Pure exchange seems quintessentially academic, a storybook portrayal of economic interaction far removed from what we observe in all but the most primitive of societies. Production, and the organization of production by firms, must surely be regarded as the very essence of a modern, capitalistic economy. You might imagine, therefore, that allowing for production would lead to a drastic modification of the theory of general equilibrium. But you would be wrong because, at least as the theory is currently formulated, adding production changes very little.

Of course, the fact that not much changes is a signal that the general equilibrium theory of production does not amount to much. The passive, price-taking firm in Walrasian equilibrium provides little scope for entrepreneurial skill or managerial know-how. But, having acknowledged these shortcomings, it is equally important to give the general equilibrium treatment of production its due. Viewed on its own terms, it is an intellectual tour de force — the first (some would say the only!) successful attempt to build a model in which consumers and firms interact in a logically consistent fashion.

The goal of this chapter is neither to disparage the general equilibrium theory of production nor to claim more than the theory can deliver. Rather I emphasize what is perhaps the most attractive feature of this theoretical point of view, the clear parallel which it draws between economies of pure exchange and those with production, a parallel emphasized both through choice of notation and through the use of an (appropriately modified) net trade diagram.