Neoclassical Economics

References

• Neoclassical Economics Wikipedia Article

Notes

Neoclassical economics is an approach to economics in which the production, consumption, and valuation (pricing) of goods and service are observed as driven by the supply and demand model. According to this line of thought, the value of a good or service is determined through a hypothetical maximalization 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.

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 onwards.

Classification

• The term was originally introduced by Thorstein Veblen in his 1900 article Preconceptions of Economic Science, in which he relates marginalists in the tradition of Alfred Marshall et al. in the Austrian School:
• • 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 water owes to the greater additional satisfaction of the diamonds over the water. Thus, while the water has greater total utility, the diamond has greater marginal utility.

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.

• Today, it is used to refer to mainstream economics.
• Neoclassical economics is characterized by several assumptions common to many schools of economic thought.
• There is not complete agreement on what is meant by neoclassical economics.

Theory

Assumptions and Objectives

1. People have rational preferences between outcomes that can be identified and associated with values.

• • Rational choice theory refers to a set of guidelines that help understand economic and social behavior. The theory originated in the eighteenth century and can be traced back to Adam Smith. The theory postulates that an individual will perform cost-benefit analysis to determine whether an option is right for them.

2. Individuals maximize utility and firms maximize profits.

• • In microeconomics, the utility maximalization problem is the problem consumers face: How should I spend my money in order to maximize my utility?
  • In economics, profit maximization is the short run or long run process by which a firm may determine the price, input and output levels that will lead to the highest possible total profit.

3. People act independently on the basis of full and relevant information.

• • In economics, perfect information is a feature of perfect competition. With perfect information in a market, all consumers and producers have complete and instantaneous knowledge of all market prices, their own utility, and own cost functions.
• The allocation of scarce resources among alternative ends is often considered the definition of economics to neoclassical theorists.

Supply and Demand Model

• An important device of neoclassical market analysis is the graph presenting supply and demand curves

• 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).
• Neoclassical economics emphasizes equilibria, which are the solutions f agent maximalization problems. Regularities in economics 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.

Utility Theory of Value

• The utility theory of value states that the value of a good is determined by the marginal utility experienced by the user.
• • This is a distinguishing factor of neoclassical economics as earlier schools of thought emphasized the labor theory of value.
• 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.

Market Failure and Externalities

• 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.

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 pursing 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 is called the Pareto optimum (criterion) after its discoverer Vilfredo Pareto.
• Normative (fairness) judgements 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.

International Trade

• They favor free trade according to Ricardo's theory of comparative advantage.

Origins

• Neoclassical economics broke from classical economics in how they emphasized the consumers' role in determining the price of a good and in their emphasis on margins' role in economic decisions.

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. This revolution occurred near the end of the 19th century.
• Historians have debated:
• • Whether utility or marginalism was more essential to the revolution
  • Whether this new school of thought was truly revolutionary
  • Whether grouping these economists together disguises differences more important than their similarities

Cambridge and Lausanne School

• Cambridge 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 general equilibrium theory attempts to explain the behavior of supply, demands, and prices in a whole economy with several or many interacting markets, by seeking to prove the interaction if demand and supply will result in an overall general equilibrium.

Evolution

• The development of neoclassical economics can be divided into three phrases.

1. The first phase is dated between the initial forming of neoclassical economics in the second half of the 19th century and the arrival of Keynesian economics in the 1930s
2. The second is dated between the year 1940 and the second half of the 1970s
3. 1. During this phase Keynesian economics dominated.
3. 1. One of the products of the second phase was the Neoclassical synthesis, representing a special combination of neoclassical microeconomics and Keynesian macroeconomics.
3. The third phase began in the 1970s
4. 1. During this phase Keynesian economics was in crisis.

• In 1933, Joan Robinson published The Economics of Imperfect Competition which introduced models of imperfect competition.

The conclusions of her work for welfare 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 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.

Neoclassical Synthesis

• 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 1950 to the 1970s.
• The dominance of Keynesian economics was upset by its inability to explain the economic crises of the 197-s - 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.

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.

Criticisms

Methodology and Mathematical Models

• Some see mathematical models used in contemporary research in mainstream economics as having transcended neoclassical economics, while others disagree.

Objectivity and Pluralism

• Neoclassical economics is often criticized for having a normative bias despite sometimes claiming to be value-free.

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 in reality.

Inequality

• Neoclassical economics is often criticized as promoting policies that increase inequality and as failing to recognize the impact of inequality on economic outcomes.

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.