Neoclassical economics
Encyclopedia
Neoclassical economics is a term variously used for approaches to economics
focusing on the determination of prices, outputs, and income distribution
s in markets through supply and demand
, often mediated through a hypothesized maximization of utility
by income-constrained individuals and of profit
s by cost-constrained firms employing available information and factors of production, in accordance with rational choice theory
. Neoclassical economics dominates microeconomics, and together with Keynesian economics
forms the neoclassical synthesis
, which dominates mainstream economics
today. There have been many critiques of neoclassical economics, often incorporated into newer versions of neoclassical theory as human awareness of economic criteria changes.
The term was originally introduced by Thorstein Veblen
in 1900, in his Preconceptions of Economic Science, to distinguish marginalist
s in the tradition of Alfred Marshall
from those in the Austrian School
.
It was later used by John Hicks
, George Stigler
, and others to include the work of Carl Menger
, William Stanley Jevons
, 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.
As expressed by E. Roy Weintraub
, neoclassical economics rests on three assumptions, although certain branches of neoclassical theory may have different approaches:
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".
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, where equilibria 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
.
, 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 margin
s. For example, a person decides to buy a second sandwich based on how full they are 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.
's Theory of Political Economy (1871), Carl Menger
's Principles of Economics (1871), and Leon Walras
's Elements of Pure Economics (1874–1877). These three economists have been said to have begun “the Marginal Revolution”. Historians of economics and economists have debated:
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. Walras' conception of utility, like that of Menger, was that of usefulness in general, rather than the hedonic conception of Bentham or of Mill; and 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:
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.
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 curve
s 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
.
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 Gerard 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 has been the dominant paradigm of economic reasoning in English-speaking countries since the 1950s. Hicks and Samuelson were for example instrumental in mainstreaming Keynesian economics.
Macroeconomics influenced the neoclassical synthesis from the other direction, undermining foundations of classical economic theory such as Say's Law
, and assumptions about political economy
such as the necessity for a hard-money standard. These developments are reflected in neoclassical theory by the search for the occurrence in markets of the equilibrium conditions of Pareto optimality and self-sustainability.
bias. In this view, it does not focus on explaining actual economies, but instead on describing a "utopia" in which Pareto optimality
applies.
The assumption that individuals act rationally may be viewed as ignoring important aspects of human behavior. Many see the "economic man
" as being quite different from real people. Many economists, even contemporaries, have criticized this model of economic man. Thorstein Veblen
put it most sardonically. Neoclassical economics assumes a person to be,
Large corporations might perhaps come closer to the neoclassical ideal of profit maximization, but this is not necessarily viewed as desirable if this comes at the expense of neglect of wider social issues. The response to this is that neoclassical economics is descriptive and not normative. It addresses such problems with concepts of private versus social utility.
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 the 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 the equilibrium is stable and unique are quite restrictive.
Neoclassical economics is also often seen 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 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
. Critics of neoclassical economics are divided in those who think that highly mathematical method is inherently wrong and those who think that mathematical method is potentially good even if contemporary methods have problems.
The assumption of rational expectations
which has been introduced in some more modern neoclassical models (sometimes also called new classical) can also be criticized on the grounds of realism.
In general, allegedly overly unrealistic assumptions are one of the most common criticisms towards neoclassical economics. It is fair to say that many (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).
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
focusing on the determination of prices, outputs, and income distribution
Distribution (economics)
Distribution in economics refers to the way total output, income, or wealth is distributed among individuals or among the factors of production .. In general theory and the national income and product accounts, each unit of output corresponds to a unit of income...
s in markets through supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
, often mediated through a hypothesized maximization of utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....
by income-constrained individuals and of profit
Profit (economics)
In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
s by cost-constrained firms employing available information and factors of production, in accordance with rational choice theory
Rational choice theory
Rational choice theory, also known as choice theory or rational action theory, is a framework for understanding and often formally modeling social and economic behavior. It is the main theoretical paradigm in the currently-dominant school of microeconomics...
. Neoclassical economics dominates microeconomics, and together with Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
forms the neoclassical synthesis
Neoclassical synthesis
Neoclassical synthesis is a postwar academic movement in economics that attempts to absorb the macroeconomic thought of John Maynard Keynes into the thought of neoclassical economics...
, which dominates mainstream economics
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
today. There have been many critiques of neoclassical economics, often incorporated into newer versions of neoclassical theory as human awareness of economic criteria changes.
The term was originally introduced by Thorstein Veblen
Thorstein Veblen
Thorstein Bunde Veblen, born Torsten Bunde Veblen was an American economist and sociologist, and a leader of the so-called institutional economics movement...
in 1900, in his Preconceptions of Economic Science, to distinguish marginalist
Marginalism
Marginalism refers to the use of marginal concepts in economic theory. Marginalism is associated with arguments concerning changes in the quantity used of a good or service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity...
s in the tradition of Alfred Marshall
Alfred Marshall
Alfred Marshall was an Englishman and one of the most influential economists of his time. His book, Principles of Economics , was the dominant economic textbook in England for many years...
from those in the Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...
.
"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
John Hicks
Sir John Richard Hicks was a British economist and one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model , which...
, George Stigler
George Stigler
George Joseph Stigler was a U.S. economist. He won the Nobel Memorial Prize in Economic Sciences in 1982, and was a key leader of the Chicago School of Economics, along with his close friend Milton Friedman....
, and others to include the work of Carl Menger
Carl Menger
Carl Menger was the founder of the Austrian School of economics, famous for contributing to the development of the theory of marginal utility, which contested the cost-of-production theories of value, developed by the classical economists such as Adam Smith and David Ricardo.- Biography :Menger...
, William Stanley Jevons
William Stanley Jevons
William Stanley Jevons was a British economist and logician.Irving Fisher described his book The Theory of Political Economy as beginning the mathematical method in economics. It made the case that economics as a science concerned with quantities is necessarily mathematical...
, John Bates Clark
John Bates Clark
John Bates Clark was an American neoclassical economist. He was one of the pioneers of the marginalist revolution and opponent to the Institutionalist school of economics, and spent most of his career teaching at Columbia University.-Biography:Clark was born and raised in Providence, Rhode...
and many others. Today it is usually used to refer to mainstream economics
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
, although it has also been used as an umbrella term
Umbrella term
An umbrella term is a word that provides a superset or grouping of concepts that all fall under a single common category. Umbrella term is also called a hypernym. For example, cryptology is an umbrella term that encompasses cryptography and cryptanalysis, among other fields...
encompassing a number of other schools of thought, notably excluding institutional economics
Institutional economics
Institutional economics focuses on understanding the role of the evolutionary process and the role of institutions in shaping economic behaviour. Its original focus lay in Thorstein Veblen's instinct-oriented dichotomy between technology on the one side and the "ceremonial" sphere of society on the...
, various historical schools of economics
Historical school of economics
The Historical school of economics was an approach to academic economics and to public administration that emerged in 19th century in Germany, and held sway there until well into the 20th century....
, and Marxian economics
Marxian economics
Marxian economics refers to economic theories on the functioning of capitalism based on the works of Karl Marx. Adherents of Marxian economics, particularly in academia, distinguish it from Marxism as a political ideology and sociological theory, arguing that Marx's approach to understanding the...
, in addition to various other heterodox approaches to economics
Heterodox economics
"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...
.
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.
As expressed by E. Roy Weintraub
E. Roy Weintraub
E. Roy Weintraub is an American economist and mathematician. He works as a Professor of Economics in Duke University.Weintraub was trained as a mathematician though his professional career has been as an economist. In recent years his research and teaching activities have focused upon the history...
, neoclassical economics rests on three assumptions, although certain branches of neoclassical theory may have different approaches:
- People have rational preferencesRational choice theoryRational choice theory, also known as choice theory or rational action theory, is a framework for understanding and often formally modeling social and economic behavior. It is the main theoretical paradigm in the currently-dominant school of microeconomics...
among outcomes that can be identified and associated with a value. - Individuals maximize utility and firms maximize profitsProfit maximizationIn economics, profit maximization is the process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem...
. - People act independently on the basis of full and relevant informationInformation asymmetryIn economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
.
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
William Stanley Jevons
William Stanley Jevons was a British economist and logician.Irving Fisher described his book The Theory of Political Economy as beginning the mathematical method in economics. It made the case that economics as a science concerned with quantities is necessarily mathematical...
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
Theory of the firm
The theory of the firm consists of a number of economic theories that describe the nature of the firm, company, or corporation, including its existence, behavior, structure, and relationship to the market.-Overview:...
, while the derivation of demand
Demand
- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...
curves leads to an understanding of consumer goods, and the supply
Supply (economics)
In economics, supply is the amount of some product producers are willing and able to sell at a given price all other factors being held constant. Usually, supply is plotted as a supply curve showing the relationship of price to the amount of product businesses are willing to sell.In economics the...
curve allows an analysis of the factors of production
Factors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
. 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
Reservation price
In microeconomics, the reservation price is the highest price a buyer is willing to pay for goods or a service; or; the smallest price at which a seller is willing to sell a good or service...
. 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
Production, costs, and pricing
The following outline is provided as an overview of and topical guide to industrial organization:Industrial organization – describes the behavior of firms in the marketplace with regard to production, pricing, employment and other decisions...
relationship of that factor in the output market.
Neoclassical economics emphasizes equilibria, where equilibria are the solutions of agent
Agent (economics)
In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....
maximization problems. Regularities in economies are explained by methodological individualism
Methodological individualism
Methodological individualism is the theory that social phenomena can only be accurately explained by showing how they result from the intentional states that motivate the individual actors. The idea has been used to criticize historicism, structural functionalism, and the roles of social class,...
, the position that economic phenomena can be explained by aggregating over the behavior of agents. The emphasis is on microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...
. Institutions, which might be considered as prior to and conditioning individual behavior, are de-emphasized. Economic subjectivism accompanies these emphases. See also general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
.
Origins
Classical economicsClassical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....
, developed in the 18th and 19th centuries, included a value theory
Value theory
Value theory encompasses a range of approaches to understanding how, why and to what degree people should value things; whether the thing is a person, idea, object, or anything else. This investigation began in ancient philosophy, where it is called axiology or ethics. Early philosophical...
and distribution
Distribution (economics)
Distribution in economics refers to the way total output, income, or wealth is distributed among individuals or among the factors of production .. In general theory and the national income and product accounts, each unit of output corresponds to a unit of income...
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
Adam Smith was a Scottish social philosopher and a pioneer of political economy. One of the key figures of the Scottish Enlightenment, Smith is the author of The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations...
and David Ricardo
David Ricardo
David Ricardo was an English political economist, often credited with systematising economics, and was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill. He was also a member of Parliament, businessman, financier and speculator,...
.
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
Utilitarianism
Utilitarianism is an ethical theory holding that the proper course of action is the one that maximizes the overall "happiness", by whatever means necessary. It is thus a form of consequentialism, meaning that the moral worth of an action is determined only by its resulting outcome, and that one can...
of Jeremy Bentham
Jeremy Bentham
Jeremy Bentham was an English jurist, philosopher, and legal and social reformer. He became a leading theorist in Anglo-American philosophy of law, and a political radical whose ideas influenced the development of welfarism...
and later of John Stuart Mill
John Stuart Mill
John Stuart Mill was a British philosopher, economist and civil servant. An influential contributor to social theory, political theory, and political economy, his conception of liberty justified the freedom of the individual in opposition to unlimited state control. He was a proponent of...
.)
The third step from political economy to economics was the introduction of marginalism
Marginalism
Marginalism refers to the use of marginal concepts in economic theory. Marginalism is associated with arguments concerning changes in the quantity used of a good or service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity...
and the proposition that economic actors made decisions based on margin
Margin (economics)
In economics, a margin is a set of constraints conceptualised as a border. A marginal change is the change associated with a relaxation or tightening of constraints — either change of the constraints, or a change in response to this change of the constraints.- Extensive and intensive margins...
s. For example, a person decides to buy a second sandwich based on how full they are 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 Marginal Revolution
Neoclassical economics is frequently dated from William Stanley JevonsWilliam Stanley Jevons
William Stanley Jevons was a British economist and logician.Irving Fisher described his book The Theory of Political Economy as beginning the mathematical method in economics. It made the case that economics as a science concerned with quantities is necessarily mathematical...
's Theory of Political Economy (1871), Carl Menger
Carl Menger
Carl Menger was the founder of the Austrian School of economics, famous for contributing to the development of the theory of marginal utility, which contested the cost-of-production theories of value, developed by the classical economists such as Adam Smith and David Ricardo.- Biography :Menger...
's Principles of Economics (1871), and Leon Walras
Léon Walras
Marie-Esprit-Léon Walras was a French mathematical economist associated with the creation of the general equilibrium theory.-Life and career:...
's Elements of Pure Economics (1874–1877). These three economists have been said to have begun “the Marginal Revolution”. Historians of economics and economists have debated:
- Whether utilityUtilityIn economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....
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
Jeremy Bentham
Jeremy Bentham was an English jurist, philosopher, and legal and social reformer. He became a leading theorist in Anglo-American philosophy of law, and a political radical whose ideas influenced the development of welfarism...
'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. Walras' conception of utility, like that of Menger, was that of usefulness in general, rather than the hedonic conception of Bentham or of Mill; and Walras was more interested in the interaction of markets than in explaining the individual psyche.
Alfred Marshall
Alfred Marshall
Alfred Marshall was an Englishman and one of the most influential economists of his time. His book, Principles of Economics , was the dominant economic textbook in England for many years...
'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
Maffeo Pantaleoni
Maffeo Pantaleoni was an Italian economist, and a notable proponent of neoclassical economics. He was occasionally referred to as "the Marshall of Italy", because of his unrelenting defence of laissez-faire economic policies....
by calling him the "Marshall of Italy". Marshall thought classical economics
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....
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 costMarginal costIn economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good...
and marginal revenueMarginal revenueIn microeconomics, marginal revenue is the extra revenue that an additional unit of product will bring. It is the additional income from selling one more unit of a good; sometimes equal to price...
, where profits are maximized. Economic rentEconomic rentEconomic rent is typically defined by economists as payment for goods and services beyond the amount needed to bring the required factors of production into a production process and sustain supply. A recipient of economic rent is a rentier....
s exist in short period equilibrium for fixed factors, and the rate of profit is not equated across sectors. - Long period. The stock of capitalCapital (economics)In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
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.
Further developments
An important change in neoclassical economics occurred around 1933. Joan RobinsonJoan Robinson
Joan Violet Robinson FBA was a post-Keynesian economist who was well known for her knowledge of monetary economics and wide-ranging contributions to economic theory...
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
Imperfect competition
In economic theory, imperfect competition is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied...
. Theories of market forms and industrial organization
Industrial organization
Industrial organization is the field of economics that builds on the theory of the firm in examining the structure of, and boundaries between, firms and markets....
grew out of this work. They also emphasized certain tools, such as the marginal revenue
Marginal revenue
In microeconomics, marginal revenue is the extra revenue that an additional unit of product will bring. It is the additional income from selling one more unit of a good; sometimes equal to price...
curve.
Joan Robinson's work on imperfect competition, at least, was a response to certain problems of Marshallian partial equilibrium
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
theory highlighted by Piero Sraffa
Piero Sraffa
Piero Sraffa was an influential Italian economist whose book Production of Commodities by Means of Commodities is taken as founding the Neo-Ricardian school of Economics.- Early life :...
. Anglo-American economists also responded to these problems by turning towards general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
theory, developed on the European continent by Walras and Vilfredo Pareto
Vilfredo Pareto
Vilfredo Federico Damaso Pareto , born Wilfried Fritz Pareto, was an Italian engineer, sociologist, economist, political scientist and philosopher. He made several important contributions to economics, particularly in the study of income distribution and in the analysis of individuals' choices....
. J. R. Hicks's Value and Capital
Value and Capital
Value and Capital is a book by the British economist John Richard Hicks, published in 1939. It is considered a classic exposition of microeconomic theory...
(1939) was influential in introducing his English-speaking colleagues to these traditions. He, in turn, was influenced by the Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...
economist Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...
's move to the London School of Economics
London School of Economics
The London School of Economics and Political Science is a public research university specialised in the social sciences located in London, United Kingdom, and a constituent college of the federal University of London...
, where Hicks then studied.
These developments were accompanied by the introduction of new tools, such as indifference curve
Indifference curve
In microeconomic theory, an indifference curve is a graph showing different bundles of goods between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another. One can equivalently refer to each point on the indifference curve...
s and the theory of ordinal utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....
. The level of mathematical sophistication of neoclassical economics increased. Paul Samuelson
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...
's Foundations of Economic Analysis
Foundations of Economic Analysis
Foundations of Economic Analysis is a book by Paul A. Samuelson published in 1947 by Harvard University Press. It sought to demonstrate a common mathematical structure underlying multiple branches of economics from two basic principles: maximizing behavior of agents and stability of equilibrium...
(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
Institutional economics
Institutional economics focuses on understanding the role of the evolutionary process and the role of institutions in shaping economic behaviour. Its original focus lay in Thorstein Veblen's instinct-oriented dichotomy between technology on the one side and the "ceremonial" sphere of society on the...
competing for allegiance. Frank Knight
Frank Knight
Frank Hyneman Knight was an American economist who spent most of his career at the University of Chicago, where he became one of the founders of the Chicago school. Nobel laureates James M. Buchanan, Milton Friedman and George Stigler were all students of Knight at Chicago. Knight supervised...
, an early Chicago school
Chicago school (economics)
The Chicago school of economics describes a neoclassical school of thought within the academic community of economists, with a strong focus around the faculty of The University of Chicago, some of whom have constructed and popularized its principles...
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
World War II
World War II, or the Second World War , was a global conflict lasting from 1939 to 1945, involving most of the world's nations—including all of the great powers—eventually forming two opposing military alliances: the Allies and the Axis...
.
Hicks' book, Value and Capital
Value and Capital
Value and Capital is a book by the British economist John Richard Hicks, published in 1939. It is considered a classic exposition of microeconomic theory...
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
Arrow-Debreu model
In mathematical economics, the Arrow–Debreu model suggests that under certain economic assumptions there must be a set of prices such that aggregate supplies will equal aggregate demands for every commodity in the economy.The model is central to the theory of...
of intertemporal equilibrium
Intertemporal equilibrium
Intertemporal equilibrium is a notion of economic equilibrium conceived over many periods of time. The term has a different meaning in contemporary macroeconomics from its earlier meaning in Austrian economics....
. The Arrow-Debreu model has canonical presentations in Gerard 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
Econometrics
Econometrics has been defined as "the application of mathematics and statistical methods to economic data" and described as the branch of economics "that aims to give empirical content to economic relations." More precisely, it is "the quantitative analysis of actual economic phenomena based on...
, 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
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
, or the study of whole economies. The attempt to combine neo-classical microeconomics and Keynesian
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
macroeconomics would lead to the neoclassical synthesis
Neoclassical synthesis
Neoclassical synthesis is a postwar academic movement in economics that attempts to absorb the macroeconomic thought of John Maynard Keynes into the thought of neoclassical economics...
which has been the dominant paradigm of economic reasoning in English-speaking countries since the 1950s. Hicks and Samuelson were for example instrumental in mainstreaming Keynesian economics.
Macroeconomics influenced the neoclassical synthesis from the other direction, undermining foundations of classical economic theory such as Say's Law
Say's law
Say's law, or the law of market, is an economic principle of classical economics named after the French businessman and economist Jean-Baptiste Say , who stated that "products are paid for with products" and "a glut can take place only when there are too many means of production applied to one kind...
, and assumptions about political economy
Political economy
Political economy originally was the term for studying production, buying, and selling, and their relations with law, custom, and government, as well as with the distribution of national income and wealth, including through the budget process. Political economy originated in moral philosophy...
such as the necessity for a hard-money standard. These developments are reflected in neoclassical theory by the search for the occurrence in markets of the equilibrium conditions of Pareto optimality and self-sustainability.
Criticisms
Neoclassical economics is sometimes criticized for having a normativeNormative economics
Normative economics is that part of economics that expresses value judgments about economic fairness or what the economy ought to be like or what goals of public policy ought to be....
bias. In this view, it does not focus on explaining actual economies, but instead on describing a "utopia" in which Pareto optimality
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...
applies.
The assumption that individuals act rationally may be viewed as ignoring important aspects of human behavior. Many see the "economic man
Homo economicus
Homo economicus, or Economic human, is the concept in some economic theories of humans as rational and narrowly self-interested actors who have the ability to make judgments toward their subjectively defined ends...
" as being quite different from real people. Many economists, even contemporaries, have criticized this model of economic man. Thorstein Veblen
Thorstein Veblen
Thorstein Bunde Veblen, born Torsten Bunde Veblen was an American economist and sociologist, and a leader of the so-called institutional economics movement...
put it most sardonically. 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."
Large corporations might perhaps come closer to the neoclassical ideal of profit maximization, but this is not necessarily viewed as desirable if this comes at the expense of neglect of wider social issues. The response to this is that neoclassical economics is descriptive and not normative. It addresses such problems with concepts of private versus social utility.
Problems exist with making the neoclassical general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
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
Cambridge capital controversy
The Cambridge capital controversy – sometimes simply called "the capital controversy" – refers to a theoretical and mathematical debate during the 1960s among economists concerning the nature and role of capital goods and the critique of the dominant neoclassical vision of aggregate...
"—about the validity of neoclassical economics, with an emphasis on the economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
, capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
, 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
Sonnenschein-Mantel-Debreu Theorem
The Sonnenschein–Mantel–Debreu theorem is a result in general equilibrium economics. It states that the excess demand function for an economy is not restricted by the usual rationality restrictions on individual demands in the economy...
suggests that the assumptions that must be made to ensure that the equilibrium is stable and unique are quite restrictive.
Neoclassical economics is also often seen as relying too heavily on complex mathematical models, such as those used in general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
theory, without enough regard to whether these actually describe the real economy. Many 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
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
'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
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...
, linear programming
Linear programming
Linear programming is a mathematical method for determining a way to achieve the best outcome in a given mathematical model for some list of requirements represented as linear relationships...
, and econometrics
Econometrics
Econometrics has been defined as "the application of mathematics and statistical methods to economic data" and described as the branch of economics "that aims to give empirical content to economic relations." More precisely, it is "the quantitative analysis of actual economic phenomena based on...
. Critics of neoclassical economics are divided in those who think that highly mathematical method is inherently wrong and those who think that mathematical method is potentially good even if contemporary methods have problems.
The assumption of rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...
which has been introduced in some more modern neoclassical models (sometimes also called new classical) can also be criticized on the grounds of realism.
In general, allegedly overly unrealistic assumptions are one of the most common criticisms towards neoclassical economics. It is fair to say that many (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).
See also
- microeconomicsMicroeconomicsMicroeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...
- static equilibrium
- marginalismMarginalismMarginalism refers to the use of marginal concepts in economic theory. Marginalism is associated with arguments concerning changes in the quantity used of a good or service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity...
- neo-classical synthesis
External links
- Neoclassical economics from the Concise Library of Economics
- Introduction to neoclassical economics at Drexel