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Neoclassical economics is an approach to economics focusing on the determination of goods, outputs, and income distributions in markets through supply and demand. This determination is often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by firms facing production costs and employing available information and factors of production, in accordance with rational choice theory, a theory that has come under considerable question in recent years.
Neoclassical economics dominated microeconomics and, together with Keynesian economics, formed the neoclassical synthesis which dominated mainstream economics as Neo-Keynesian economics from the 1950s to the 1970s. It competed with New Keynesian economics as New classical macroeconomics in explaining macroeconomic phenomenon from the 1970s till the 1990s, when it was identified as having became a part of the new neoclassical synthesis along with New Keynesianism. There have been many critiques of neoclassical economics, often incorporated into newer versions of neoclassical theory, but some remaining distinct fields.
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.
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
It was later used by John Hicks, George Stigler, and others 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, 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.
Three central assumptions
- 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's 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 labour 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.
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.
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 prior to and conditioning individual behavior, are de-emphasized. Economic subjectivism accompanies these emphases. See also general equilibrium.
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Classical economics, developed in the 18th and 19th centuries, included a value theory and distribution 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 of Adam Smith and David Ricardo.
However, some economists gradually began emphasizing the perceived value 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 the utilitarianism of Jeremy Bentham and later of John Stuart Mill.)
The third step from political economy to economics was the introduction of marginalism and the proposition that economic actors made decisions based on margins. 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. It is frequently dated from William Stanley Jevons's Theory of Political Economy (1871), Carl Menger's Principles of Economics (1871), and Léon Walras's Elements of Pure Economics (1874–1877). Historians of economics and economists have debated:
- Whether utility or marginalism was more essential to this revolution (whether the noun or the adjective in the phrase "marginal utility" is more important)
- Whether there was a revolutionary change of thought or merely a gradual development and change of emphasis from their predecessors
- Whether grouping these economists together disguises differences more important than their similarities.
In particular, Jevons saw his economics as an application and development of Jeremy Bentham's utilitarianism and never had a fully developed general 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. 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.
Alfred Marshall's textbook, Principles of Economics (1890), was the dominant textbook in England a generation later. Marshall's influence extended elsewhere; Italians would compliment Maffeo Pantaleoni by calling him the "Marshall of Italy". Marshall thought classical economics attempted to explain prices by the cost 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 upper or the under blade of a pair of scissors that cuts a piece of paper, as whether 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:
- Market period. The goods produced for sale on the market are taken as given data, e.g. in a fish market. Prices quickly adjust to clear markets.
- Short period. Industrial capacity is taken as given. The level of output, the level of employment, the inputs of raw materials, and prices fluctuate to equate marginal cost and marginal revenue, where profits are maximized. Economic rents exist in short period equilibrium for fixed factors, and the rate of profit is not equated across sectors.
- Long period. The stock of capital goods, such as factories and machines, is not taken as given. Profit-maximizing equilibria determine both industrial capacity and the level at which it is operated.
- Very long period. Technology, population trends, habits and customs are not taken as given, but allowed to vary in very long period models.
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.
An important change in neoclassical economics occurred around 1933. Joan Robinson and Edward H. Chamberlin, with the near simultaneous publication of their respective books, The Economics of Imperfect Competition (1933) and The Theory of Monopolistic Competition (1933), introduced models of imperfect competition. Theories of market forms and industrial organization grew out of this work. They also emphasized certain tools, such as the marginal revenue curve.
Joan Robinson's work on imperfect competition, at least, was a response to certain problems of Marshallian partial equilibrium theory highlighted by Piero Sraffa. Anglo-American economists also responded to these problems by turning towards general equilibrium theory, developed on the European continent by Walras and Vilfredo Pareto. J. R. Hicks's Value and Capital (1939) was influential in introducing his English-speaking colleagues to these traditions. He, in turn, was influenced by the Austrian School economist Friedrich Hayek's move to the London School of Economics, where Hicks then studied.
These developments were accompanied by the introduction of new tools, such as indifference curves and the theory of ordinal utility. The level of mathematical sophistication of neoclassical economics increased. Paul Samuelson's Foundations of Economic Analysis (1947) contributed to this increase in mathematical modelling.
The interwar period in American economics has been argued to have been pluralistic, with neoclassical economics and institutionalism competing for allegiance. Frank Knight, an early Chicago 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 argue that outside political interventions, such as McCarthyism, 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 the Arrow–Debreu model of intertemporal equilibrium. The Arrow–Debreu model has canonical presentations in Gérard Debreu's Theory of Value (1959) and in Arrow and Hahn's "General Competitive Analysis" (1971).
Many of these developments were against the backdrop of improvements in both econometrics, that is the ability to measure prices and changes in goods and services, as well as their aggregate quantities, and in the creation of macroeconomics, or the study of whole economies. The attempt to combine neo-classical microeconomics and Keynesian macroeconomics would lead to the neoclassical synthesis 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 of Neo-Keynesian economics was upset by its inability to explain the economic crises of the 1970s- neoclassical economics emerged distinctly in macroeconomics as the new classical school, which sought to explain macroeconomic phenomenon using neoclassical microeconomics. It and its contemporary New Keynesian economics contributed to the new neoclassical synthesis of the 1990s, which informs much of mainstream economics today.
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Criticism of Neoclassical economics was offered by Leijonhufvud in the contention that "Instead of looking for an alternative to replace it, we should try to imagine an economic theory to transcend its limitations." In criticism, neoclassical economics is often conflated with all of mainstream economics.
Neoclassical economics is sometimes criticized for having a normative bias. In this view, it does not focus on explaining actual economies, but instead on describing a theoretical world in which Pareto optimality applies.
Criticisms of neoclassical economics are also directed at the rationality assumption, in particular on the basis of the view that the rationality assumption cannot be reconciled with altruisric behaviour. Many[who?] see the "economic man" as being quite different from real people, the Econ different from the Human.  Many economists[who?], even contemporaries, have criticized this model of economic man, with empirical evidence (as noted, especially in Behavioral Economics) growing[quantify] in support of representing a person as a Human rather than an Econ. Thorstein 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.
Neoclassical economics, according to this criticism, has extreme difficulty explaining such things as voting behavior, or someone running into a burning building to save a complete stranger.[improper synthesis?] Such so-called "non-rational" decision making has been examined in Behavioral Economics. G.A. Cory claims that behavioral Economics has demonstrated that while the Econ almost exclusively pursues only self-interest, the Human pursues a Dual Interest. The Dual Interest, according to Cory, includes both the Ego-based self-interest and the Empathy-based other (shared with others, yet internalized within the own-self)-interest.
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 the marginal productivity theory of distribution. 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 the Sonnenschein–Mantel–Debreu theorem suggests that the assumptions that must be made to ensure that equilibrium is stable and unique are quite restrictive.
Neoclassical economics is also often seen[by whom?] as relying too heavily on complex mathematical models, such as those used in general equilibrium theory, without enough regard to whether these actually describe the real economy. Many[who?] see an attempt to model a system as complex as a modern economy by a mathematical model as unrealistic and doomed to failure. A famous answer to this criticism is Milton Friedman's claim that theories should be judged by their ability to predict events rather than by the realism of their assumptions. Mathematical models also include those in game theory, linear programming, and econometrics. Some see mathematical models used in contemporary research in mainstream economics as having transcended neoclassical economics, while others disagree. 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.
In general, allegedly overly unrealistic assumptions are one of the most common criticisms of neoclassical economics. It is fair[according to whom?] to say that many[further explanation needed] (but not all) of these criticisms can only be directed towards a subset of the neoclassical models (for example, there are many neoclassical models where unregulated markets fail to achieve Pareto-optimality and there has recently been an increased interest in modeling non-rational decision making).
It has been argued within the field of Ecological Economics that the Neoclassical Economics system is by nature dysfunctional. It, according to Ecological economics, considers the destruction of the natural world through the accelerating consumption of non-renewable resources as well as the exhaustion of the "waste sinks" of the ecosphere as mere "externalities." Such externalities, in turn, are allegedly viewed as occurring only occasionally, and easily rectified by shifting public property to private property: The Market will resolve any externalitity, given the opportunity to do so; so, there is no need for any kind of Government, or any other kind of Community "intervention."  The need to consider "Empathy"[further explanation needed], in order to address the matter of achieving sustainability on a "Spaceship Earth", is also becoming a theme in the natural and environmental sciences.
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- Leijonhufvud, A. (2004). "rento Summer School: Adaptive Economic Dynamics" In: Daniel Friedman and Alessandra Casser (eds). Economics Lab: An Intensive Course in Experimental Economics. New York: Routledge. pp. 5–11.
- For example, see Alfred S. Eichner and Jan Kregel (Dec. 1975) An Essay on Post-Keynesian Theory: A New Paradigm in Economics, Journal of Economic Literature.
- Hayes, W.M.; Lynne, G.D. (2013). The Evolution of Ego and Empathy: Progress in Forming the Centerpiece for Ecological Economic Theory In: Robert B. Richardson (ed.) In Building a Green Economy: Perspectives from Ecological Economics. East Lansing, MI: Michigan State University Press. pp. 107–118.
- Thaler, R.H.; Sunstein, C.R. (2008). Nudge: Improving Decisions About Health, Wealth, and Happiness. New Haven, MA: Yale University Press.
- Thorstein Veblen (1898) Why Is Economics Not an Evolutionary Science?, reprinted in The Place of Science in Modern Civilization (New York, 1919), p. 73.
- Cory, G.A. (2006). "A Behavioral Model of the Dual Motive Approach to Behavioral Economics and Social Exchange". Journal of Socio-Economics. 35 (4): 592–612. doi:10.1016/j.socec.2005.12.017.
- Lynne, G.D.; Czap, N.V.; Czap, H.J; Burbach, M.E. "Theoretical Foundation for Empathy Conservation: Toward Avoiding the Tragedy of the Commons". Review of Behavioral Economics. 3: 245–279.
- Avi J. Cohen and G. C. Harcourt (2003) Whatever happened to the Cambridge theory controversies? Journal of Economic Perspectives, V. 17, No. 1, pp. 199-214.
- Friedman argued for this in essays III, IV and V in "Essays in Positive Economics". http://www.econ.umn.edu/~schwe227/teaching.s11/files/articles/friedman-1953.pdf
- For example, David Colander, Richard Holt, and J. Barkley Rosser Jr. (2004) The changing face of mainstream economics, Review of Political Economy, V. 16, No. 4: pp. 485–99)
- For example, Matias Vernengo (2010) Conversation or monologue? On advising heterodox economists, Journal of Post Keynesian Economics, V. 32, No. 3" pp. 485–99.
- Jamie Morgan (ed.) (2016) 'What is Neoclassical Economics? Debating the origins, meaning and significance', Routledge.
- Hayes, W.M.; Lynne, G.D. (2004). "Towards a Centerpiece for Ecological Economics." Ecological Economics". Ecological Economics. 49 (3): 287–301. doi:10.1016/j.ecolecon.2004.01.014.
- Hayes, W.M.; Lynne, G.D. (2013). The Evolution of Ego and Empathy: Progress in Forming the Centerpiece for Ecological Economic Theory In: Robert B. Richardson (ed.) Building a Green Economy: Perspectives from Ecological Economics. East Lansing, MI: Michigan State University Press. pp. 107–118.
- Brown, K.; Adger, W.N.; Devine-Wright, P.; Anderies, J.M.; Barr, S.; Bousquet, F.; Butler, C.; Evans, L.; Marshall, N.; Quinn, T. (2019). "Empathy, Place and Identity Interactions for Sustainability". Global Environmental Change. 56: 11–17. doi:10.1016/j.gloenvcha.2019.03.003. hdl:10871/37001.