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Neoclassical economics is an approach to economics in which the production, consumption and valuation (pricing) of goods and services are driven by the
supply and demand In microeconomics, supply and demand is an economic model In economics, a model is a theory, theoretical construct representing economic wikt:process, processes by a set of Variable (mathematics), variables and a set of logical and/or quant ...

supply and demand
model. According to this line of thought, the value of a good or service is determined through a hypothetical maximization of
utility As a topic of economics Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within thos ...

utility
by income-constrained individuals and of profits by firms facing production costs and employing available information and
factors of production In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods a ...
. This approach has often been justified by appealing to
rational choice theory Rational choice theory, also known as theory of rational choice, choice theory or rational action theory, is a framework for understanding and often formally Model (abstract), modeling social and economic behavior. It dictates that every person, ...
, a theory that has come under considerable question in recent years. Neoclassical economics dominated
microeconomics Microeconomics is a branch of that studies the behavior of individuals and in making decisions regarding the allocation of and the interactions among these individuals and firms. Microeconomics focuses on the study of individual markets, se ...
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 The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a post-World War II World War II or the Second World War, often abbreviated as WWII or WW2, was a World war, global war that lasted from ...
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 het ...
as
neo-Keynesian economics Neo-Keynesian economics is a school of macroeconomic thought that was developed in the post-war period from the writings of John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946) was an English ...
from the 1950s to the 1970s.Clark, B. (1998). ''Principles of political economy: A comparative approach''. Westport, Connecticut: Praeger. Nadeau, R. L. (2003). ''The Wealth of Nature: How mainstream economics has failed the environment.'' New York City, NY: Columbia University Press. It competed with
new Keynesian economics New Keynesian economics is a school of macroeconomics that strives to provide microfoundations, microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new cla ...
as
new classical macroeconomics New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical economics, neoclassical framework. Specifically, it emphasizes the importan ...
in explaining macroeconomic phenomena from the 1970s until the 1990s, when it was identified as having become a part of the
new neoclassical synthesis The new neoclassical synthesis (NNS) or new synthesis is the fusion of the major, modern macroeconomic schools of thought, new classical and New-Keynesianism, into a consensus on the best way to explain short-run fluctuations in the economy. Thi ...
along with new Keynesianism. There have been many critiques of neoclassical economics, a number of which have been incorporated into newer versions of neoclassical theory, whilst some remain distinct fields.


Classification

The term was originally introduced by
Thorstein Veblen Thorstein Bunde Veblen (July 30, 1857 – August 3, 1929) was a Norwegian-American economist and sociologist who, during his lifetime, emerged as a well-known critic of capitalism. In his best-known book, ''The Theory of the Leisure Class'' (1 ...
in his 1900 article "Preconceptions of Economic Science", in which he related marginalists in the tradition of
Alfred Marshall Alfred Marshall (26 July 1842 – 13 July 1924) was an English economist, who was one of the most influential economists of his time. His book, '' Principles of Economics'' (1890), was the dominant economic textbook in England for many years. ...

Alfred Marshall
et al. to those in the
Austrian School The Austrian School is a heterodox In religion, heterodoxy (from Ancient Greek Ancient Greek includes the forms of the Greek language used in ancient Greece and the classical antiquity, ancient world from around 1500 BC to 300 BC. It ...
.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 Sir John Hicks (8 April 1904 – 20 May 1989) was a British economist An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply theories and concepts from ...

John Hicks
,
George Stigler George Joseph Stigler (; January 17, 1911 – December 1, 1991) was an American economist An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply theorie ...
, and others George J. Stigler (1941 . ''Production and Distribution Theories''. New York: Macmillan
Preview.
/ref> to include the work of
Carl Menger Carl Menger (; ; 28 February 1840 – 26 February 1921) was an Austrian economist and the founder of the Austrian School of economics. Menger contributed to the development of the theory of marginalism (marginal utility), which rejected the cos ...
,
William Stanley Jevons William Stanley Jevons FRS (; 1 September 183513 August 1882) was an English economist An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply theories ...

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 Men ...
,
John Bates Clark John Bates Clark (January 26, 1847 – March 21, 1938) was an American neoclassical economist An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply the ...

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 het ...
, although it has also been used as an
umbrella term In linguistics, hyponymy (from Greek language, Greek ὑπό, ''hupó'', "under", and ὄνυμα, ''ónuma'', "name") is a semantics, semantic relation between a hyponym denoting a subtype and a hypernym or hyperonym denoting a supertype. In oth ...
encompassing a number of other schools of thought, notably excluding
institutional economics Institutional economics focuses on understanding the role of the evolutionary Evolution is change in the Heredity, heritable Phenotypic trait, characteristics of biological populations over successive generations. These characteristics are t ...
, various historical schools of economics, and
Marxian economics Marxian economics, or the Marxian school of economics, is a school of political economic thought. Its foundations can be traced back to . However, unlike , Marxian economists tend to accept the concept of as a reasonable object of inquiry in i ...
, in addition to various other heterodox approaches to economics. Neoclassical economics is characterized by several assumptions common to many
schools of economic thought A school is an educational institution designed to provide learning spaces and learning environments for the teaching of students (or "pupils") under the direction of teachers. Most countries have systems of formal education, which is someti ...
. 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 . # People act independently on the basis of full and relevant information. From these three assumptions, neoclassical economists have built a structure to understand the allocation of scarce resources among alternative ends—in fact, understanding such allocation is often considered the definition of economics to neoclassical theorists. Here's how
William Stanley Jevons William Stanley Jevons FRS (; 1 September 183513 August 1882) was an English economist An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply theories ...

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 The theory of the firm consists of a number of economic theories Economics () is the social science that studies how people interact with value; in particular, the production, distribution, and consumption of goods and services Goo ...
, while the derivation of
demand In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...

demand
curves A curve In mathematics, a curve (also called a curved line in older texts) is an object similar to a line (geometry), line, but that does not have to be Linearity, straight. Intuitively, a curve may be thought of as the trace left by a moving p ...

curves
leads to an understanding of
consumer good A final good or consumer good is a final product ready for sale that is used by the consumer to satisfy current wants or needs, unlike intermediate goods which is utilized to produce other goods. A microwave oven or a bicycle is a final good, wher ...
s, and the
supply Supply may refer to: *The amount of a resource Resource refers to all the materials available in our environment which help us to satisfy our needs and wants. Resources can broadly be classified upon their availability — they are classified int ...
curve allows an analysis of the
factors of production In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods a ...
. 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 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 are reflecting 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 Agent may refer to: Espionage, investigation, and law *, spies or intelligence officers * Law of agency, laws involving a person authorized to act on behalf of another ** Agent of record, a person with a contractual agreement with an insuran ...
maximization problems. Regularities in economies are explained by
methodological individualism In the social sciences, methodological individualism is the principle that subjective individual motivation explains social phenomena, rather than class or group dynamics which are (according to proponents of individualistic principles) illusory ...
, 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 that studies the behavior of individuals and in making decisions regarding the allocation of and the interactions among these individuals and firms. Microeconomics focuses on the study of individual markets, se ...
. Institutions, which might be considered as prior to and conditioning individual behavior, are de-emphasized.
Economic subjectivism An economy (from Greek Greek may refer to: Greece Anything of, from, or related to Greece Greece ( el, Ελλάδα, , ), officially the Hellenic Republic, is a country located in Southeast Europe. Its population is approximately 10.7 m ...
accompanies these emphases. See also
general equilibrium In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods a ...
.


Utility theory of value

Neoclassical economics uses the
utility theory of valueIn economics, utility is the satisfaction or benefit derived by consuming a product; thus the marginal utility of a Goods (economics), good or Service (economics), service is the change in the utility from an increase in the Consumption (economics), ...
, which states that the value of a good is determined by the
marginal utility In economics Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within those societies. ...
experienced by the user. This is one of the main distinguishing factors between neoclassical economics and other earlier economic theories, such as
Classical Classical may refer to: European antiquity *Classical antiquity, a period of history from roughly the 7th or 8th century B.C.E. to the 5th century C.E. centered on the Mediterranean Sea *Classical architecture, architecture derived from Greek and ...
and
MarxianMarxian is a term generally used to refer to things related to Karl Marx other than Marxism. It can refer to: * Marxian economics * Marxist philosophy * Marxian class theory See also

* Marxism, which is usually referred to as "Marxist", rathe ...
, which use the
labor theory of value The labor theory of value (LTV) is a theory of value that argues that the economic value In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), produc ...
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).


Cambridge quantity theory of money

The Cambridge version of the
quantity theory of money#REDIRECT Quantity theory of money In monetary economics, the quantity theory of money (QTM) states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply In macroeco ...
was developed mainly by
Alfred Marshall Alfred Marshall (26 July 1842 – 13 July 1924) was an English economist, who was one of the most influential economists of his time. His book, '' Principles of Economics'' (1890), was the dominant economic textbook in England for many years. ...

Alfred Marshall
,
Arthur Cecil Pigou Arthur Cecil Pigou (; 18 November 1877 – 7 March 1959) was an English economist An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply theories and c ...
, Ralph George Hawtrey and Dennis Holme Robertson, and is understood as the income version of the money theory. The basis of the Cambridge quantity theory of money is the Cambridge equation: :M_d = kPY, where M_d is the demand for money, k is the Cambridge (Marshall) coefficient expressing the part of real income in the form of cash, P is the price level and Y is the real income. The left side of the Cambridge equation is expressing the money supply, i.e. the amount of money that people have at their disposal, whereas the right side is expressing the sum of cash people actually want to have, i.e. it is expressing the money demand. Thus, the Cambridge equation is focusing on exploring the conditions of equilibrium in the money market.


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 In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...

externalities
. Externalities are considered a form of
market failure In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. Market failures can be viewed as scenarios where indivi ...
. 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 Pareto efficiency or Pareto optimality is a situation where no individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after ...
(criterion) after its discoverer Vilfredo Pareto. Wolff and Resnick (2012) describe the
Pareto optimality Pareto efficiency or Pareto optimality is a situation where no individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after Vi ...

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 Normative generally means relating to an evaluative standard. Normativity is the phenomenon in human societies of designating some actions or outcomes as good or desirable or permissible and others as bad or undesirable or impermissible. A norm Nor ...
judgments in neoclassical economics are shaped by the Pareto criterion. As a result, many neoclassical economists favor a relatively
laissez-faire ''Laissez-faire'' ( ; from french: laissez faire , ) is an economic system An economic system, or economic order, is a system of Production (economics), production, allocation of resources, resource allocation and Distribution (economics), d ...
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 In welfare economics Welfare economics is a branch of economics that uses microeconomic Microeconomics (from Greek prefix ''mikro-'' meaning "small" + ''economics'') is a branch of economics that studies the behavior of individuals and Theo ...
, 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 A commercial policy (also referred to as a trade policy or international trade policy) is a government's policy governing international trade International trade is the exchange of capital, goods, and service ...
according to
David Ricardo David Ricardo (18 April 1772 – 11 September 1823) was a British political economist, one of the most influential of the classical economists along with Thomas Malthus Thomas Robert Malthus (; 13/14 February 1766 – 23 December 1834) w ...

David Ricardo
's theory of
comparative advantage In an economic model, agent (economics), agents have a comparative advantage over others in producing a particular Goods (economics), good if they can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative ...

comparative advantage
. This idea holds that free trade between two countries is always mutually beneficial because it allows the greatest total consumption in both countries.


Origins

Classical economics Classical economics or classical political economy is a school of thought in economics that flourished, primarily in Kingdom of Great Britain, Britain, in the late 18th and early-to-mid 19th century. Its main thinkers are held to be Adam Smith, Je ...
, developed in the 18th and 19th centuries, included a
value theory In the , value theory involves various approaches that examine how, why, and to what degree humans value things and whether the object or subject of valuing is a person, idea, object, or anything else. Within , it is also known as or . Traditio ...
and
distributionDistribution may refer to: Mathematics *Distribution (mathematics) Distributions, also known as Schwartz distributions or generalized functions, are objects that generalize the classical notion of functions in mathematical analysis. Distr ...
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 ( 1723 – 17 July 1790) was a Scottish economist, philosopher as well as a moral philosopher Ethics or moral philosophy is a branch of philosophy that "involves systematizing, defending, and recommending concepts of right and ...

Adam Smith
and
David Ricardo David Ricardo (18 April 1772 – 11 September 1823) was a British political economist, one of the most influential of the classical economists along with Thomas Malthus Thomas Robert Malthus (; 13/14 February 1766 – 23 December 1834) w ...

David Ricardo
. However, some economists gradually began emphasizing the perceived
value Value or values may refer to: * Value (ethics) it may be described as treating actions themselves as abstract objects, putting value to them ** Values (Western philosophy) expands the notion of value beyond that of ethics, but limited to Western s ...
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 is a family of normative Normative generally means relating to an evaluative standard. Normativity is the phenomenon in human societies of designating some actions or outcomes as good or desirable or permissible and others as ba ...
of
Jeremy Bentham Jeremy Bentham (; 15 February 1748 _4_February_1747.html" ;"title="nowiki/> 4 February 1747">nowiki/> 4 February 1747ref name="Johnson2012" /> – 6 June 1832) was an English , , and regarded as the founder of modern . Bentham defined as th ...

Jeremy Bentham
and later of
John Stuart Mill John Stuart Mill (20 May 1806 – 7 May 1873), also cited as J. S. Mill, was an English philosopher, Political economy, political economist, Member of Parliament (United Kingdom), Member of Parliament (MP) and civil servant. One of the most i ...
.) The third step from political economy to economics was the introduction of
marginalism Marginalism is a theory of economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economic ...
and the proposition that economic actors made decisions based on margins. For example, a person decides to buy a second sandwich based on how full he or she is after the first one, a firm hires a new employee based on the expected increase in profits the employee will bring. This differs from the aggregate decision-making of classical political economy in that it explains how vital goods such as water can be cheap, while luxuries can be expensive.


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 William Stanley Jevons FRS (; 1 September 183513 August 1882) was an English economist An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply theories ...

William Stanley Jevons
's ''Theory of Political Economy'' (1871),
Carl Menger Carl Menger (; ; 28 February 1840 – 26 February 1921) was an Austrian economist and the founder of the Austrian School of economics. Menger contributed to the development of the theory of marginalism (marginal utility), which rejected the cos ...
'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 Men ...
's ''Elements of Pure Economics'' (1874–1877). Historians of economics and economists have debated: * Whether
utility As a topic of economics Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within thos ...

utility
or marginalism was more essential to this revolution (whether the noun or the adjective in the phrase "marginal utility" is more important) * Whether there was a revolutionary change of thought or merely a gradual development and change of emphasis from their predecessors * Whether grouping these economists together disguises differences more important than their similarities.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
Jeremy Bentham Jeremy Bentham (; 15 February 1748 _4_February_1747.html" ;"title="nowiki/> 4 February 1747">nowiki/> 4 February 1747ref name="Johnson2012" /> – 6 June 1832) was an English , , and regarded as the founder of modern . Bentham defined as th ...

Jeremy Bentham
's utilitarianism and never had a fully developed
general equilibrium theory In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an ove ...
. 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 Alfred Marshall (26 July 1842 – 13 July 1924) was an English economist, who was one of the most influential economists of his time. His book, '' Principles of Economics'' (1890), was the dominant economic textbook in England for many years. ...

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 Maffeo Pantaleoni (; Frascati, 2 July 1857Milan Milan (, , Milanese: ; it, Milano ) is a city in northern Italy, capital of Lombardy, and the second-most populous city in Italy after Rome. Milan served as the capital of the Western Roman ...

Maffeo Pantaleoni
by calling him the "Marshall of Italy". Marshall thought
classical economics Classical economics or classical political economy is a school of thought in economics that flourished, primarily in Kingdom of Great Britain, Britain, in the late 18th and early-to-mid 19th century. Its main thinkers are held to be Adam Smith, Je ...
attempted to explain prices by the
cost of productionManufacturing cost is the sum of costs of all resources consumed in the process of making a product. The manufacturing cost is classified into three categories: direct materials costDirect materials cost the cost of direct materials which can be eas ...
. 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 In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods a ...

marginal cost
and
marginal revenue Marginal revenue (or marginal benefit) is a central concept in microeconomics Microeconomics (from Greek prefix ''mikro-'' meaning "small" + ''economics'') is a branch of economics that studies the behavior of individuals and Theory of the f ...
, where profits are maximized. Economic rents exist in short period equilibrium for fixed factors, and the rate of profit is not equated across sectors. * Long period. The stock of
capital Capital most commonly refers to: * Capital letter Letter case (or just case) is the distinction between the letters that are in larger uppercase or capitals (or more formally ''majuscule'') and smaller lowercase (or more formally ''minusc ...
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 College town, university city and the county town of Cambridgeshire, England, on the River Cam approximately north of London. At the United Kingdom Census 2011, the population of the Cambridge built-up area (which is larger ...
and
Lausanne SchoolThe Lausanne School of economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), cons ...
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 In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an ove ...
became the general basis of neoclassical economics and the marginal equilibrium theory was understood as its simplification.SOJKA, M. (2010) Dějiny ekonomických teorií. Prague: Havlíček Brain Team. pp. 153. ISBN 978-80-87109-21-2. Available at: https://ndk.cz/uuid/uuid:1c8026b0-5fc7-11e6-b155-001018b5eb5c. 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 Alfred Marshall (26 July 1842 – 13 July 1924) was an English economist, who was one of the most influential economists of his time. His book, '' Principles of Economics'' (1890), was the dominant economic textbook in England for many years. ...

Alfred Marshall
, and among the main representatives were
Arthur Cecil Pigou Arthur Cecil Pigou (; 18 November 1877 – 7 March 1959) was an English economist An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply theories and c ...
, Ralph George Hawtrey and Dennis Holme Robertson. Pigou worked on the theory of
welfare economics Welfare economics is a branch of economics that uses microeconomics, microeconomic techniques to evaluate well-being (welfare) at the aggregate (economy-wide) level. Attempting to apply the principles of welfare economics gives rise to the fiel ...
and the
quantity theory of money#REDIRECT Quantity theory of money In monetary economics, the quantity theory of money (QTM) states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply In macroeco ...
. 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 An economist is a professional and practitioner in the social science Social science is the branch The branches and leaves of a ...

John Maynard Keynes
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 Men ...
,
Vilfredo Pareto Vilfredo Federico Damaso Pareto ( , , , ; born Wilfried Fritz Pareto; 15 July 1848 – 19 August 1923) was an Italian civil engineer A civil engineer is a person who practices civil engineering Civil engineering is a Regulation and licensur ...

Vilfredo Pareto
and
Enrico Barone Enrico Barone (; 22 December 1859, Naples Naples (; it, Napoli ; nap, Napule ; grc, wikt:Νεάπολις, Νεάπολις, Neápolis), from grc, Νεάπολις, lit=new city. is the regional capital of Campania and the third-largest c ...
. The school became famous for developing the
general equilibrium theory In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an ove ...
. 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 het ...
in the form of
New classical macroeconomics New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical economics, neoclassical framework. Specifically, it emphasizes the importan ...
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#REDIRECT Quantity theory of money In monetary economics, the quantity theory of money (QTM) states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply In macroeco ...
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 and is labeled as the neoclassical renaissance, the revival of neoclassical economics. During this era, Neo-Keynesian economics was in crisis, which encouraged the creation of new neoclassical lines of thoughts such as Monetarism,
New classical macroeconomics New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical economics, neoclassical framework. Specifically, it emphasizes the importan ...
, Supply-side economics, or the Public choice theory. 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. Theories of market forms and industrial organization grew out of this work. They also emphasized certain tools, such as the
marginal revenue Marginal revenue (or marginal benefit) is a central concept in microeconomics Microeconomics (from Greek prefix ''mikro-'' meaning "small" + ''economics'') is a branch of economics that studies the behavior of individuals and Theory of the f ...
curve. In her book, Robinson formalized a type of limited competition. The conclusions of her work for
welfare economics Welfare economics is a branch of economics that uses microeconomics, microeconomic techniques to evaluate well-being (welfare) at the aggregate (economy-wide) level. Attempting to apply the principles of welfare economics gives rise to the fiel ...
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 supply and demand, partial equilibrium theory highlighted by Piero Sraffa. Anglo-American economists also responded to these problems by turning towards
general equilibrium theory In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an ove ...
, 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 civil engineer A civil engineer is a person who practices civil engineering Civil engineering is a Regulation and licensur ...

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 The Austrian School is a heterodox In religion, heterodoxy (from Ancient Greek Ancient Greek includes the forms of the Greek language used in ancient Greece and the classical antiquity, ancient world from around 1500 BC to 300 BC. It ...
economist Friedrich Hayek's move to the London School of Economics, where Hicks then studied. These developments were accompanied by the introduction of new tools, such as indifference curves and the theory of ordinal utility. The level of mathematical sophistication of neoclassical economics increased. Paul Samuelson's ''Foundations of Economic Analysis'' (1947) contributed to this increase in mathematical modeling. The interwar period in American economics has been argued to have been pluralistic, with neoclassical economics and institutional economics, institutionalism competing for allegiance. Frank Knight, an early Chicago school (economics), Chicago school economist attempted to combine both schools. But this increase in mathematics was accompanied by greater dominance of neoclassical economics in Anglo-American universities after World War II. Some argue that outside political interventions, such as McCarthyism, and internal ideological bullying played an important role in this rise to dominance. Hicks' book, ''Value and Capital'' had two main parts. The second, which was arguably not immediately influential, presented a model of temporary equilibrium. Hicks was influenced directly by Hayek's notion of intertemporal coordination and paralleled by earlier work by Lindhal. This was part of an abandonment of disaggregated long-run models. This trend probably reached its culmination with the Arrow–Debreu model of intertemporal equilibrium. The Arrow–Debreu model has canonical presentations in Gérard Debreu's ''Theory of Value'' (1959) and in Arrow and Hahn's "General Competitive Analysis" (1971).


Neoclassical synthesis

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 economics, Keynesian macroeconomics would lead to the
neoclassical synthesis The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a post-World War II World War II or the Second World War, often abbreviated as WWII or WW2, was a World war, global war that lasted from ...
which was the dominant paradigm of economic reasoning in English-speaking countries from the 1950s till the 1970s. Hicks and Samuelson were for example instrumental in mainstreaming Keynesian economics. The dominance of Neo-Keynesian economics was upset by its inability to explain the economic crises of the 1970s- neoclassical economics emerged distinctly in macroeconomics as the new classical macroeconomics, 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 The new neoclassical synthesis (NNS) or new synthesis is the fusion of the major, modern macroeconomic schools of thought, new classical and New-Keynesianism, into a consensus on the best way to explain short-run fluctuations in the economy. Thi ...
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 (economics), 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 Marxian economics, Marxist, Behavioral economics, Behavioral, Joseph Schumpeter, Schumpeterian, Developmentalism, Developmentalist, Austrian School, Austrian, Post Keynesian, and Institutionalist political economy, 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 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, linear programming, and econometrics. 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 Function (mathematics), 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 hard sciences. Milton Friedman, 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 economics, normative bias despite sometimes claiming to be Value-free economics, "value-free". Such critics argue an Ideology, 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 Pluralism in economics, pluralistic.


Rational behavior assumptions

One of the most widely criticized aspects of neoclassical economics is its set of assumptions about human behavior and rationality. According to Edward Fullbrook, these assumptions were chosen not because they were observed to be true by studying human behavior, but because they were the required conditions to reach a Economic equilibrium, market equilibrium. The "Homo economicus, 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 Thorstein Bunde Veblen (July 30, 1857 – August 3, 1929) was a Norwegian-American economist and sociologist who, during his lifetime, emerged as a well-known critic of capitalism. In his best-known book, ''The Theory of the Leisure Class'' (1 ...
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.
His characterization references a number of commonly criticized rationality assumptions: that people make decisions using a rigid Utilitarianism, utilitarian framework, have perfect information available about their options, have perfect information processing ability allowing them to immediately calculate
utility As a topic of economics Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within thos ...

utility
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 economics, Institutional school, the Behavioral economics, Behavioral school of economics is focused on studying the mechanisms of human decision-making 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 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."Becker, G. (1962). 'Irrational Behavior and Economic Theory', ''Journal of Political Economy'', 70(1), 1–13. Available at: https://www.jstor.org/stable/1827018?seq=1 (Accessed: May 3, 2021). 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.Alchian, A. (1950). 'Uncertainty, Evolution, and Economic Theory', ''Journal of Political Economy'', 58(1), 211–221. Available at: https://www.jstor.org/stable/1827159?seq=1 (Accessed: May 28, 2021). 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 apply 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 implausible assumptions.


Methodological individualism

Neoclassical economics offers an approach to study 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 economic inequality, 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 that use of markets for certain goods is inherently unethical. Political philosopher Michael Sandel 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 * Market economy * Microeconomics * Neoclassical synthesis * Static equilibrium (economics)


References


External links

*
Neoclassical Economics
William King, Drexel University {{Authority control Neoclassical economics, Thorstein Veblen 1900s neologisms