Neoclassical economics is an approach toeconomics in which the production, consumption, and valuation (pricing) of goods and services are observed as driven by thesupply and demand model.[1] According to this line of thought, the value of a good or service is determined through a hypothetical maximization ofutility by income-constrained individuals and ofprofits by firms facing production costs and employing available information andfactors of production. This approach has often been justified by appealing torational choice theory.[2]
Neoclassical economics is the dominant approach tomicroeconomics and, together withKeynesian economics, formed theneoclassical synthesis which dominatedmainstream economics as "neo-Keynesian economics" from the 1950s onward.
The term was originally introduced byThorstein Veblen in his 1900 article "Preconceptions of Economic Science", in which he relatedmarginalists in the tradition ofAlfred Marshallet al. to those in theAustrian School.[3][4]
No attempt will here be made even to pass a verdict on the relative claims of the recognized two or three main "schools" of theory, beyond the somewhat obvious finding that, for the purpose in hand, the so-called Austrian school is scarcely distinguishable from the neo-classical, unless it be in the different distribution of emphasis. The divergence between the modernized classical views, on the one hand, and the historical and Marxist schools, on the other hand, is wider, so much so, indeed, as to bar out a consideration of the postulates of the latter under the same head of inquiry with the former.[5]
It was later used byJohn Hicks,George Stigler, and others[6] to include the work ofCarl Menger,William Stanley Jevons,Léon Walras,John Bates Clark, and many others.[3] Today it is usually used to refer tomainstream economics, although it has also been used as anumbrella term encompassing a number of other schools of thought,[7] notably excludinginstitutional economics, varioushistorical schools of economics, andMarxian economics, in addition to various otherheterodox approaches to economics.
Neoclassical economics is characterized by several assumptions common to manyschools of economic thought. There is not a complete agreement on what is meant by neoclassical economics, and the result is a wide range of neoclassical approaches to various problem areas and domains—ranging from neoclassical theories of labor to neoclassical theories of demographic changes.
It was expressed byE. Roy Weintraub that neoclassical economics rests on three assumptions, although certain branches of neoclassical theory may have different approaches:[8]
From these three assumptions, neoclassical economists have built a structure to understand the allocation of scarce resources among alternative ends—in fact, understanding such allocation is often considered the definition of economics to neoclassical theorists. Here is howWilliam Stanley Jevons presented "the problem of Economics".
Given, a certain population, with various needs and powers of production, in possession of certain lands and other sources of material: required, the mode of employing their labor which will maximize the utility of their produce.[9]
From the basic assumptions of neoclassical economics comes a wide range of theories about various areas of economic activity. For example, profit maximization lies behind the neoclassicaltheory of the firm, while the derivation ofdemandcurves leads to an understanding ofconsumer goods, and thesupply curve allows an analysis of thefactors of production. Utility maximization is the source for the neoclassical theory of consumption, the derivation of demand curves for consumer goods, and the derivation of labor supply curves andreservation demand.[10]
Market analysis is typically the neoclassical answer to price questions, such as why does an apple cost less than an automobile, why does the performance of work command a wage, or how to account for interest as a reward for saving. An important device of neoclassical market analysis is the graph presenting supply and demand curves. The curves reflect the behavior of individual buyers and individual sellers. Buyers and sellers interact with each other in and through these markets, and their interactions determine the market prices of anything they buy and sell. In the following graph, the specific price of the commodity being bought/sold is represented by P*.[11]
In reaching agreed outcomes of their interactions, the market behaviors of buyers and sellers are driven by their preferences (= wants, utilities, tastes, choices) and productive abilities (= technologies, resources). This creates a complex relationship between buyers and sellers. Thus, the geometrical analytics of supply and demand is only a simplified way how to describe and explore their interaction.[12]Market supply and demand are aggregated across firms and individuals. Their interactions determine equilibrium output and price. The market supply and demand for each factor of production is derived analogously to those for market final output[13] to determine equilibrium income and the income distribution. Factor demand incorporates themarginal productivity relationship of that factor in the output market.[6][14][15][16]
Neoclassical economics emphasizes equilibria, which are the solutions ofagent maximization problems. Regularities in economies are explained bymethodological individualism, the position that economic phenomena can be explained by aggregating over the behavior of agents. The emphasis is onmicroeconomics. Institutions, which might be considered as before and conditioning individual behavior, are de-emphasized.Economic subjectivism accompanies these emphases. See alsogeneral equilibrium.
Neoclassical economics uses theutility theory of value, which states that the value of a good is determined by themarginal utility experienced by the user. This is one of the main distinguishing factors between neoclassical economics and other earlier economic theories, such asClassical andMarxian, which use thelabor theory of value that value is determined by the labor required for production.[17]
The partial definition of the neoclassical theory of value states that the value of an object of market exchange is determined by human interaction between the preferences and productive abilities of individuals. This is one of the most important neoclassical hypotheses. However, the neoclassical theory also asks what exactly is causing the supply and demand behaviors of buyers and sellers, and how exactly the preferences and productive abilities of people determine the market prices. Therefore, the neoclassical theory of value is a theory of these forces: the preferences and productive abilities of humans. They are the final causal determinants of the behavior of supply and demand and therefore of value. According to neoclassical economics, individual preferences and productive abilities are the essential forces that generate all other economic events (demands, supplies, and prices).[18]
Despite favoring markets to organize economic activity, neoclassical theory acknowledges that markets do not always produce the socially desirable outcome due to the presence ofexternalities.[17] Externalities are considered a form ofmarket failure. Neoclassical economists vary in terms of the significance they ascribe to externalities in market outcomes.
In a market with a very large number of participants and under appropriate conditions, for each good, there will be a unique price that allows all welfare–improving transactions to take place. This price is determined by the actions of the individuals pursuing their preferences. If these prices are flexible, meaning that all parties are able to pursue transactions at any rates they find mutually beneficial, they will, under appropriate assumptions, tend to settle at price levels that allow for all welfare–improving transactions. Under these assumptions, free-market processes yield an optimum of social welfare. This type of group welfare is called thePareto optimum (criterion) after its discoverer Vilfredo Pareto.[19]Wolff and Resnick (2012) describe thePareto optimality in another way. According to them, the term "Pareto optimal point" signifies the equality of consumption and production, which indicates that the demand (as a ratio of marginal utilities) and supply (as a ratio of marginal costs) sides of an economy are in balance with each other. The Pareto optimum point also signifies that society has fully realized its potential output.[20]
Normative judgments in neoclassical economics are shaped by thePareto criterion. As a result, many neoclassical economists favor a relativelylaissez-faire approach to government intervention in markets, since it is very difficult to make a change where no one will be worse off. However, many less conservative neoclassical economists instead use thecompensation principle, which says that an intervention is good if the total gains are larger than the total losses, even if losers are not compensated in practice.[17]
Neoclassical economics favorsfree trade according toDavid Ricardo's theory ofcomparative advantage.[21] This idea holds that free trade between two countries is mutually beneficial because it allows the greatest total consumption in both countries.
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Classical economics, developed in the 18th and 19th centuries, included avalue theory anddistribution theory. The value of a product was thought to depend on the costs involved in producing that product. The explanation of costs in classical economics was simultaneously an explanation of distribution. A landlord received rent, workers received wages, and a capitalist tenant farmer received profits on their investment. This classic approach included the work ofAdam Smith andDavid Ricardo.
However, some economists gradually began emphasizing the perceivedvalue of a good to the consumer. They proposed a theory that the value of a product was to be explained with differences in utility (usefulness) to the consumer. (In England, economists tended to conceptualize utility in keeping with theutilitarianism ofJeremy Bentham and later ofJohn Stuart Mill.)
The third step from political economy to economics was the introduction ofmarginalism and the proposition that economic actors made decisions based onmargins. For example, a person decides to buy a second sandwich based on how full he or she is after the first one, a firm hires a new employee based on the expected increase in profits the employee will bring. This differs from the aggregate decision-making of classical political economy in that it explains how vital goods such as water can be cheap, while luxuries can be expensive.
The change in economic theory from classical to neoclassical economics has been called the "marginal revolution", although it has been argued that the process was slower than the term suggests.[22] It is frequently dated fromWilliam Stanley Jevons'sTheory of Political Economy (1871),Carl Menger'sPrinciples of Economics (1871), andLéon Walras'sElements of Pure Economics (1874–1877). Historians of economics and economists have debated:
In particular, Jevons saw his economics as an application and development ofJeremy Bentham's utilitarianism and never had a fully developedgeneral equilibrium theory. Menger did not embrace this hedonic conception, explained diminishing marginal utility in terms of subjective prioritization of possible uses, and emphasized disequilibrium and the discrete; further, Menger had an objection to the use of mathematics in economics, while the other two modeled their theories after 19th-century mechanics.[24] Jevons built on the hedonic conception of Bentham or of Mill, while Walras was more interested in the interaction of markets than in explaining the individual psyche.[23]
Alfred Marshall's textbook,Principles of Economics (1890), was the dominant textbook in England a generation later. Marshall's influence extended elsewhere; Italians would complimentMaffeo Pantaleoni by calling him the "Marshall of Italy". Marshall thoughtclassical economics attempted to explain prices by thecost of production. He asserted that earlier marginalists went too far in correcting this imbalance by overemphasizing utility and demand. Marshall thought that "We might as reasonably dispute whether it is the upperor the under blade of a pair of scissors that cuts a piece of paper, as to whether the value is governed by utility or cost of production".
Marshall explained price by the intersection of supply and demand curves. The introduction of different market "periods" was an important innovation of Marshall's:
Marshall took supply and demand as stable functions and extended supply and demand explanations of prices to all runs. He argued supply was easier to vary in longer runs, and thus became a more important determinant of price in the very long run.
Cambridge andLausanne School of economics form the basis of neoclassical economics. Until the 1930s, the evolution of neoclassical economics was determined by the Cambridge school and was based on themarginal equilibrium theory. At the beginning of the 1930s, the Lausannegeneral equilibrium theory became the general basis of neoclassical economics and the marginal equilibrium theory was understood as its simplification.[25]
The thinking of the Cambridge school continued in the steps of classical political economics and its traditions but was based on the new approach that originated from the marginalist revolution. Its founder wasAlfred Marshall, and among the main representatives wereArthur Cecil Pigou,Ralph George Hawtrey andDennis Holme Robertson. Pigou worked on the theory ofwelfare economics and thequantity theory of money. Hawtrey and Robertson developed the Cambridge cash balance approach totheory of money and influenced thetrade cycle theory. Until the 1930s,John Maynard Keynes was also influencing the theoretical concepts of the Cambridge school. The key characteristic of the Cambridge school was its instrumental approach to the economy – the role of the theoretical economist is first to define theoretical instruments of economic analysis and only just then apply them to real economic problems.[25]
The main representatives of the Lausanne school of economic thought wereLéon Walras,Vilfredo Pareto andEnrico Barone. The school became famous for developing thegeneral equilibrium theory. In the contemporary economy, the general equilibrium theory is the methodologic basis ofmainstream economics in the form ofNew classical macroeconomics andNew Keynesian macroeconomics.[25]
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The evolution of neoclassical economics is sometimes divided into three phases.
The pre-Keynesian phase began when neoclassical economics initially formed (in the second half of the nineteenth century) and continued until the arrival ofKeynesian economics in the 1930s.
The Keynesian phase occurred from 1940 through the first half of the 1970s. During this era,Keynesian economics dominated the world's economy but neoclassical economics did not cease to exist. It continued in the development of its microeconomic theory and began creating its own macroeconomic theory. The development of the neoclassical macroeconomic theory was based on the development of thequantity theory of money and thetheory of distribution. One of the products of the second phase was theNeoclassical synthesis, representing a special combination of neoclassical microeconomics and Keynesian macroeconomics.
The third phase began in the 1970s when neoclassical schools of thoughts such asMonetarism andNew classical macroeconomics were developed and rose to prominence. Despite the diverse focus and approach of these theories, they are all based on the theoretical and methodological principles of traditional neoclassical economics.[26]
An important change in neoclassical economics occurred around 1933.Joan Robinson andEdward H. Chamberlin, with the nearly simultaneous publication of their respective books,The Economics of Imperfect Competition (1933) andThe Theory of Monopolistic Competition (1933), introduced models ofimperfect competition. Theories ofmarket forms andindustrial organization grew out of this work. They also emphasized certain tools, such as themarginal revenue curve. In her book, Robinson formalized a type of limited competition. The conclusions of her work forwelfare economics were worrying: they were implying that the market mechanism operates in a way that the workers are not paid according to the full value of theirmarginal productivity of labor and that also the principle ofconsumer sovereignty is impaired. This theory heavily influenced the anti–trust policies of many Western countries in the 1940s and 1950s.[27]
Joan Robinson's work on imperfect competition, at least, was a response to certain problems of Marshallianpartial equilibrium theory highlighted byPiero Sraffa. Anglo-American economists also responded to these problems by turning towardsgeneral equilibrium theory, developed on the European continent by Walras andVilfredo Pareto.J. R. Hicks'sValue and Capital (1939) was influential in introducing his English-speaking colleagues to these traditions. He, in turn, was influenced by theAustrian School economistFriedrich Hayek's move to theLondon School of Economics, where Hicks then studied.[citation needed]
These developments were accompanied by the introduction of new tools, such asindifference curves and the theory ofordinal utility. The level of mathematical sophistication of neoclassical economics increased.Paul Samuelson'sFoundations of Economic Analysis (1947) contributed to this increase in mathematical modeling.
The interwar period in American economics has been argued to have been pluralistic, with neoclassical economics andinstitutionalism competing for allegiance.Frank Knight, an earlyChicago school economist attempted to combine both schools. But this increase in mathematics was accompanied by greater dominance of neoclassical economics in Anglo-American universities after World War II. Some[28] argue that outside political interventions, such asMcCarthyism, and internal ideological bullying played an important role in this rise to dominance.
Hicks' book,Value and Capital had two main parts. The second, which was arguably not immediately influential, presented a model of temporary equilibrium. Hicks was influenced directly by Hayek's notion of intertemporal coordination and paralleled by earlier work by Lindhal. This was part of an abandonment of disaggregated long-run models. This trend probably reached its culmination with theArrow–Debreu model ofintertemporal equilibrium. The Arrow–Debreu model has canonical presentations in Gérard Debreu'sTheory of Value (1959) and in Arrow and Hahn's "General Competitive Analysis" (1971).
Many of these developments were against the backdrop of improvements in botheconometrics, that is the ability to measure prices and changes in goods and services, as well as their aggregate quantities, and in the creation ofmacroeconomics, or the study of whole economies. The attempt to combine neo-classical microeconomics andKeynesian macroeconomics would lead to theneoclassical synthesis[29] which was the dominant paradigm of economic reasoning in English-speaking countries from the 1950s till the 1970s. Hicks and Samuelson were for example instrumental in mainstreaming Keynesian economics.
The dominance ofKeynesian economics was upset by its inability to explain the economic crises of the 1970s-[30] neoclassical economics emerged distinctly in macroeconomics as thenew classical school, which sought to explain macroeconomic phenomenon using neoclassical microeconomics.[31] It and its contemporaryNew Keynesian economics contributed to thenew neoclassical synthesis of the 1990s, which informs much of mainstream macroeconomics today.[32][33]
Problems exist with making the neoclassical general equilibrium theory compatible with an economy that develops over time and includes capital goods. This was explored in a major debate in the 1960s—the "Cambridge capital controversy"—about the validity of neoclassical economics, with an emphasis on economic growth,capital, aggregate theory, and themarginal productivity theory of distribution.[34] There were also internal attempts by neoclassical economists to extend the Arrow–Debreu model to disequilibrium investigations of stability and uniqueness. However, a result known as theSonnenschein–Mantel–Debreu theorem suggests that the assumptions that must be made to ensure that equilibrium is stable and unique are quite restrictive.
Although the neoclassical approach is dominant in economics, the field of economics includes others, such asMarxist,behavioral,Schumpeterian,developmentalist,Austrian,post-Keynesian,Humanistic economics,real-world economics and institutionalist schools.[17] All of these schools differ with the neoclassical school and each other, and incorporate various criticisms of the neoclassical economics.[35] Not all criticism comes from other schools: some prominent economists such as Nobel Prize recipient and former chief economist of theWorld BankJoseph Stiglitz are vocally critical of mainstream neoclassical economics.[36]
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Some see mathematical models used in contemporary research in mainstream economics as having transcended neoclassical economics,[37] while others disagree.[38] Mathematical models also include those ingame theory,linear programming, andeconometrics. Critics of neoclassical economics are divided into those who think that highly mathematical method is inherently wrong and those who think that mathematical method is useful even if neoclassical economics has other problems.[39]
Critics such asTony Lawson contend that neoclassical economics' reliance onfunctional relations is inadequate for social phenomena in which knowledge of one variable does not reliably predict another.[40] The different factors affecting economic outcomes cannot be experimentally isolated from one another in a laboratory; therefore the explanatory and predictive power of mathematical economic analysis is limited. Lawson proposes an alternative approach called the contrast explanation which he says is better suited for determining causes of events in social sciences. More broadly, critics of economics as a science vary, with some believing that all mathematical economics is problematic or evenpseudoscience and others believing it is still useful but has less certainty and higher risk of methodology problems than in other fields.[41][42]
Milton Friedman, one of the most prominent and influential neoclassical economists of the 20th century, responded to criticisms that assumptions in economic models were often unrealistic by saying that theories should be judged by their ability to predict events rather than by the supposed realism of their assumptions.[43] He claimed that, on the contrary, a theory with more absurd assumptions has stronger predictive power. He argued that a theory's ability to theoretically explain reality is irrelevant compared to its ability to empirically predict reality, no matter the method of getting to that prediction.
Neoclassical economics is often criticized for having anormative bias despite sometimes claiming to be"value-free".[44][45] Such critics argue anideological side of neoclassical economics, generally to argue that students should be taught more than one economic theory and that economics departments should be morepluralistic.[46][47]
One of the most widely criticized aspects of neoclassical economics is its set of assumptions about human behavior and rationality. The "economic man", or a hypothetical human who acts according to neoclassical assumptions, does not necessarily behave the same way as humans do in reality.[48] The economist and critic of capitalismThorstein Veblen claimed that neoclassical economics assumes a person to be "a lightning calculator of pleasures and pains, who oscillates like a homogeneous globule of desire of happiness under the impulse of stimuli that shift about the area, but leave him intact."[49]
Veblen's characterization references a number of commonly criticized rationality assumptions: that people make decisions using a rigidutilitarian framework, have perfect information available about their options, have perfect information processing ability allowing them to immediately calculateutility for all possible options, and are independent decision-makers whose choices are unaffected by their surroundings or by other people. While Veblen is from theInstitutional school, theBehavioral school of economics is focused on studying the mechanisms of humandecision-making and how they differ from neoclassical assumptions of rationality. Altruistic or empathy-based behavior is another form of "non-rational" decision making studied by behavioral economists, which differs from the neoclassical assumption that people only act in self-interest.[50][51] Behavioral economists account for how psychological, neurological, and even emotional factors significantly affect economic perceptions and behaviors.[52]
Rational choice theory need not be problematic according to a paper written by the economistGary Becker which was published in 1962 in theJournal of Political Economy called "Irrational Behavior and Economic Theory".[53] According to Becker, this paper demonstrates "how the important theorems of modern economics result from a general principle which not only includes rational behavior and survivor arguments as special cases, but also much irrational behavior." The specific important theorems and results which are shown to result from a broad range of different type of irrational behavior, as well as rational behavior by market participants in the paper, are that market demand curves are downward sloping or "negatively inclined", and that if an industry transformed from a competitive industry to a completely monopolistic cartel and profits are always maximized, then output per firm under the cartel would decrease compared to its equilibrium level when the industry was competitive.
This paper was largely based on the 1950 paper "Uncertainty, Evolution, and Economic Theory" byArmen Alchian.[54] The paper sets out a justification for supply analysis separate from relying on the assumption of rational consumption, the representative firm and the way neoclassical economists analyze firm behavior in markets which does not rely on rational behavior by the decision makers in those firms, nor any other type of foresighted or goal directed behavior by them. Becker's subsequent 1962 paper provides an independent justification for neoclassical market demand analysis. The two papers offer separate justifications for the use of neoclassical methodology for supply and demand analysis without relying on assumptions otherwise criticised as implausible.
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Neoclassical economics offers an approach to studying the economic behavior ofhomo-economicus. This theory is based on methodological individualism and adopts an atomistic approach to social phenomena, according to which social atoms are the individuals and their actions.[55] According to this doctrine, individuals are independent of social phenomena, but the opposite is not true. Individuals' actions can explain macro-scale behavior, and social collections are nothing more than aggregates, and they do not add anything to its components (Ibid). Although methodological individualism does not negate complex social phenomena such as institutions or behavioral rules, it argues any explanation should be based on constituent components' characteristics of those institutions. This is a reductionist approach based on which it is believed that the characteristics of the social system are derived from the individuals' preferences and their actions.[56]
A critique of this approach is that the individuals' preferences and interests are not fixed. The structures contextualize individual's. According to social constructivists, systems are co-constituted alongside the actors, and ideas within the system define actors' identities, their interests, and thus their behavior.[57] In this regard, actors in various circumstances (exposed to different impressions and experiences) will construct their interests and preferences differently, both within each other and over time.[58] Given the individualistic foundation of the economic theory, critics argue that this theory should consider individual action's structural contexts.
Neoclassical economics is often criticized as promoting policies that increaseinequality and as failing to recognise the impact of inequality on economic outcomes. In the case of the former claim, neoclassical economics is often used for analysis in support of policies reducing economic inequality—in particular through determining the diminishing marginal utility of income, whereby poorer individuals gain greater net benefits from a given increase in income than comparable richer individuals,[59][60] but more generally by being the primary means by which the impact on inequality of any given policy is assessed. In the case of the latter claim, neoclassical economics is the prevailing lens through which the relationship between inequality and economic outcomes is studied.[61]
Neoclassical economics tends to promotecommodification andprivatization of goods due to its principle that market exchange generally results in the most effective allocation of goods. For example, some economists support markets for human organs, on the basis that it increases supply of life-saving organs and benefits willing donors financially.[62] However, there are arguments inmoral philosophy that use of markets for certain goods is inherently unethical. Political philosopherMichael Sandel summarizes that market exchanges have two ethical problems: coercion and corruption.[63] Coercion happens because market participation may not be as free as proponents often claim: people often participate in markets because it is the only way to survive, which is not truly voluntary. Corruption describes how commodification of a good can inherently degrade its value.
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