Neoclassical economics is an approach to
economics
Economics () is a behavioral science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services.
Economics focuses on the behaviour and interac ...
in which the production, consumption, and valuation (pricing) of goods and services are observed as driven by the
supply and demand
In microeconomics, supply and demand is an economic model of price determination in a Market (economics), market. It postulates that, Ceteris_paribus#Applications, holding all else equal, the unit price for a particular Good (economics), good ...
model. According to this line of thought, the value of a good or service is determined through a hypothetical maximization of
utility
In economics, utility is a measure of a certain person's satisfaction from a certain state of the world. Over time, the term has been used with at least two meanings.
* In a normative context, utility refers to a goal or objective that we wish ...
by income-constrained individuals and of
profits by firms facing production costs and employing available information and
factors of production
In economics, factors of production, resources, or inputs are what is used in the production process to produce output—that is, goods and services. The utilised amounts of the various inputs determine the quantity of output according to the rela ...
. This approach has often been justified by appealing to
rational choice theory
Rational choice modeling refers to the use of decision theory (the theory of rational choice) as a set of guidelines to help understand economic and social behavior. The theory tries to approximate, predict, or mathematically model human behav ...
.
Neoclassical economics is the dominant approach to
microeconomics
Microeconomics is a branch of economics that studies the behavior of individuals and Theory of the firm, firms in making decisions regarding the allocation of scarcity, scarce resources and the interactions among these individuals and firms. M ...
and, together with
Keynesian economics
Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomics, macroeconomic theories and Economic model, models of how aggregate demand (total spending in the economy) strongl ...
, formed the
neoclassical synthesis which dominated
mainstream economics
Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Also known as orthodox economics, it can be contrasted to ...
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
The Austrian school is a Heterodox economics, heterodox Schools of economic thought, school of economic thought that advocates strict adherence to methodological individualism, the concept that social phenomena result primarily from the motivat ...
.
[Colander, David;]
The Death of Neoclassical Economics
," ''Journal of the History of Economic Thought'' 22(2), 2000.
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.
It was later used by
John Hicks,
George Stigler
George Joseph Stigler (; January 17, 1911 – December 1, 1991) was an American economist. He was the 1982 laureate in Nobel Memorial Prize in Economic Sciences and is considered a key leader of the Chicago school of economics.
Early life and e ...
, and others
[ George J. Stigler (1941 994. ''Production and Distribution Theories''. New York: Macmillan]
Preview.
to include the work of
Carl Menger,
William Stanley Jevons,
Léon Walras
Marie-Esprit-Léon Walras (; 16 December 1834 – 5 January 1910) was a French mathematical economics, mathematical economist and Georgist. He formulated the Marginalism, marginal theory of value (independently of William Stanley Jevons and Carl ...
,
John Bates Clark, and many others.
Today it is usually used to refer to
mainstream economics
Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Also known as orthodox economics, it can be contrasted to ...
, although it has also been used as an
umbrella term
Hypernymy and hyponymy are the wikt:Wiktionary:Semantic relations, semantic relations between a generic term (''hypernym'') and a more specific term (''hyponym''). The hypernym is also called a ''supertype'', ''umbrella term'', or ''blanket term ...
encompassing a number of other schools of thought, notably excluding
institutional economics
Institutional economics focuses on understanding the role of the Sociocultural evolution, evolutionary process and the role of institutions in shaping Economy, economic Human behavior, behavior. Its original focus lay in Thorstein Veblen's instin ...
, 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
In economics, demand is the quantity of a goods, good that consumers are willing and able to purchase at various prices during a given time. In economics "demand" for a commodity is not the same thing as "desire" for it. It refers to both the desi ...
curves leads to an understanding of
consumer goods, and the
supply curve allows an analysis of the
factors of production
In economics, factors of production, resources, or inputs are what is used in the production process to produce output—that is, goods and services. The utilised amounts of the various inputs determine the quantity of output according to the rela ...
. 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.
Supply and demand model
Market analysis
A market analysis studies the attractiveness and the dynamics of a special market within a special industry. It is part of the industry analysis and thus in turn of the global environmental analysis. Through all of these analyses the strengths, ...
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*.

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.
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
Microeconomics is a branch of economics that studies the behavior of individuals and Theory of the firm, firms in making decisions regarding the allocation of scarcity, scarce resources and the interactions among these individuals and firms. M ...
. 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
Marginal utility, in mainstream economics, describes the change in ''utility'' (pleasure or satisfaction resulting from the consumption) of one unit of a good or service. Marginal utility can be positive, negative, or zero. Negative marginal utilit ...
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).
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.
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.
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
Free trade is a trade policy that does not restrict imports or exports. In government, free trade is predominantly advocated by political parties that hold Economic liberalism, economically liberal positions, while economic nationalist politica ...
according to
David Ricardo's theory of
comparative advantage
Comparative advantage in an economic model is the advantage over others in producing a particular Goods (economics), good. A good can be produced at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior t ...
. This idea holds that free trade between two countries is mutually beneficial because it allows the greatest total consumption in both countries.
Origins
Classical economics
Classical economics, also known as the classical school of economics, or classical political economy, is a school of thought in political economy that flourished, primarily in Britain, in the late 18th and early-to-mid 19th century. It includ ...
, developed in the 18th and 19th centuries, included a
value theory
Value theory, also called ''axiology'', studies the nature, sources, and types of Value (ethics and social sciences), values. It is a branch of philosophy and an interdisciplinary field closely associated with social sciences such as economics, ...
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
Adam Smith (baptised 1723 – 17 July 1790) was a Scottish economist and philosopher who was a pioneer in the field of political economy and key figure during the Scottish Enlightenment. Seen by some as the "father of economics"——— or ...
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
In ethical philosophy, utilitarianism is a family of normative ethical theories that prescribe actions that maximize happiness and well-being for the affected individuals. In other words, utilitarian ideas encourage actions that lead to the ...
of
and later of
John Stuart Mill
John Stuart Mill (20 May 1806 – 7 May 1873) was an English philosopher, political economist, politician and civil servant. One of the most influential thinkers in the history of liberalism and social liberalism, he contributed widely to s ...
.)
The third step from political economy to economics was the introduction of
marginalism
Marginalism is a theory of economics that attempts to explain the discrepancy in the value of goods and services by reference to their secondary, or marginal, utility. It states that the reason why the price of diamonds is higher than that of wa ...
and the proposition that economic actors made decisions based on
margins
Margin may refer to:
Physical or graphical edges
*Margin (typography), the white space that surrounds the content of a page
*Continental margin, the zone of the ocean floor that separates the thin oceanic crust from thick continental crust
*Leaf ...
. 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.
Marginal revolution
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
Marie-Esprit-Léon Walras (; 16 December 1834 – 5 January 1910) was a French mathematical economics, mathematical economist and Georgist. He formulated the Marginalism, marginal theory of value (independently of William Stanley Jevons and Carl ...
's ''Elements of Pure Economics'' (1874–1877). Historians of economics and economists have debated:
* Whether
utility
In economics, utility is a measure of a certain person's satisfaction from a certain state of the world. Over time, the term has been used with at least two meanings.
* In a normative context, utility refers to a goal or objective that we wish ...
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.
[William Jaffé (1976) "Menger, Jevons, and Walras De-Homogenized", ''Economic Inquiry'', V. 14 (December): 511–25]
In particular, Jevons saw his economics as an application and development of
'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
Classical economics, also known as the classical school of economics, or classical political economy, is a school of thought in political economy that flourished, primarily in Britain, in the late 18th and early-to-mid 19th century. It includ ...
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 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:
* 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 rent
In economics, economic rent is any payment to the owner of a factor of production in excess of the costs needed to bring that factor into production. In classical economics, economic rent is any payment made (including imputed value) or bene ...
s 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.
Cambridge and Lausanne school
Cambridge
Cambridge ( ) is a List of cities in the United Kingdom, city and non-metropolitan district in the county of Cambridgeshire, England. It is the county town of Cambridgeshire and is located on the River Cam, north of London. As of the 2021 Unit ...
and
Lausanne 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 the
marginal equilibrium theory. At the beginning of the 1930s, the Lausanne
general equilibrium theory became the general basis of neoclassical economics and the marginal equilibrium theory was understood as its simplification.
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 was
Alfred Marshall, and among the main representatives were
Arthur Cecil Pigou,
Ralph George Hawtrey and
Dennis Holme Robertson. Pigou worked on the theory of
welfare economics
Welfare economics is a field of economics that applies microeconomic techniques to evaluate the overall well-being (welfare) of a society.
The principles of welfare economics are often used to inform public economics, which focuses on the ...
and the
quantity theory of money. Hawtrey and Robertson developed the Cambridge cash balance approach to
theory of money and influenced the
trade cycle theory. Until the 1930s,
John Maynard Keynes
John Maynard Keynes, 1st Baron Keynes ( ; 5 June 1883 – 21 April 1946), was an English economist and philosopher whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originall ...
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.
The main representatives of the Lausanne school of economic thought were
Léon Walras
Marie-Esprit-Léon Walras (; 16 December 1834 – 5 January 1910) was a French mathematical economics, mathematical economist and Georgist. He formulated the Marginalism, marginal theory of value (independently of William Stanley Jevons and Carl ...
,
Vilfredo Pareto
Vilfredo Federico Damaso Pareto (; ; born Wilfried Fritz Pareto; 15 July 1848 – 19 August 1923) was an Italian polymath, whose areas of interest included sociology, civil engineering, economics, political science, and philosophy. He made severa ...
and
Enrico Barone
Enrico Barone (; 22 December 1859, Naples, Kingdom of the Two Sicilies – 14 May 1924, Rome, Italy) was a soldier, military historian, and an economist.
Biography
Barone studied the classics and mathematics before becoming an army officer. He t ...
. The school became famous for developing the
general equilibrium theory. In the contemporary economy, the general equilibrium theory is the methodologic basis of
mainstream economics
Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Also known as orthodox economics, it can be contrasted to ...
in the form of
New classical macroeconomics and
New Keynesian macroeconomics.
Evolution
The evolution of neoclassical economics can be divided into three phases. The first phase (= a pre-Keynesian phase) is dated between the initial forming of neoclassical economics (the second half of the nineteenth century) and the arrival of
Keynesian economics
Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomics, macroeconomic theories and Economic model, models of how aggregate demand (total spending in the economy) strongl ...
in the 1930s. The second phase is dated between the year 1940 and the half of the 1970s. During this era,
Keynesian economics
Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomics, macroeconomic theories and Economic model, models of how aggregate demand (total spending in the economy) strongl ...
was dominating the world's economy but neoclassical economics did not cease to exist. It continued in the development of its microeconomics theory and began creating its own macroeconomics theory. The development of the neoclassical macroeconomic theory was based on the development of the
quantity theory of money and the
theory of distribution. One of the products of the second phase was the
Neoclassical synthesis, representing a special combination of neoclassical microeconomics and Keynesian macroeconomics. The third phase began in the 1970s. During this era,
Keynesian economics
Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomics, macroeconomic theories and Economic model, models of how aggregate demand (total spending in the economy) strongl ...
was in crisis, which encouraged the creation of new neoclassical lines of thoughts such as
Monetarism and
New classical macroeconomics. Despite the diverse focus and approach of these theories, they are all based on the theoretic and methodologic principles of traditional neoclassical economics.
An important change in neoclassical economics occurred around 1933.
Joan Robinson and
Edward H. Chamberlin, with the nearly simultaneous publication of their respective books, ''
The Economics of Imperfect Competition'' (1933) and ''The Theory of Monopolistic Competition'' (1933), introduced models of
imperfect competition
In economics, imperfect competition refers to a situation where the characteristics of an economic market do not fulfil all the necessary conditions of a perfectly competitive market. Imperfect competition causes market inefficiencies, resulting in ...
. Theories of
market forms and
industrial organization
In economics, industrial organization is a field that builds on the theory of the firm by examining the structure of (and, therefore, the boundaries between) firms and markets. Industrial organization adds real-world complications to the per ...
grew out of this work. They also emphasized certain tools, such as the
marginal revenue curve. In her book, Robinson formalized a type of limited competition. The conclusions of her work for
welfare economics
Welfare economics is a field of economics that applies microeconomic techniques to evaluate the overall well-being (welfare) of a society.
The principles of welfare economics are often used to inform public economics, which focuses on the ...
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 their
marginal productivity of labor and that also the principle of
consumer sovereignty is impaired. This theory heavily influenced the anti–trust policies of many Western countries in the 1940s and 1950s.
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
Vilfredo Federico Damaso Pareto (; ; born Wilfried Fritz Pareto; 15 July 1848 – 19 August 1923) was an Italian polymath, whose areas of interest included sociology, civil engineering, economics, political science, and philosophy. He made severa ...
.
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
The Austrian school is a Heterodox economics, heterodox Schools of economic thought, school of economic thought that advocates strict adherence to methodological individualism, the concept that social phenomena result primarily from the motivat ...
economist
Friedrich Hayek's move to the
London School of Economics
The London School of Economics and Political Science (LSE), established in 1895, is a public research university in London, England, and a member institution of the University of London. The school specialises in the social sciences. Founded ...
, 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
Paul Anthony Samuelson (May 15, 1915 – December 13, 2009) was an American economist who was the first American to win the Nobel Memorial Prize in Economic Sciences. When awarding the prize in 1970, the Swedish Royal Academies stated that he "h ...
's ''
Foundations 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 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
McCarthyism is a political practice defined by the political repression and persecution of left-wing individuals and a Fear mongering, campaign spreading fear of communist and Soviet influence on American institutions and of Soviet espionage i ...
, 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
In mathematical economics, the Arrow–Debreu model is a theoretical general equilibrium model. It posits that under certain economic assumptions (convex preferences, perfect competition, and demand independence), there must be a set of prices su ...
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).
Neoclassical synthesis
Many of these developments were against the backdrop of improvements in both
econometrics
Econometrics is an application of statistical methods to economic data in order to give empirical content to economic relationships. M. Hashem Pesaran (1987). "Econometrics", '' The New Palgrave: A Dictionary of Economics'', v. 2, p. 8 p. 8 ...
, 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
Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study topics such as output (econ ...
, 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
Keynesian economics
Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomics, macroeconomic theories and Economic model, models of how aggregate demand (total spending in the economy) strongl ...
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 macroeconomics today.
Cambridge capital controversy
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.
Criticisms
Although the neoclassical approach is dominant in economics, the field of economics includes others, such as
Marxist
Marxism is a political philosophy and method of socioeconomic analysis. It uses a dialectical and materialist interpretation of historical development, better known as historical materialism, to analyse class relations, social conflic ...
,
behavioral,
Schumpeterian,
developmentalist,
Austrian,
post-Keynesian,
Humanistic economics,
real-world economics and institutionalist schools.
All of these schools differ with the neoclassical school and each other, and incorporate various criticisms of the neoclassical economics.
Not all criticism comes from other schools: some prominent economists such as Nobel Prize recipient and former chief economist of the
World Bank
The World Bank is an international financial institution that provides loans and Grant (money), grants to the governments of Least developed countries, low- and Developing country, middle-income countries for the purposes of economic development ...
Joseph Stiglitz are vocally critical of mainstream neoclassical economics.
Methodology and mathematical models
Some see mathematical models used in contemporary research in mainstream economics as having transcended neoclassical economics, while others disagree. Mathematical models also include those in
game theory
Game theory is the study of mathematical models of strategic interactions. It has applications in many fields of social science, and is used extensively in economics, logic, systems science and computer science. Initially, game theory addressed ...
,
linear programming
Linear programming (LP), also called linear optimization, is a method to achieve the best outcome (such as maximum profit or lowest cost) in a mathematical model whose requirements and objective are represented by linear function#As a polynomia ...
, and
econometrics
Econometrics is an application of statistical methods to economic data in order to give empirical content to economic relationships. M. Hashem Pesaran (1987). "Econometrics", '' The New Palgrave: A Dictionary of Economics'', v. 2, p. 8 p. 8 ...
. 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.
Critics such as
Tony Lawson contend that neoclassical economics' reliance on
functional relations is inadequate for social phenomena in which knowledge of one variable does not reliably predict another. 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 even
pseudoscience and others believing it is still useful but has less certainty and higher risk of methodology problems than in other fields.
Milton Friedman
Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and ...
, 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. 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.
Objectivity and pluralism
Neoclassical economics is often criticized for having a
normative bias despite sometimes claiming to be
"value-free". Such critics argue an
ideological side of neoclassical economics, generally to argue that students should be taught more than one economic theory and that economics departments should be more
pluralistic.
Rational behavior assumptions
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. The economist and critic of capitalism
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."
Veblen's characterization references a number of commonly criticized rationality assumptions: that people make decisions using a rigid
utilitarian framework, have perfect information available about their options, have perfect information processing ability allowing them to immediately calculate
utility
In economics, utility is a measure of a certain person's satisfaction from a certain state of the world. Over time, the term has been used with at least two meanings.
* In a normative context, utility refers to a goal or objective that we wish ...
for all possible options, and are independent decision-makers whose choices are unaffected by their surroundings or by other people. While Veblen is from the
Institutional school, the
Behavioral school of economics is focused on studying the mechanisms of human
decision-making
In psychology, decision-making (also spelled decision making and decisionmaking) is regarded as the Cognition, cognitive process resulting in the selection of a belief or a course of action among several possible alternative options. It could be ...
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. Behavioral economists account for how psychological, neurological, and even emotional factors significantly affect economic perceptions and behaviors.
Rational choice theory
Rational choice modeling refers to the use of decision theory (the theory of rational choice) as a set of guidelines to help understand economic and social behavior. The theory tries to approximate, predict, or mathematically model human behav ...
need not be problematic according to a paper written by the economist
Gary Becker which was published in 1962 in the ''
Journal of Political Economy'' called "Irrational Behavior and Economic Theory".
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" by
Armen Alchian.
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.
Methodological individualism
Neoclassical economics offers an approach to studying the economic behavior of ''homo-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. 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.
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. 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. Given the individualistic foundation of the economic theory, critics argue that this theory should consider individual action's structural contexts.
Inequality
Neoclassical economics is often criticized as promoting policies that increase
inequality 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, 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.
Ethics of markets
Neoclassical economics tends to promote
commodification and
privatization 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. However, there are arguments in
moral philosophy
Ethics is the philosophical study of moral phenomena. Also called moral philosophy, it investigates normative questions about what people ought to do or which behavior is morally right. Its main branches include normative ethics, applied et ...
that use of markets for certain goods is inherently unethical. Political philosopher
Michael Sandel
Michael Joseph Sandel (; born March 5, 1953) is an American political philosopher and the Anne T. and Robert M. Bass Professor of Government at Harvard University, where his course ''Justice'' was the university's first course to be made fre ...
summarizes that market exchanges have two ethical problems: coercion and corruption.
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.
See also
*
Marginalism
Marginalism is a theory of economics that attempts to explain the discrepancy in the value of goods and services by reference to their secondary, or marginal, utility. It states that the reason why the price of diamonds is higher than that of wa ...
*
Market economy
*
Microeconomics
Microeconomics is a branch of economics that studies the behavior of individuals and Theory of the firm, firms in making decisions regarding the allocation of scarcity, scarce resources and the interactions among these individuals and firms. M ...
*
Static equilibrium (economics)
References
External links
*
Neoclassical Economics William King,
Drexel University
Drexel University is a private university, private research university with its main campus in Philadelphia, Pennsylvania, United States. Drexel's undergraduate school was founded in 1891 by Anthony Joseph Drexel, Anthony J. Drexel, a financier ...
{{Authority control
Thorstein Veblen
1900s neologisms