Between Walras and Marshall: Menger's Third Way

Abstract

Neoclassical economics is bifurcated between Marshall’s partial-equilibrium and Walras’s general-equilibrium analyses. Given the failure of neoclassical theory to explain the Great Depression, Keynes proposed an explanation of involuntary unemployment. Keynes’s contribution was later subsumed under the neoclassical synthesis of the Keynesian and Walrasian theories. Lacking microfoundations consistent with Walrasian theory, the neoclassical synthesis collapsed. But Walrasian GE theory provides no plausible account of how GE is achieved. Whatever plausibility is attributed to the assumption that price flexibility leads to equilibrium derives from Marshallian PE analysis, with prices equilibrating supply and demand. But Marshallian PE analysis presumes that all markets, but the small one being analyzed, are at equilibrium, so that price adjustments in the analyzed market neither affect nor are affected by other markets. The demand and cost (curves) of PE analysis are drawn on the assumption that all other prices reflect Walrasian GE values. While based on Walrasian assumptions, modern macroeconomics relies on the Marshallian intuition that agents know or anticipate the prices consistent with GE. Menger’s third way offers an alternative to this conceptual impasse by recognizing that nearly all economic activity is subjective and guided by expectations of the future. Current prices are set based on expectations of future prices, so equilibrium is possible only if agents share the same expectations of future prices. If current prices are set based on differing expectations, arbitrage opportunities are created, causing prices and expectations to change, leading to further arbitrage, expectational change, and so on, but not necessarily to equilibrium.