
not perfect substitutes. Obviously, monopolistic competition is a realistic
description of the structure of real-world markets. Nonetheless, general equi-
librium theory assumes perfect competition in all markets. Once this assump-
tion is relaxed and monopolistic competition is introduced, solutions to
general equilibrium models may not exist. This implication of the SMD theo-
rem also casts doubt on the extent to which the highly idealized general
Gao 37

equilibrium theory can be expanded and reformulated to incorporate as much

economic reality as possible. In the fourteenth chapter of the first volume of
the Handbook of Mathematical Economics, published in 1982, Shafer and
Sonnenschein summarize all these important results of the SMD theorem,
and since then they have become accepted wisdom among neoclassical theo-
rists (Shafer and Sonnenschein, 1982).
It is through the lens of the aggregation problem exemplified by the SMD
theorem that post-Keynesians have endeavored to ascertain why general
equilibrium theory declined and why neoclassical theorists turned to the
more flexible models of game theory. According to the American post-
Keynesian S. Abu Turab Rizvi:

In part because of a conviction that progress could not be made in general

equilibrium theory, there was a substantial redirection in economic theory. As
the results in SMD theory became well known, for example through Wayne
Shafer and Hugo Sonnenschein’s survey (1982), economists began to question
the centrality of general equilibrium theory and put forward alternatives to it.
Thus in the ten years following the Shafer-Sonnenschein survey, we find a
number of new directions in economic theory. It was around this time that
rational-choice game theory methods came to be adopted throughout the
profession, and they represented a thoroughgoing change in the mode of
economic theory. (Rizvi, 2006: 230)

Interpreting the decline of general equilibrium theory from the angle of

the aggregation problem is a contribution of the post-Keynesians critical to
understanding the postwar development of the neoclassical theory. Post-
Keynesians have persistently probed the logical and conceptual dilemma of
neoclassical economics via the aggregation problem. Nonetheless, though the
post-Keynesians’ explanation of why general equilibrium theory declined is
convincing, their explanation for why the new microeconomic theories—
they take game theory as an example—have replaced general equilibrium
theory is weak. Notably, in an earlier paper, Rizvi recounts the history of
game theory from the classical works of John von Neumann and Oskar
Morgenstern (1944) and John Nash (1950) to the cutting-edge research of the
early 1990s and points out that, although there has been remarkable progress
in modeling skills, mathematical techniques, and applications, game theory
has not made any substantial breakthrough in dealing with the aggregation
problem (Rizvi, 1994). Thus, by turning to game theory, neoclassical theo-
rists have merely set their past problems aside and not really solved them.
One must ask why it is that game theory, and not any of the other “new direc-
tions in economic theory,” as Rizvi puts it, has become the theoretical center
38 Modern China 48(1)

of gravity of neoclassical economics. For example, why has evolutionary

economics, which also gained a great deal of attention in the 1980s, not
become the successor to general equilibrium theory?
On the other hand, there is still a small group of mainstream economists
working on the aggregation problem within the framework of general equi-
librium as well as a similar small group working on asymmetric information
within the same framework. The first group tried to introduce heterogeneous
consumers, and then heterogeneous producers based on production networks,
into general equilibrium models. Though this did not solve the aggregation
problem, it at least shows that it is possible to make limited progress in this
line of theoretical studies. But why have these efforts to solve the aggregation
problem failed to become the core of neoclassical economics during the past
three decades? Why are they deemed to be “applied theory,” which the neo-
classical community considers inferior to “pure theory,” and why are they
located on the periphery of the knowledge production system of mainstream
economic theory, in contrast to decision theory, game theory, and mechanism
design, which are obviously at the center? These questions can only be satis-
factorily answered when one adopts a perspective outside mainstream eco-
nomics or post-Keynesianism.

Historians of Economic Thought: Mathematization à la

Bourbaki
Recent studies in the history of economic thought have provided a perspec-
tive that has been overlooked by both mainstream neoclassical economists
and post-Keynesians. This perspective does not explain the decline of gen-
eral equilibrium theory and the rise of the new microeconomic theories
through factors within the discipline, such as the consistency of conceptual
relations and the richness of theory, but instead examines the evolution of
postwar neoclassical economics from an angle outside of the discipline,
revealing how the postwar development of neoclassical economic theory
was deeply influenced by Bourbakist mathematical philosophy. Represented
by the work of Nicola Giocoli, this vein of literature emphasizes that the
replacement of general equilibrium theory by the new microeconomic theo-
ries was in fact part of an ever-deepening process of mathematization à la
Bourbaki (Giocoli, 2003).
Bourbakism has shaped modern mathematics by turning previously
loosely organized mathematical knowledge into a more structured system. It
shows that the various branches of mathematics can all be reduced to three
basic structures: order structure, algebraic structure, and topological structure
(Bourbaki, 1950). Using a combination of these basic structures, along with
Gao 39

logical deduction and mathematician initiation, Bourbakism reconstructed

modern mathematics into an architecture with crystal-clear, axiomized struc-
tures. It also created a new, modern style of mathematical writing in the form
of “definition-proposition-proof.” Pre-Bourbakist academic writings on
mathematics were not unified and were heterogeneous among mathemati-
cians. Qualitative proofs of theorems, based more on intuition than logical
rigor and formal deduction, were still to some degree tolerated in many fields.
Bourbakism swept away this artifact and unified the writing of textbooks,
articles, and monographs into a single pattern of “definition-proposition-
proof.” The Bourbakist magnum opus, Elements of Mathematics, would have
surprised the older generation of mathematicians in how exactingly it follows
such a formalized style of writing.
It is exactly in these two respects that Bourbakism shaped mainstream
economists’ notions of what mathematics can really provide their discipline.
Using mathematical terms as auxiliary devices to help express ideas in eco-
nomic studies was not itself new. This postwar wave of mathematization,
however, was something different. It was not about introducing more math-
ematical symbols, equations, and formulas into a discipline mainly expressed
in terms of qualitative arguments to make it more powerful and flexible. On
the contrary, it thoroughly changed the way neoclassical economists do eco-
nomic theory and compose academic writings. For the new generation of
neoclassical theorists influenced by Bourbakism, “doing theory” meant more
than anything else building a new model, proposing new propositions based
on that model, and proving these propositions. It also meant that academic
writings would be structured in terms of “definition-proposition-proof.”
Giocoli has observed that, under the Bourbakist influence, postwar studies of
economic theory moved ever closer to the practice of mathematics (Giocoli,
2003). Today, theoretical economics is no longer “economics with the assis-
tance of mathematical expressions”; it is in effect a branch of applied math-
ematics with some of its concepts springing from economic contexts.
The first work representative of Bourbakist economic studies is Arrow and
Debreu’s now classic 1954 article presenting their general equilibrium the-
ory. In its style the article is very much like a mathematical article in a math-
ematical journal. Until the 1980s, generations of neoclassical economists
were trained in the Bourbakist mathematical philosophy, and consequently
they theorized by proposing propositions and constructing proofs. Their pro-
duction of theoretical economic knowledge was just like that of skilled math-
ematicians. Thus, the dilemma of general equilibrium theory was first of all a
crisis of this mode of “knowledge production”—working exclusively within
the framework of general equilibrium virtually guaranteed that only a limited
number of theoretical publications could be generated, thus impeding the
40 Modern China 48(1)

entire profession of theoretical economic research. The marginal benefit from

investing additional intellectual labor in general equilibrium theory saw a
considerable decline in the 1970s–1980s, due to the reasons pointed out by
mainstream economists and post-Keynesians, as discussed above. The new
microeconomic theories—decision theory, game theory, and mechanism
design—replaced the declining general equilibrium theory in leading knowl-
edge production in the field of neoclassical economic theory because they
can be the basis for theoretical publications structured around definition-
proposition-proof. This is because they are fields created mainly by mathe-
maticians, and before being accepted as valid branches of economics, they
had long been cultivated in departments of operations research (Mirowski
and Nik-Khah, 2017: 76).
To summarize, the story told by historians of economic thought fills in
many blanks left by mainstream neoclassical economists and post-Keynes-
ians. It explains why it is that decision theory, game theory, and mechanism
design have taken the place of general equilibrium theory from the perspec-
tive of methodology and to some extent the sociology of the economics pro-
fession. It emphasizes the importance of analyzing the change in the “form”
of economics rather than its content alone. Yet, like mainstream neoclassical
and post-Keynesian economists, historians of economic thought have also
missed an important part of the story, a subject to which we now turn.

What Can We Learn from the Rise of the New

Microeconomic Theories?
All three of the explanations discussed above miss the fact that the fall of
general equilibrium theory and the rise of the new microeconomic theories
entailed a shift from “grand theory” to “small models.” The difficulties that
general equilibrium theorists faced when trying to build a grandiose frame-
work for economics through the core idea of general equilibrium, as summa-
rized by mainstream neoclassical economists and post-Keynesians,
demonstrate that marketism has no valid scientific foundation. Indeed, it is an
ideology that takes for granted that markets free of intervention are the best
mechanism for resource allocation and that all market trade consists of equal
and mutually beneficial exchanges.
They also fail to appreciate a methodological trend behind the rise of the
new microeconomic theories—the substantivization of formalist economics.
By putting aside the straightjacket of general equilibrium theory, economic
theorists can now develop small models that are more flexible and more
closely related to the empirical world—but only at a considerable cost. These
models have abandoned the dream of generations of economists of a theory
Gao 41

that can grasp the essence of “the economy”—that is, a social system con-
nected with what can be called “economic” activities. By embracing decision
theory, game theory, and mechanism design as the theoretical core of the
discipline, neoclassical economists have moved their profession even further
away from classical political economy and closer to a discipline of formal-
ized studies of human behavior.

From Grand Theory to Small Models

The decline of general equilibrium theory and the rise of decision theory,
game theory, and mechanism design involve more than an ordinary shift in
hot spots of economic studies. General equilibrium theory and the new micro-
economic theories represent research agendas that differ in nature: the former
seeks to grasp the economy as a whole, while the latter is much more modest,
eschewing the search for big concepts and universalized laws that purport to
describe how the economy works as a system.
In this respect, the research agenda of general equilibrium theorists is
close to that of the classical political economists, such as Adam Smith, David
Ricardo, et al. When Léon Walras first proposed a prototype of the general
equilibrium theory in the late nineteenth century, he was searching for an
answer to the same core question that had concerned the classical political
economists: How does a market economy distribute and determine the value
of commodities, products, and production factors?12 In this sense, general
equilibrium theory is a theory of value, where the concept of value plays the
central role in grasping the essence of the economy.13 The concept of value
will immediately be rendered meaningless once it is removed from the con-
text of the economy, a societal system in which goods are produced, traded,
distributed, and consumed. One can talk about value only in relation to the
economy, for it is a social construct that depends on the existence of a certain
system of economic activities. By establishing this concept, economists also
defined a sphere of social reality that can be called “the economy,” a space
distinguished from all other departments of society. In seeking a logical, con-
sistent, and precise way of showing how value is formed in the market econ-
omy, general equilibrium theorists after Walras embraced an everlasting
process of mathematization and formalization, leading to the adoption of
Bourbakism.
Like classical political economists, general equilibrium theorists must
proceed from their version of the theory of value to answer how the products
of the economy are distributed and how capital, the single most important
good in a modern economy, achieves value in the market and accumulates.
Exactly for these reasons, neoclassical economists like Paul Samuelson and
42 Modern China 48(1)

Robert Solow, who work within the general equilibrium framework, must
debate with their post-Keynesian counterparts—who are closer to classical
political economists both in spirit and in research style—over the nature of
value and the conceptualization of capital, exactly because they know these
are at the very core of their profession. In this sense, the decline of general
equilibrium theory in the 1970s–1980s implies that the theory of value was
no longer the foremost research agenda of the neoclassical school. Since
then, the once intrinsic historical link between neoclassical economics and
classical political economy has disappeared. And thus, mainstream econo-
mists are no longer concerned with establishing a grand theory to grasp the
essence of the economy.
Unlike general equilibrium theory, the new microeconomic theories of
decision theory, game theory, and mechanism design are not much con-
cerned with the essence of the economy as a whole and as a societal system
with distinguishable empirical particularities. Rather, their focus is on for-
malizing how human beings make decisions universally and how they inter-
act with each other strategically. They are also concerned with formulating
reasonable protocols governing strategic interactions. In other words, these
theories are in fact part of a discipline of formalized/mathematized studies
of human behavior and can hardly be called “economic” theories in the
sense of classical political economy because there is in fact nothing particu-
larly “economic” about the concepts and theorems that have been con-
structed and derived from them.
In the 1950s the American mathematician Leonard Savage established
decision theory in its modern form (Savage, 1954). At its core, the object of
Savage’s decision theory is to formalize how agents, or decision-makers,
make their choices under uncertainty. By representing the beliefs of agents as
probability distributions and by requiring agents to modify their beliefs in line
with Bayes’ theorem, a critical mathematical theorem in modern statistics and
probability theory, Savage for the first time constructed a universalized frame-
work to model how agents make choices in the face of uncertainty. In that
framework, agents make decisions not by following particular rules, such as
“utility maximization,” which is linked to the particularity of certain kinds of
agents called “consumers,” or “profit maximization,” which is linked to the
particularity of what can be called “firms” or “producers.” Savage’s theory
ignores all these particularities and proposes seven axioms as the principles
governing how idealized agents behave when they choose among alternatives.
These axioms are so general that they can in theory cover all agents and not
solely “economic agents.” Savage’s work was not immediately recognized by
mainstream economists, but it paved the way for economists to eventually
consider the study of general decision-making processes a legitimate part of
economics.
Gao 43

Savage’s work had a far-reaching impact by fueling the development of

game theory in the 1960s–1970s. Though game theory had already attracted
attention from first-class mathematicians in Europe in the 1900s and had
been summarized in von Neumann and Morgenstern’s 1944 magnum opus,
its real breakthrough for economic application was achieved by John Harsanyi
when he solved the problem of how to model strategic interactions in an
environment with uncertainty (Harsanyi, 1967). After that, economists could
build models to study how agents interact with each other when they have
only partial information on how others would gain from the interaction. This
paved the way for the first successful application of game theory in a major
field of economics—industrial organization, in which asymmetric informa-
tion abounds (Giocoli, 2008). Consequently, by the 1980s, game theory was
transformed from a theoretical toy of mathematicians to a workhorse of
mainstream economists.
Paralleling the development of game theory was the rise of mechanism
design as another vigorous field of mainstream economics. Mechanism design
grew out of social choice theory, founded in the 1950s by Kenneth Arrow
(1951). In contrast to game theory, which takes multi-agent interactions as
given, mechanism design studies how to design the rules or protocols that
agents interacting with each other should follow in order to achieve certain
social objectives, especially the maximization of social welfare. In this sense,
a good mechanism is one that prompts agents to reveal their true preferences
and prevents them from strategically misreporting their preferences, espe-
cially in the sense of distortion, where the selected alternative may be of pri-
vate benefit but does not maximize social welfare. Later, the idea of mechanism
design was also used in constructing protocols that can maximize the profit of
a certain agent rather than that of society as a whole. Such applications include
auction designs, monopolistic pricing, contract design, product bundle design,
and so on. Like game theory, mechanism design earned its fame in the 1980s
in dealing with these once tricky issues in industrial organization.
Decision theory, game theory, and mechanism design replicate the Arrow-
Debreu general equilibrium theory in style: they are all written in terms of
formalized definitions, propositions, and proofs. In other words, they are
Bourbakist. But in their basic problematique, the new microeconomic theo-
ries are sharply distinct from general equilibrium theory, as discussed above.
None of the new approaches is a theory of value and none seeks to construct
“covering laws” to grasp the essence of the whole economy. Their scope is
relatively “small” compared with general equilibrium theory: they are tar-
geted at small systems of multi-agent interactions.
Once these new microeconomic theories gained traction, studies of mar-
kets also shifted “from grand to small.” While general equilibrium theory
formalizes all the markets in the economy in a single model, game theory and
44 Modern China 48(1)

mechanism design study one market or a couple of markets in one model.

They are used to analyze particular and concrete markets rather than the over-
arching, abstract system of markets that is at the core of general equilibrium
theory. Studies of these concrete markets quickly became the favorite subject
of economic theorists since the pioneering work of George Akerlof on mar-
kets with asymmetric information (Akerlof, 1970). Akerlof’s new style of
theoretical work involves, first, describing stylized facts about a particular
market, such as his market for “lemons” (i.e., “bad cars”), then building a
model with mathematical rigor to illustrate how this market can be formal-
ized using theoretical language, and finally trying to solve the model or prove
some theorems on the major properties of the model. This new style of aca-
demic writing was quite unfamiliar to general equilibrium theorists, who treat
the market as an abstract object and part of a grandiose theoretical construct
rather than as an inspiration for building small models.

The Substantivization of Formalist Economics and the Rise of

Economic Engineering
In a previous study, this author discussed the methodological trend of substan-
tivization of formalist economics in postwar neoclassical economics—that is,
the mathematization and formalization of neoclassical economics turned to
building models with empirically delimited utility (Gao, 2021). Substantivization
refers to the march toward the mathematization of neoclassical economics and
formalization to building models with empirically delimited utility (Gao,
2021). What must be emphasized here is that the shift in the theoretical focus
of neoclassical economics from general equilibrium theory to the new micro-
economic theories also exemplifies this trend. In this respect, decision theory
and game theory provide basic concepts and an analytical framework, while
mechanism design supplies “substantivization”—that is, it functions as an
intermediary between pure theory and the empirical world.
Mechanism design in the 1950s–1970s was much like decision theory and
game theory, focusing on pure theory, with a research style similar to that of
mathematics. It was closer in that period to social choice theory, which is a
purely theoretical subfield of postwar mainstream economics. Since the
1980s, mechanism design has become increasingly close to the real world
and thus is one of the few fields in economics with relatively solid predictive
power when it comes to empirical cases.
The idea of using mechanism design to solve real-world problems was
initially driven by the development of studies of industrial organization
boosted by the rise of neoliberalism in the 1980s. In line with their agenda of
privatizing public services, neoliberal economists asked, What would be an
Gao 45

optimal government design to divide and privatize a public enterprise? And

what government-organized bidding procedure would ensure that private
firms would compete with one another to provide the goods/services, at rea-
sonable prices, previously supplied by government? Many preeminent econ-
omists, including Jean-Jacques Laffont and Jean Tirole, participated in this
search, using as their compass, in the main, mechanism design (Laffont and
Tirole, 1993).
The second wave of real-world applications of mechanism design arrived
in the 1990s and continues to this day. This wave was set in motion by the
need to design decentralized mechanisms to allocate resources in realms
where efficient institutions of resource allocation have been absent.
Mechanism design theorists have pointed to auctions and matching as two
principal mechanisms, since they both involve decentralized competitive sys-
tems with large numbers of participants. The key difference between the two
is that in auctions monetary payments for welfare transfers between partici-
pants are allowed, while in matching they are not. Typical applications of
auctions have been, first, the selling of the use right of state-owned telecom-
munication spectrums to private firms, followed by expansion into the realms
of selling carbon emission rights, fishing rights, and use-rights for other natu-
ral resources. Typical applications of matching have been, first, the assigning
of interns to hospitals, followed by organ transplant systems, public housing
projects, school choice, and even the settlement of refugees.14
The real-world-application side of mechanism design today has earned its
own name: “market design.” The word “market” suggests that this subfield of
economic theory is concerned with designing mechanisms that are at once
decentralized and competitive. In auctions, bidders compete to buy the
objects for sale, and in matching, agents on one side or both sides compete to
match with their best partners. For both mechanisms, resources are allocated
not through top-down commands but instead via the search for private bene-
fit. Thus, these mechanisms are in spirit the same as the naturally evolved
markets guided by the “invisible hand,” though there are no monetary pay-
ments and prices. Again, as one can see, these objects of market design are
empirically delimited, concrete objects, not an overarching, abstract system
of markets as envisioned by general equilibrium theory.
Furthermore, mechanism design/market design has relied on empirical
data to calibrate model settings to improve predictive power when studying
empirical cases. First, econometrics has been used to estimate key parameters
in the model in order to measure the welfare effect the model predicts.
Second, methods of experimental economics have been employed to collect
field data on agents’ behavior patterns—better knowledge of agents will
improve design mechanisms. While these two well-developed tools are taken
46 Modern China 48(1)

from empirical economic studies, a third tool, computational algorithms, has

been borrowed from computer science, a field that has been tightly imbri-
cated with economics in recent years. Unlike econometrics and experimental
economics, which use data to estimate unknown parameters in models, the
method of algorithms proceeds instead from the model and seeks to translate
the mechanism designed into workable programs in the most economical
manner with the help of computation theory. For example, when designing
auctions for selling use-rights of telecommunication spectrums or land plots,
the mechanism designer needs to first build a model to determine what the
best mechanism is when bidders have preferences complicated by substitu-
tion and complementarity. Then, she can construct suitable algorithms to find
a computationally feasible way to solve the model. Here the researcher needs
the help of computer science to deal with the complexity of solving models
of mechanism design in applications that have evolved to such an extent that
they are far beyond the capabilities of a single personal computer. In short,
mechanism/market design has been proceeding toward a field that syncre-
tizes mathematical theory, econometric and experimental methods, and com-
putational algorithms. Its object, aside from the exploration of purely
theoretical topics, is to attack practical issues with empirically delimited util-
ity—much like those studied in operations research. It is in this sense that
Alvin Roth, who won a Nobel Prize for studies of two-sided matching, calls
this practice-oriented trend of mechanism/market design “microeconomic
engineering” (Roth, 2002). It is the newest form of what this author has
termed the “substantivization of formalist economics” (Gao, 2021).

Insights for a New Political Economy?

Recently Philip Huang (2021) has proposed a path toward a new political
economy that can grasp China’s evolving political-economic system. Huang’s
object is to criticize marketism, which, without reflection, equates the various
practices of trade with idealized, mutually beneficial exchanges, and to
emphasize the combination and interaction between the state and markets/
society, a subject overlooked by (neo)liberals as well as most mainstream
economists. For Huang’s project, the postwar changes in neoclassical eco-
nomics analyzed in this article can provide some insights.
As already discussed, the failure of general equilibrium theory demon-
strates that it is impossible to build a grand theory to grasp the practice of the
economy if the theory begins with the proposition that the economic system
equates to a universally valid market mechanism. This is because such a the-
ory will inescapably come face to face with logical inconsistencies. Past stud-
ies of the difficulties plaguing general equilibrium theory in dealing with
Gao 47

asymmetric information and the aggregation problem have shown that its
barebones framework cannot incorporate these practical and meaningful con-
cepts. It can be logically consistent only if it operates in a highly idealized,
impractical world. Proving the existence of an equilibrium solution—the
holy grail for general equilibrium theory—can be guaranteed only by resort-
ing to idealized assumptions, for example, perfect competition. Since the pre-
condition of a universally valid market mechanism lies at the center of
marketism, the decline of general equilibrium theory as the grand theory for
grasping the essence of the economy shows that marketism is nothing but an
ideology empty of scientific content. Thus, the dynamics behind the postwar
change in the theoretical center of gravity of neoclassical economics explored
in this article point to the need for a realistic and practical alternative to
marketism.
By cultivating decision theory, game theory, and mechanism design as the
new core of its theoretical domain, neoclassical economics has in fact sev-
ered its historical link with classical political economy on the theoretical
front. But in ridding itself of general equilibrium theory, it has given up the
search for a grand theory that can grasp the economy as a whole at the soci-
etal-system level. The new microeconomic theories have certainly opened
the way to many research topics that can combine theory and reality to make
better predictions about empirical cases than other approaches to economics,
but these topics are by nature similar to those of operations research. On criti-
cal issues that have challenged economists since the birth of the discipline of
economic studies, such as the relationship between state and society, the new
microeconomic theories have made no substantial progress. By embracing
these theories as the core of the domain of theoretical innovations, neoclassi-
cal economists are more like engineers than classical political economists.
This creates an opportunity for a new political economy that emphasizes the
interaction between state and society in economic activities. The method-
ological trends in postwar neoclassical economics, as explored in this article,
can also be of use to advocates of a new political economy in thinking about
their own methodological advantages over the formalism of neoclassical
economics.

Conclusion
In the 1970s–1980s, the theoretical focus of postwar neoclassical economics
shifted from general equilibrium theory to the new microeconomic theories,
consisting mainly of decision theory, game theory, and mechanism design.
This article has examined three past explanations for this shift and proposes
its own interpretation.
48 Modern China 48(1)

The decline of general equilibrium theory reveals the failure of the pursuit
of a grand theory to grasp the essence of the economy within the paradigm of
neoclassical economics. Of all the theories churned out by the neoclassical
school, general equilibrium theory may have come the closest to that ideal.
Yet, it turned out to be unworkable for the reasons mainstream economists
and post-Keynesians have pointed out. Since at the very core of general equi-
librium theory is the proposition that competitive markets are the most effi-
cient approach to allocating resources, the decline of general equilibrium
theory also implies the failure of the ideology of marketism.
The rise of decision theory, game theory, and mechanism design as the
core theoretical innovations in economics suggests that neoclassical econo-
mists have lost interest in finding another grand theory. Rather, they have
turned to small models that are only locally valid and that have empirically
delimited utility. These models cannot address the nature of the economy as
a societal system—the key issue in classical political economy and general
equilibrium theory—but they can serve as cognitive devices for probing cer-
tain patterns of human behavior. By giving up general equilibrium theory as
its theoretical workhorse and turning to small theories targeted at explaining
human behavior and engineering protocols governing multi-agent systems in
very specific contexts, neoclassical economics has moved away from the
vision of classical political economy. This has created an opportunity for pro-
ceeding toward a new political economy of practice.

Declaration of Conflicting Interests

The author declared no potential conflicts of interest with respect to the research,
authorship, and/or publication of this article.

Funding
The author received no financial support for the research, authorship, and/or publica-
tion of this article.

Notes
1. Mainstream economics defines “mechanism design” narrowly. This article uses
a broader definition, which refers not only to mechanism design in its narrower
sense but also to the subfields of “contract theory” and “market design,” which
are juxtaposed to mechanism design in the mainstream classification of the eco-
nomic discipline. According to the mainstream classification, mechanism design
in its narrower sense consists principally of the study of the issue of hidden infor-
mation (also known as adverse selection), while contract theory consists in the
study of the issue of hidden action (also known as moral hazard). In this scheme,
market design refers to the more application-oriented practice of mechanism
Gao 49

design. This article instead treats mechanism design as a subfield of econom-

ics that studies the design of protocols for multi-agent interactions and as an
inverse project of game theory, since the latter views multi-agent interactions as
given while the former tries to “design” them. It is in this much broader sense of
mechanism design that this article juxtaposes it with decision theory and game
theory as one of the three stars in the constellation of the new microeconomic
theories.
2. Asymmetric information refers to the situation where two agents have different
understandings of how an economic parameter takes values. A famous example
of asymmetric information is from Akerlof (1970), who observes that in a used-
car market the seller knows the real value of the car, but the buyer does not.
3. For example, constructing the aggregate demand on the market through individ-
ual preferences for goods, and aggregate supply through firm-level production
functions.
4. Beginning in the mid-1930s, a group of French mathematicians using a collec-
tive pseudonym, Nicolas Bourbaki, wrote a series of textbooks on modern math-
ematics, later known as Elements of Mathematics. The mathematical philosophy
they shared is referred to as Bourbakism, and their group is usually called the
Bourbaki school. For a summary of their key ideas on modern mathematics, see
Bourbaki, 1950.
5. For a recent detailed discussion of marketism, see Huang, 2022.
6. Adverse selection refers to a market situation where one agent has information
that is unknown to others. For example, in the insurance market, when selling
insurance, the insurance company does not have knowledge of private informa-
tion about potential buyers. This can lead a company to extend insurance cover-
age to individuals whose actual risk is substantially higher than the risk known
by the company. Moral hazard refers to the fact that one agent (usually called the
“principal”) cannot oversee the action of other agents. For example, in an agri-
cultural co-op, the co-op head does not know the extent of the efforts the co-op
members would really make in farming.
7. The capital controversy was a far-reaching academic debate between American
economists, represented by Paul Samuelson and Robert Solow, and English
economists, represented by Joan Robinson and Piero Sraffa, over the validity of
the concept of capital and of the aggregate production function in neoclassical
economics. See Cohen and Harcourt, 2003, for a review.
8. The aggregate production function depicts how total factor inputs, especially
labor and capital, are related to total outcomes of the economy.
9. The aggregate excess demand function describes how the prices of goods are
related to their demanded quantities in the economy.
10. These properties include: the aggregate excess demand function is continuous
and homogenous of degree zero, and the values of the excess demand sum to
zero (also known as the Walras’ law).
11. This is the usual way that neoclassical economists today attack the problem.
12. There is no question that general equilibrium theory has a very different notion
of value than that of classical political economy. According to its logic, the
50 Modern China 48(1)

values of goods in a competitive market economy are the “equilibrium prices”

that are “dual” to the equilibrium quantities of goods traded in the markets, while
classical political economy considers the values of goods to be determined by the
(abstract) labor used to produce those goods.
13. Notably, Debreu himself called his masterpiece in general equilibrium theory the
Theory of Value (Debreu, 1959).
14. For a thorough review of these applications of auctions and matching, see
Kominers, Teytelboym, and Crawford, 2017.

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Author Biography
Yuan Gao 高原 is an associate professor in the School of Agricultural Economics
and Rural Development of Renmin University of China. He is currently working on a
project on comparing the methodologies of mainstream formalist economics and clas-
sical political economy.