Neoclassical economics is an approach to economics in which the production, consumption, and valuation (pricing) of goods and services are observed as driven by the supply and demand model.Encyclopedia Britannica (July 20, 1998) Alfred Marshall, Britannica. Available at: https://www.britannica.com/biography/Alfred-Marshall (Accessed: May 13, 2021). According to this line of thought, the value of a good or service is determined through a hypothetical maximization of utility by income-constrained individuals and of profits by firms facing production costs and employing available information and factors of production. This approach has often been justified by appealing to rational choice theory.Antonietta Campus (1987), "marginal economics.” The New Palgrave: A Dictionary of Economics v. 3, p. 323.
Neoclassical economics is the dominant approach to microeconomics and, together with Keynesian economics, formed the neoclassical synthesis which dominated mainstream economics as "neo-Keynesian economics" from the 1950s onward.
Classification The term was originally introduced by Thorstein Veblen in his 1900 article "Preconceptions of Economic Science", in which he related marginalists in the tradition of Alfred Marshall et al. to those in the Austrian School.Colander, David; "The Death of Neoclassical Economics ," Journal of the History of Economic Thought 22(2), 2000.Aspromourgos, T. (1986). On the origins of the term "neoclassical". Cambridge Journal of Economics, 10(3), 265–70.
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.Veblen, T. (1900). 'The Preconceptions of Economic Science – III', The Quarterly Journal of Economics, 14(2), 240–69. (Term on pg. 261). It was later used by John Hicks, George Stigler, and othersGeorge J. Stigler (1941 ). Production and Distribution Theories. New York: Macmillan. Preview. to include the work of Carl Menger, William Stanley Jevons, Léon Walras, John Bates Clark, and many others. Today it is usually used to refer to mainstream economics, although it has also been used as an umbrella term encompassing a number of other schools of thought,Fonseca G. L.; “Introduction to the Neoclassicals” , The New School. notably excluding institutional economics, various historical schools of economics, and Marxian economics, in addition to various other heterodox approaches to economics.
Neoclassical economics is characterized by several assumptions common to many schools 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.
Theory
Assumptions and objectives It was expressed by E. Roy Weintraub that neoclassical economics rests on three assumptions, although certain branches of neoclassical theory may have different approaches:
People have rational preferences between outcomes that can be identified and associated with values. Individuals maximize utility and firms maximize profits. People act independently on the basis of full and relevant information.
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 how William 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.
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 neoclassical theory of the firm, while the derivation of demand curves leads to an understanding of consumer goods, and the supply curve allows an analysis of the factors 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 and reservation demand.Philip H. Wicksteed The Common Sense of Political Economy
Supply and demand model 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*.Wolff, R. D. and Resnick, S. A. (2012) Contending Economic Theories. The MIT Press. pp. 56.
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.Wolff, R. D. and Resnick, S. A. (2012) Contending Economic Theories. The MIT Press. pp. 57–58. 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 to determine equilibrium income and the income distribution. Factor demand incorporates the marginal productivity relationship of that factor in the output market.Christopher Bliss (1987), "distribution theories, neoclassical", The New Palgrave: A Dictionary of Economics, v. 1, pp. 883–86, doi:10.1057/978-1-349-95121-5 105-1.Robert F. Dorfman (1987), "marginal productivity theory", The New Palgrave: A Dictionary of Economics, v. 3, pp. 323–25, doi:10.1057/978-1-349-95121-5 988-2.C.E. Ferguson (1969). The Neoclassical Theory of Production and Distribution. Cambridge. , ch. 1: pp. 1–10 (excerpt).
Neoclassical economics emphasizes equilibria, which are the solutions of agent maximization problems. Regularities in economies are explained by methodological individualism, the position that economic phenomena can be explained by aggregating over the behavior of agents. The emphasis is on microeconomics. Institutions, which might be considered as before and conditioning individual behavior, are de-emphasized. Economic subjectivism accompanies these emphases. See also general equilibrium.
Utility theory of value Neoclassical economics uses the utility theory of value, which states that the value of a good is determined by the marginal utility experienced by the user. This is one of the main distinguishing factors between neoclassical economics and other earlier economic theories, such as Classical and Marxian, which use the labor theory of value that value is determined by the labor required for production.
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).Wolff, R. D. and Resnick, S. A. (2012) Contending Economic Theories. The MIT Press. pp. 58–59.
Market failure and externalities Despite favoring markets to organize economic activity, neoclassical theory acknowledges that markets do not always produce the socially desirable outcome due to the presence of externalities. Externalities are considered a form of market failure. Neoclassical economists vary in terms of the significance they ascribe to externalities in market outcomes.
Pareto criterion 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 the Pareto optimum (criterion) after its discoverer Vilfredo Pareto.CAPORASO, James A., and LEVINE, David P., 1992, Theories of Political Economy. Cambridge: Cambridge University Press. pp. 82–83. ISBN 978-0-521-41561-3 Wolff and Resnick (2012) describe the Pareto 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.Wolff, R. D., and Resnick, S. A. (2012) Contending Economic Theories. The MIT Press. pp. 101.
Normative judgments in neoclassical economics are shaped by the Pareto criterion. As a result, many neoclassical economists favor a relatively laissez-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 the compensation 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.
International trade Neoclassical economics favors free trade according to David Ricardo's theory of comparative advantage. This idea holds that free trade between two countries is mutually beneficial because it allows the greatest total consumption in both countries.
Origins