Neoclassical economics

Neoclassical economics refers to a general approach in economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand. These are 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. Mainstream economics is largely neoclassical in its assumptions, at least at the microeconomic level.

President Richard Nixon, defending deficit spending against the conservative charge that it was "Keynesian," is reported to have replied, "…We're all Keynesians now…..." In fact, what he should have said is "….We're all neoclassicals now, even the Keynesians…..," because what is taught to students, what is mainstream economics today, is neoclassical economics ( E. R. Weintraub, 1985.)

History of neoclassical economics

Classical economics, 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.

By the middle of the nineteenth century, English-speaking economists generally shared a perspective on value theory and distribution theory. The value of a bushel of corn, for example, was thought to depend on the costs involved in producing that bushel. The output or product of an economy was thought to be divided or distributed among the different social groups in accord with the costs borne by those groups in producing the output. This, roughly, was the "Classical Theory" developed by Adam Smith, David Ricardo, Thomas Robert Malthus, John Stuart Mill, andKarl Marx.

But there were difficulties in this approach. Chief among them was that prices in the market did not necessarily reflect the "value" so defined, for people were often willing to pay more than an object was "worth." The classical "substance" theories of value, which took value to be a property inherent in an object, gradually gave way to a perspective in which value was associated with the relationship between the object and the person obtaining the object.

Several economists in different places at about the same time (the 1870s and 1880s) began to base value on the relationship between costs of production and "subjective elements," later called "supply" and "demand." This came to be known as the Marginal Revolution in economics, and the overarching theory that developed from these ideas came to be called neoclassical economics. The first to use the term "neoclassical economics" seems to have been the American economist Thorstein Veblen ( see T. Veblen, 1900.)

It was then used by George Stigler and John Hicks broadly to include the work of Carl Menger, William Stanley Jevons, and John Bates Clark. Today it is often used to refer to mainstream economics and the Chicago school. Neoclassical economists usually assume, in other words, that human beings make the choices that give them the best possible advantage, given the circumstances they face. Circumstances include the prices of resources, goods and services, limited income, limited technology for transforming resources into goods and services, and taxes, regulations, and similar objective limitations on the choices they may make ( see E.R. Weintraub, 1985. )

Overview and Assumptions

The framework of neoclassical economics is easily summarized. Buyers attempt to maximize their gains from getting goods, and they do this by increasing their purchases of a good until what they gain from an extra unit is just balanced by what they have to give up to obtain it. In this way they maximize "utility"—the satisfaction associated with the consumption of goods and services. Likewise, individuals provide labor to firms that wish to employ them, by balancing the gains from offering the marginal unit of their services (the wage they would receive) with the disutility of labor itself—the loss of leisure. Individuals make choices at the margin. This results in a theory of demand for goods, and supply of productive factors.

Similarly, producers attempt to produce units of a good so that the cost of producing the incremental or marginal unit is just balanced by the revenue it generates. In this way they maximize profits. Firms also hire employees up to the point that the cost of the additional hire is just balanced by the value of output that the additional employee would produce.

Neoclassical economics conceptualized the agents, households and firms, as rational actors. Agents were modeled as optimizers who were led to "better" outcomes. The resulting equilibrium was "best" in the sense that any other allocation of goods and services would leave someone worse off. Thus, the social system in the neoclassical vision was free of unresolvable conflict.

The very term "social system" is a measure of the success of neoclassical economics, for the idea of a system, with its interacting components, its variables and parameters and constraints, is the language of mid-nineteenth-century physics. This field of rational mechanics was the model for the neoclassical framework. The following excerpt clears many misunderstanding:

“…..We understand that the allocation of resources is a social problem in any modern economy. Any modern economic system must somehow answer the questions posed by the allocation of resources. If we are further to understand the way in which people respond to this social problem, we have to make some assumptions about human behavior…….. The assumption at the basis of the neoclassical approach is that people are rational and (more of less) self-interested. This should be understood as an instance of positive economics (about what is) not normative economics (about what ought to be). This distinction, positive versus normative economics, is important in itself and is a key to understanding many aspects of economics…..” ( B. Huberman and T. Hogg, 1995.)

Agents, mentioned above, were like atoms; utility was like energy; utility maximization was like the minimization of potential energy, and so forth. In this way was the rhetoric of successful science linked to the neoclassical theory, and in this way economics became linked to science itself. Whether this linkage was planned by the early Marginalists, or rather was a feature of the public success of science itself, is less important than the implications of that linkage. For once neoclassical economics was associated with scientific economics, to challenge the neoclassical approach was to seem to challenge science and progress and modernity. 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.

Value is linked to unlimited desires and wants colliding with constraints, or scarcity. The tensions, the decision problems, are worked out in markets. Prices are the signals that tell households and firms whether their conflicting desires can be reconciled.

EXAMPLE: At some price of cars, for example, I want to buy a new car. At that same price others may also want to buy cars. But manufacturers may not want to produce as many cars as we all want. Our frustration may lead us to "bid up" the price of cars, eliminating some potential buyers and encouraging some marginal producers. As the price changes, the imbalance between buy orders and sell orders is reduced. This is how optimization under constraint and market interdependence lead to an economic equilibrium. This is the neoclassical vision ( ibid.)

To summarize: Neoclassical economics is what is called a metatheory. That is, it is a set of implicit rules or understandings for constructing satisfactory economic theories. It is a scientific research program that generates economic theories. Its fundamental assumptions are not open to discussion in that they define the shared understandings of those who call themselves neoclassical economists, or economists without any adjective. Those fundamental assumptions include the following:

• People have rational preferences among outcomes that can be identified and associated with a value.

• Individuals maximize utility and firms maximize profits.

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

Theories based on, or guided by, these assumptions are neoclassical theories. Thus, we can speak of a neoclassical theory of profits, or employment, or growth, or money. We can create neoclassical production relationships between inputs and outputs, or neoclassical theories of marriage and divorce and the spacing of births. Consider layoffs, for example. A theory which assumes that a firm's layoff decisions are based on a balance between the benefits of laying off an additional worker and the costs associated with that action will be a neoclassical theory. A theory that explains the layoff decision by the changing tastes of managers for employees with particular characteristics will not be a neoclassical theory ( ibid.)

The value of neoclassical economics can be assessed in the collection of truths to which we are led by its light. The kinds of truths about incentives—about prices and information, about the interrelatedness of decisions and the unintended consequences of choices—are all well developed in neoclassical theories, as is a self-consciousness about the use of evidence.

EXAMPLE: In planning for future electricity needs in my state, for example, the Public Utilities Commission develops a (neoclassical) demand forecast, joins it to a (neoclassical) cost analysis of generation facilities of various sizes and types (e.g., an 800-megawatt low-sulfur coal plant), and develops a least-cost system growth plan and a (neoclassical) pricing strategy for implementing that plan. Those on all sides of the issues, from industry to municipalities, from electric companies to environmental groups, all speak the same language of demand elasticities and cost minimization, of marginal costs and rates of return. The rules of theory development and assessment are clear in neoclassical economics, and that clarity is taken to be beneficial to the community of economists. The scientificness of neoclassical economics, on this view, is not its weakness but its strength ( ibid. )

Critique of neoclassical economics

The rational consumer of the mainstream economist is a working assumption that was meant to free economists from dependence on psychology (e.g. Tversky and Kahneman 1986.)

The dilemma is that the assumption of rationality as intertemporally optimising is often confused with, and regularly presented as, real, purposive behaviour. In fact, the living consumer in historical time routinely makes decisions in undefined contexts. They muddle through, they adapt, they copy, they try what worked in the past, they gamble, they take uncalculated risks, they engage in costly altruistic activities, and regularly make unpredictable, even unexplainable, decisions (Sandven 1995).

It mostly looks like that modern corporations are not even "acting as if" they equilibrate marginal cost-marginal revenue to maximise profits. Rather, they attempt to beat the average. References to the "average" or "normal" pervade the business literature - from the analysis of stock performance, through the stacking of country growth rates and risk premia, to the ranking of corporate profitability.

In these terms, according to Nitzan and Bichler, the primary goal becomes "differential pecuniary accumulation", through which the corporation seeks to control a "larger share of the societal surplus". Consequently, success has less to do with the intuitively convincing textbook equality between marginal cost and marginal revenue, than with the capture of external contested income, thereby redistributing the available social surplus ( H. Thompson, 1997.)

One neoclassical defence is to suggest that equilibrium is only a tendency towards which the system is moving. However, Weintraub (1991) reveals the manner whereby econometricians, such as Negishi, maintain that the equilibrium contained in a model is real and intuitively justified.

They do this by appealing to the "…..reality out there…in which it is known that the economy is fairly shock-proof….We know from experience that prices usually do not explode to infinity or contract to zero…" (Negishi, 1962.)

Neoclassical economics has represented, for two hundred years, the political self-representation of autonomous, self-subsistent, and self-interest-optimising individuals.

And no matter how hard neoclassical economists try to drive away the world of complexity, it too continues to confront them. Yet, to the frustration of "heterogeneous" antagonists the neoclassical paradigm remains dominant, blatantly promoting ignorance-squared. Elegance and technique have replaced relevance. What has been shown herein is that the production of that elegance has involved the opportunity cost of simultaneously producing ignorance. Ignorance-squared is replicated amongst students given the social interests of those dominant in the paradigm ( H. Thompson, 1997. )

Three axioms of the modern neoclassical economics: an answer to the critique

Neoclassical theory retains its roots firmly within liberal individualist social science. The method is still unbendingly of the analytic-synthetic type: the socio-economic phenomenon under scrutiny is to be analysed by focusing on the individuals whose actions brought it about; understanding fully their ‘workings’ at the individual level; and, finally, synthesising the knowledge derived at the individual level in order to understand the complex social phenomenon at hand. In short, neoclassical theory follows the watchmaker’s method who, faced with a strange watch, studies its function by focusing on understanding, initially, the function of each of its cogs and wheels. To the neoclassical economist, the latter are the individual agents who are to be studied, like the watchmaker’ cogs and wheels, independently of the social whole their actions help bring about (Y. Varoufakis and Ch. Arnsperger, 2006.)

Methodological individualism

So, the first feature of the body of theory we think of as neoclassical is its methodological individualism: the idea that socio-economic explanation must be sought at the level of the individual agent. Note two things: First, this was not the method of classical economists like Adam Smith and David Ricardo. Or, indeed, of Keynes or Hayek.

It is, we think, indisputable that all the new manifestations of what we term neoclassicism still subscribe to methodological individualism. While it is true that mainstream economists have, during the last few decades, acknowledged that the agent is a creature of his social context, and thus that social structure and individual agency are messily intertwined, their models retain the distinction and place the burden of explanation on the individual. Individual worker effort is nowadays often modelled as a function of sectoral unemployment (e.g. efficiency wage models), and the firms’ micro-strategies reflect the macroeconomic environment. Nevertheless, and despite these interesting linkages between the micro-agent and the macro-phenomenon, the explanatory trajectory remains one that begins from the agent and maps, unidirectionally, onto the social structure ( ibid. )

Methodological instrumentalism

We label the second feature of neoclassical economics methodological instrumentalism: all behaviour is preference-driven or, more precisely, it is to be understood as a means for maximising preference-satisfaction.

Preference is given, current, fully determining, and strictly separate from both belief (which simply helps the agent predict uncertain future outcomes) and from the means employed. Everything we do and say is instrumental to preference-satisfaction so much so that there is no longer any philosophical room for questioning whether the agent will act on her preferences.

Methodological instrumentalism’s roots are traceable in David Hume’s “Treatise of Human Nature” (1739/40) in which the Scottish philosopher famously divided the human decision making process in three distinct modules: Passions, Belief and Reason.

Passions provide the destination, Reason slavishly steers a course that attempts to get us there, drawing upon a given set of Beliefs regarding the external constraints and the likely consequences of alternative actions.

A more recent development has taken neoclassicism, and homo economicus, onto higher levels of sophistication. The advent of psychological game theory (see Hargreaves-Heap and Varoufakis,2004, Ch.7) has brought on a reconsideration of the standard assumption that agents’ current preferences are separate from the structure of the interaction in which they are involved.

Suddenly, what one wants hinged on what she thought others expected she would do. And when these second order beliefs (her beliefs about the expectations of others) came to depend on the social structure in which the decision is embedded, the agent’s very preferences could not be linked just with outcomes: they depended on the structure and history of the interaction as well.

Methodological equilibrium

The reason for the axiomatic imposition of equilibrium is simple: it could not be otherwise! By this we mean that neoclassicism cannot demonstrate that equilibrium would emerge as a natural consequence of agents’ instrumentally rational choices.

Thus, the second best methodological alternative for the neoclassical theorist is to presume that behaviour hovers around some analytically-discovered equilibrium and then ask questions on the likelihood that, once at that equilibrium, the ‘system’ has a propensity to stick around or drift away (what is known as stability analysis).

More generally, it is not just difficult to demonstrate that a system of theoretical markets will generate an equilibrium in each market, on the basis of rational acts on behalf of buyers and sellers; rather, it is impossible! ( see e.g. Sonnenschein, 1973,1974.)

In Game Theory the same result obtains: in the most interesting socio-economic interactions (or games) common knowledge that all players are instrumentally rational seldom yields one of the interaction’s Nash equilibria. Something more is required to bring on an equilibrium. That something comes in the form of an axiom that the beliefs of all players are consistently aligned at each stage of every game (see Hargreaves-Heap and Varoufakis, 2004, Chapters 2&3).

This assumption is, of course, yet another reincarnation of methodological equilibration: for once we assume that agents’ beliefs are systematically and consistently aligned, they are assumed to be in a state of (Nash) equilibrium. Yet again, equilibrium is imposed axiomatically before stability

Simplified functional explanation

The functional explanation adds an interesting twist to the same tale of intellectual authoritarianism. If phenomenon X is functionally to explain the occurrence of phenomenon Y, this explanation has merit if and only if the following four conditions are met (see Elster, 1982):

• (1) Y must be beneficial for some group of agents Z.

• (2) Members of group Z must be responsible for the practices that cause X but must not intend to bring Y about through practices that result in X; indeed, Z members must remain innocent of the causal link between X and Y. Lastly,

• (3) phenomenon Y, which is caused by X, must be shown to reinforce X through a feedback mechanism involving, unintentionally, members of group Z.

In our case, Y is the discursive power of neoclassical economics, X are the practices which keep neoclassicism’s meta-axioms hidden, and Z is the set of neoclassical economists. Can a convincing functionalist explanation of how X causes Y be built along the lines sketched above? If it can, then we shall have an interesting (and possibly correct) explanation of why pluralism is absent from Economics Departments: its radical absence, which is guaranteed when an eerie silence engulfs the three neoclassical meta-axioms, emerges as a prerequisite for neoclassicism’s dominance.

References

ISBN links support NWE through referral fees

• Elster, J. , “Belief, bias and ideology”; in: Hollis-Lukes, Rationality and Relativism, 1982., pp.123—148
• Hargreaves-Heap, S. and Y. Varoufakis, Game Theory: A critical text, Routledge, London and New York, 2004
• Huberman, B. and T. Hogg, "Distributed Computation as an Economic System,"Journal of Economic Perspectives, v. 9, no. 1, Winter 1995, pp. 141-152
• Hume, D. A., Treatise of Human Nature: being an attempt to introduce the experimental method of reasoning into moral subjects, (1739/40,1888, ed. by L.A. Selby-Bigge), Oxford University Press, Oxford, 1888
• Negishi, T. "The Stability of a Competitive Economy: A Survey Article", Econometrica, 30, 1962, pp. 635-669
• Sandven, T. "Intentional Action and Pure Causality: A Critical Discussion of Some Central Conceptual Distinctions in the Work of Jon Elster", Philosophy of the Social Sciences, 25(3) September 1995, pp. 286-317
• Sonnenschein, H., “Do Walras’ Identity and Continuity Characterize the Class of Community Excess Demand Functions?”, Journal of Economic Theory, 6, 1973, pp. 345-354.
• Sonnenschein, H., “Market Excess Demand Functions,” Econometrica, 40, 1974, pp. 549-563.
• Thompson, H. "Ignorance and Ideological Hegemony: A Critique of Neoclassical Economics", Journal of Interdisciplinary Economics, 8(4), 1997, pp. 291-305
• Tversky, A. and D. Kahneman, “Rational choice and the framing of decision”, Journal of Business, 1986
• Varoufakis, Y. and Ch. Arnsperger, “What Is Neoclassical Economics?”, Post-autistic economics review, Issue no. 38, 1, July 2006
• Veblen, T. "The Preconceptions of Economic Science - III" The Quarterly Journal of Economics, vol. 14, 1900
• Weintraub, E. R., General Equilibrium Analysis: Studies in Appraisal, Cambridge University Press New York, 1985
• Weintraub, E.R. "Surveying dynamics", Journal of Post Keynesian Economics, 13(4) Summer 1991, pp. 525-543

External links

• Neoclassical economics from the Concise Library of Economics
• Introduction to neoclassical economics at Drexel
• What Is Neoclassical Economics at Post-Autistic Economics Review
• Rationality Controversy and Economic Theory from www.rationalitycontroversy.org/

Credits

New World Encyclopedia writers and editors rewrote and completed the Wikipedia article in accordance with New World Encyclopedia standards. This article abides by terms of the Creative Commons CC-by-sa 3.0 License (CC-by-sa), which may be used and disseminated with proper attribution. Credit is due under the terms of this license that can reference both the New World Encyclopedia contributors and the selfless volunteer contributors of the Wikimedia Foundation. To cite this article click here for a list of acceptable citing formats.The history of earlier contributions by wikipedians is accessible to researchers here:

• Neoclassical_economics  ^history

The history of this article since it was imported to New World Encyclopedia:

• History of "Neoclassical economics"

Note: Some restrictions may apply to use of individual images which are separately licensed.