Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often as mediated through a hypothesized maximization of income-constrained utility by individuals and of cost-constrained profits of 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 change.
The term was originally introduced by Thorstein Veblen in 1900, in his Preconceptions of Economic Science, to distinguish marginalists in the tradition of Alfred Marshall from those in the Austrian School. It was later used by John Hicks, George Stigler, and others who presumed that significant disputes amongst marginalist schools had been largely resolved to include the work of Carl Menger, William Stanley Jevons, and John Bates Clark. Today it is usually used to refer to mainstream economics, although it has also been used as an umbrella term encompassing a number of mainly defunct schools of thought, notably excluding institutional economics, various historical schools of economics, and Marxian economics, in addition to various other heterodox economics.
From these three assumptions, neoclassical economists have built a structure to understand the allocation of scarce resources among alternative ends -- in fact understanding such allocation is often considered the definition of economics to neoclassical theorists. Here's how William Stanley Jevons presented "the problem of Economics".
"Given, a certain population, with various needs and powers of production, in possession of certain lands and other sources of material: required, the mode of employing their labour which will maximize the utility of their produce.
From the basic assumptions of neoclassical economics comes a wide range of theories about various areas of economic activity. For example, profit maximization lies behind the neoclassical theory of the firm, while the derivation of demand curves leads to an understanding of consumer goods, and the supply curve allows an analysis of the factors of production. Utility maximization is the source for the neoclassical theory of consumption, the derivation of demand curves for consumer goods, and the derivation of labor supply curves and reservation demand. Market supply and demand are aggregated across firms and individuals. Their interactions determine equilibrium output and price. The market supply and demand for each factor of production is derived analogously to those for market final output to determine equilibrium income and the income distribution. Factor demand incorporates the marginal-productivity relationship of that factor in the output market.
Neoclassical economics emphasizes equilibria, 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.
However, some economists gradually began emphasizing the perceived value of a goods to the consumer. They proposed a theory that the value of a product was to be explained with differences in "utility." This is called Utilitarianism and is associated with philosopher and economic thinker John Stuart Mill.
The third step from political economy to economics was the introduction of the "marginal theory of value" or marginalism. Marginal value means that economic actors make decisions based on the "margins". 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.
In particular, Walras was more interested in the interaction of markets than in explaining the individual psyche through a hedonistic psychology. Jevons saw his economics as an application and development of Jeremy Bentham's utilitarianism and never had a fully developed general equilibrium theory. Menger emphasized disequilibrium and the discrete. Menger had a philosophical objection to the use of mathematics in economics, while the other two modeled their theories after 19th century mechanics.
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 the neoclassicals went too far in correcting this imbalance by overemphasizing utility and demand. Marshall thought the question of whether supply or demand was more important was analogous to the pointless question of which blade of a scissors did the cutting.
Marshall explained prices 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 determinate of price in the very long run.
Joan Robinson's work on imperfect competition, at least, was a response to certain problems of Marshallian partial equilibrium theory highlighted by Piero Sraffa. Anglo-American economists also responded to these problems by turning towards general equilibrium theory, developed on the European continent by Walras and Vilfredo Pareto. J. R. Hicks's Value and Capital (1939) was influential in introducing his English-speaking colleagues to these traditions. He, in turn, was influenced by the Austrian School economist Friedrich Hayek's move to the London School of Economics, where Hicks then studied.
These developments were accompanied by the introduction of new tools, such as indifference curves and the theory of ordinal utility. The level of mathematical sophistication of neoclassical economics increased. Paul Samuelson's Foundations of Economic Analysis (1947) contributed to this increase in formal rigor.
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.
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.
The assumption that individuals act rationally may be viewed as ignoring important aspects of human behavior. Many see the "economic man" as being demonstrably different from a real man on the real earth. The assumption of rational expectations which has been introduced in some more modern neo-classical models (sometimes also called new classical) can also be criticized on the grounds of realism.
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 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 insure that the equilibrium is stable and unique are quite restrictive.
In the opinion of some, these developments have found fatal weaknesses in neoclassical economics. Economists, however, have continued to use highly mathematical models, and many equate neoclassical economics with economics, unqualified. Mathematical models include those in game theory, linear programming, and econometrics, many of which might be considered non-neoclassical. So economists often refer to what has evolved out of neoclassical economics as "mainstream economics". 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 basic theory of a downward sloping aggregate demand curve is criticized for its allegedly strong assumptions.
In general, allegedly overly unrealistic assumptions are one of the most common criticisms towards neoclassical economics. For example, many theories assume perfect knowledge for market actors and the most common theory of finance markets assumes that debts are always paid back and that any actor can raise as much loan as he wants at any given point of time.
The basic theory of production in neoclassical economics is criticized for incorrect assumptions about the rationales of producers. According to the theory, increasing production costs are the reason for producers not to produce over a certain amount. Some empirical counter arguments claim that most producers are not making their production decisions in the light of increasing production costs. For example they often may have additional capacity that could be taken into use, if producing more was desirable.
Often at individual levels, variables such as supply and demand, which are independent, are (allegedly wrongly) assumed to be independent also at aggregate level. This criticism has been applied to many central theories of neoclassical economics.
The critique of the assumption of rationality is not confined to social theorists and ecologists. Many economists, even contemporaries, have criticized this vision of economic man. Thorstein Veblen 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.
Herbert Simon's theory of bounded rationality has probably been the most influential of the heterodox approaches. Is economic man a first approximation to a more realistic psychology, an approach only valid in some sphere of human lives, or a general methodological principle for economics? Early neoclassical economists often leaned toward the first two approaches, but the latter has become prevalent.
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. 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 realisticity of their assumptions. Naturally, critics claim that neoclassical economics (as well as other branches of economics) has not been very good at predicting events.
Critics of neoclassical models accuse it of copying of 19th century mechanics and the "clockwork" model of society which seems to justify elite privileges as arising "naturally" from the social order based on economic competitions. This is echoed by modern critics in the anti-globalization movement who often blame the neoclassical theory, as it has been applied by the IMF in particular, for inequities in global debt and trade relations. They assert it ignores the complexity of nature and of human creativity, and seeks mechanical ideas like equilibrium:
"And in Poinset's Elements de Statique..., which was a textbook on the theory of mechanics bristling with systems of simultaneous equations to represent, among other things, the mechanical equilibrium of the solar system, Walras found a pattern for representing the catallactic equilibrium of the market system." (William Jaffe)
The neo-Marxists Michael Hardt and Antonio Negri criticize neoclassical economics and its rejection of Keynesian regulation on philosophical grounds: they assert that neoclassical economics incorrectly posits money as a priori ("monetary Aristotelianism"), even though it is a regulatory instrument.
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 modelling bounded rationality).
Other theories of economics and variations on Neoclassical theory: