The Walras-Marshall Divide in Neoclassical Theory, Part II

In my previous post, which itself followed up an earlier post “General Equilibrium, Partial Equilibrium and Costs,” I laid out the serious difficulties with neoclassical theory in either its Walrasian or Marshallian versions: its exclusive focus on equilibrium states with no plausible explanation of any economic process that leads from disequilibrium to equilibrium.

The Walrasian approach treats general equilibrium as the primary equilibrium concept, because no equilibrium solution in a single market can be isolated from the equilibrium solutions for all other markets. Marshall understood that no single market could be in isolated equilibrium independent of all other markets, but the practical difficulty of framing an analysis of the simultaneous equilibration of all markets made focusing on general equilibrium unappealing to Marshall, who wanted economic analysis to be relevant to the concerns of the public, i.e., policy makers and men of affairs whom he regarded as his primary audience.

Nevertheless, in doing partial-equilibrium analysis, Marshall conceded that it had to be embedded within a general-equilibrium context, so he was careful to specify the ceteris-paribus conditions under which partial-equilibrium analysis could be undertaken. In particular, any market under analysis had to be sufficiently small, or the disturbance to which that market was subject had to be sufficiently small, for the repercussions of the disturbance in that market to have only minimal effect on other markets, or, if substantial, those effects had to concentrated on a specific market (e.g., the market for a substitute, or complementary, good).

By focusing on equilibrium in a single market, Marshall believed he was making the analysis of equilibrium more tractable than the Walrasian alternative of focusing on the analysis of simultaneous equilibrium in all markets. Walras chose to make his approach to general equilibrium, if not tractable, at least intuitive by appealing to the fiction of tatonnement conducted by an imaginary auctioneer adjusting prices in all markets in response to any inconsistencies in the plans of transactors preventing them from executing their plans at the announced prices.

But it eventually became clear, to Walras and to others, that tatonnement could not be considered a realistic representation of actual market behavior, because the tatonnement fiction disallows trading at disequilibrium prices by pausing all transactions while a complete set of equilibrium prices for all desired transactions is sought by a process of trial and error. Not only is all economic activity and the passage of time suspended during the tatonnement process, there is not even a price-adjustment algorithm that can be relied on to find a complete set of equilibrium prices in a finite number of iterations.

Despite its seeming realism, the Marshallian approach, piecemeal market-by-market equilibration of each distinct market, is no more tenable theoretically than tatonnement, the partial-equilibrium method being premised on a ceteris-paribus assumption in which all prices and all other endogenous variables determined in markets other than the one under analysis are held constant. That assumption can be maintained only on the condition that all markets are in equilibrium. So the implicit assumption of partial-equilibrium analysis is no less theoretically extreme than Walras’s tatonnement fiction.

In my previous post, I quoted Michel De Vroey’s dismissal of Keynes’s rationale for the existence of involuntary unemployment, a violation in De Vroey’s estimation, of Marshallian partial-equilibrium premises. Let me quote De Vroey again.

When the strict Marshallian viewpoint is adopted, everything is simple: it is assumed that the aggregate supply price function incorporates wages at their market-clearing magnitude. Instead, when taking Keynes’s line, it must be assumed that the wage rate that firms consider when constructing their supply price function is a “false” (i.e., non-market-clearing) wage. Now, if we want to keep firms’ perfect foresight assumption (and, let me repeat, we need to lest we fall into a theoretical wilderness), it must be concluded that firms’ incorporation of a false wage into their supply function follows from their correct expectation that this is indeed what will happen in the labor market. That is, firms’ managers are aware that in this market something impairs market clearing. No other explanation than the wage floor assumption is available as long as one remains in the canonical Marshallian framework. Therefore, all Keynes’s claims to the contrary notwithstanding, it is difficult to escape the conclusion that his effective demand reasoning is based on the fixed-wage hypothesis. The reason for unemployment lies in the labor market, and no fuss should be made about effective demand being [the reason rather] than the other way around.

A History of Macroeconomics from Keynes to Lucas and Beyond, pp. 22-23

My interpretation of De Vroey’s argument is that the strict Marshallian viewpoint requires that firms correctly anticipate the wages that they will have to pay in making their hiring and production decisions, while presumably also correctly anticipating the future demand for their products. I am unable to make sense of this argument unless it means that firms — and why should firm owners or managers be the only agents endowed with perfect or correct foresight? – correctly foresee the prices of the products that they sell and of the inputs that they purchase or hire. In other words, the strict Marshallian viewpoint invoked by De Vroey assumes that each transactor foresees, without the intervention of a timeless tatonnement process guided by a fictional auctioneer, the equilibrium price vector. In other words, when the strict Marshallian viewpoint is adopted, everything is simple; every transactor is a Walrasian auctioneer.

My interpretation of Keynes – and perhaps I’m just reading my own criticism of partial-equilibrium analysis into Keynes – is that he understood that the aggregate labor market can’t be analyzed in a partial-equilibrium setting, because Marshall’s ceteris-paribus proviso can’t be maintained for a market that accounts for roughly half the earnings of the economy. When conditions change in the labor market, everything else also changes. So the equilibrium conditions of the labor market must be governed by aggregate equilibrium conditions that can’t be captured in, or accounted for by, a Marshallian partial-equilibrium framework. Because something other than supply and demand in the labor market determines the equilibrium, what happens in the labor market can’t, by itself, restore an equilibrium.

That, I think, was Keynes’s intuition. But while identifying a serious defect in the Marshallian viewpoint, that intuition did not provide an adequate theory of adjustment. But the inadequacy of Keynes’s critique doesn’t rehabilitate the Marshallian viewpoint, certainly not in the form in which De Vroey represents it.

But there’s a deeper problem with the Marshallian viewpoint than just the interdependence of all markets. Although Marshall accepted marginal-utility theory in principle and used it to explain consumer demand, he tried to limit its application to demand while retaining the classical theory of the cost of production as a coordinate factor explaining the relative prices of goods and services. Marginal utility determines demand while cost determines supply, so that the interaction of supply and demand (cost and utility) jointly determine price just as the two blades of a scissor jointly cut a piece of cloth or paper.

This view of the role of cost could be maintained only in the context of the typical Marshallian partial-equilibrium exercise in which all prices — including input prices — except the price of a single output are held fixed at their general-equilibrium values. But the equilibrium prices of inputs are not determined independently of the values of the outputs they produce, so their equilibrium market values are derived exclusively from the value of whatever outputs they produce.

This was a point that Marshall, desiring to minimize the extent to which the Marginal Revolution overturned the classical theory of value, either failed to grasp, or obscured: that both prices and costs are simultaneously determined. By focusing on partial-equilibrium analysis, in which input prices are treated as exogenous variables rather than, as in general-equilibrium analysis, endogenously determined variables, Marshall was able to argue as if the classical theory that the cost incurred to produce something determines its value or its market price, had not been overturned.

The absolute dependence of input prices on the value of the outputs that they are being used to produce was grasped more clearly by Carl Menger than by Walras and certainly more clearly than by Marshall. What’s more, unlike either Walras or Marshall, Menger explicitly recognized the time lapse between the purchasing and hiring of inputs by a firm and the sale of the final output, inputs having been purchased or hired in expectation of the future sale of the output. But expected future sales are at prices anticipated, but not known, in advance, making the valuation of inputs equally conjectural and forcing producers to make commitments without knowing either their costs or their revenues before undertaking those commitments.

It is precisely this contingent relationship between the expectation of future sales at unknown, but anticipated, prices and the valuations that firms attach to the inputs they purchase or hire that provides an alternative to the problematic Marshallian and Walrasian accounts of how equilibrium market prices are actually reached.

The critical role of expected future prices in determining equilibrium prices was missing from both the Marshallian and the Walrasian theories of price determination. In the Walrasian theory, price determination was attributed to a fictional tatonnement process that Walras originally thought might serve as a kind of oversimplified and idealized version of actual market behavior. But Walras seems eventually to have recognized and acknowledged how far removed from reality his tatonnement invention actually was.

The seemingly more realistic Marshallian account of price determination avoided the unrealism of the Walrasian auctioneer, but only by attributing equally, if not more, unrealistic powers of foreknowledge to the transactors than Walras had attributed to his auctioneer. Only Menger, who realistically avoided attributing extraordinary knowledge either to transactors or to an imaginary auctioneer, instead attributing to transactors only an imperfect and fallible ability to anticipate future prices, provided a realistic account, or at least a conceptual approach toward a realistic account, of how prices are actually formed.

In a future post, I will try spell out in greater detail my version of a Mengerian account of price formation and how this account might tell us about the process by which a set of equilibrium prices might be realized.

9 Responses to “The Walras-Marshall Divide in Neoclassical Theory, Part II”

  1. 1 LAL September 27, 2021 at 7:11 pm

    enjoying your emphasis on agents’ expectations in all of these works, but I’m wondering how cardinal vs ordinal utility influences expectations in each of these frameworks. Hicks made an argument that the older cardinal view required that the disequilibrium of a price of a single good would act as either a complement for all other goods in the market or as a substitute for all other goods in the market. That would make Marshall’s equilibrium framework considerably easier to work out…Hick’s statement was in “a revision of demand theory” which i cant find my copy of at the moment…

  2. 2 charlesstp November 2, 2021 at 10:13 am

    The assumption of the neutrality and, by some, even the intrinsically benign nature of the unregulated market assumes the absence of accumulating advantage (and disadvantage) by different actors in that market.

    This needs to be reexamined. Assume instead that each transaction constitutes a negotiated contract, and that in negotiating a contract between agents of differing advantage the agent with the greater advantage will gain more advantage from the contract than the agent with the relative disadvantage. (At least in a statistical sense over all the transactions in the entire market.)

  3. 3 David Glasner November 2, 2021 at 6:43 pm

    LAL, Sorry for this tardy response. If you can find the specific statement of Hicks, I might be able to reply. But off the top of my head I don’t see why cardinal versus ordinal utility would make a difference to demand theory. I think of the distinction as affecting welfare economics not allocation, but I’m happy to reconsider if you provide a reference.

  4. 4 David Glasner November 2, 2021 at 6:53 pm

    charlesstp, I don’t dismiss the concerns you raise and I encourage others to take them up. But I have no particular insight to offer that would bear on them. I am especially concerned about the increasing political influence that extremely wealthy individuals are able to exert on the political process.

  5. 5 LAL November 2, 2021 at 6:58 pm

    I’m ordering another copy. I’ll get back to you in a couple of weeks.

  6. 6 LAL November 8, 2021 at 8:13 pm

    The argument I recalled from Hick’s “Revision of Demand Theory” applies to cardinal utility theory with an assumption independent utilities. In which case, if the price for a single good falls, the consumer would increase their demand of it. In so doing, the marginal utility of money would change, thus, the marginal utilities (and hence demands) of all other goods would move in the same direction. But I forgot about that independence assumption so probably not too relevant after all. Under interdependent utilities it just become a less precise way of breaking the effects into income and substitution effects.

  7. 7 David Glasner November 9, 2021 at 6:56 am

    Thanks for the update. I regret never having read Revision of Demand Theory. Maybe I’ll still get around to doing so.

  8. 8 C Trombley November 16, 2021 at 10:10 pm

    This is a good post, but I would like to say two things.

    One is that Marshall’s account of supply & demand does take into account imperfect knowledge albeit in a way that (very typical for Marshall) tries to glide over the problem:

    “Anticipations of that [price] rise exercise an influence on present sales for future delivery, and that in its turn influences cash prices; so that these prices are indirectly affected by estimates of the expenses of producing further supplies.”

    Second, I think if you go over the Samuelson critique of Value And Capital and the ensuing debate, then you see that many economists conflated two notions of equilibrium. One is equilibrium proper, stationarity in time. The other is equilibrium in the sense of Rousseau and game theory, no one can unilaterally change their behavior pattern.

    One last thing before I go. Keynes’s Treatise On Money era improvement on Marshall, in my opinion, is to further outline and emphasize how things like expected future spot price and forward price connect through the market. Though Keynes is doing applied econ here, I actually think this break between forward and expected spot is philosophically interesting. Unfortunately, most people who like philosophy and economics learn about Treatise On Money through Hayek’s completely tendentious “review” (a review that somehow never finds the time to talk about backwardation, normal backwardation, contango or even liquidity).

  1. 1 My Paper “Between Walras and Marshall: Menger’s Third Way” Is Now Posted on SSRN | Uneasy Money Trackback on November 18, 2021 at 8:15 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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