Neoclassical economics

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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

Classical economics, developed in the eighteenth and nineteenth 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.

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, and Karl 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 (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. Menger, founder of the Austrian school of economics, is considered significant in the origin of neoclassical thought, with its focus on utilitarianism and value determined by the subjective views of individuals (not costs). Eugen von Böhm-Bawerk and Friedrich von Wieser, followers of Menger, can also be included to a lesser extent as neoclassical economists.

Despite starting from the same point, Austrian economics became increasingly separated from neoclassical economics in both method and focus. In method, whereas mainstream neoclassical economics became increasingly mathematical Austrian economic proceeded non-mathematically, incorporating laws and institutions into its analysis. In focus, the neoclassicals focused on equilibrium while the Austrian school focused on the study of institutions, process, and disequilibrium.

Today the term neoclassical is generally used to refer to mainstream economics and the Chicago school.

Key theorists

In the years immediately following Karl Marx's publication of Das Kapital, a revolution took place in economics. Marx's development of a theory of exploitation from the labor theory of value, which had been taken as fundamental by economists since John Locke coincided with labor theory's abandonment. The new orthodoxy became the theory of marginal utility. Writing simultaneously and independently, a Frenchman (Leon Walras), an Austrian (Carl Menger), and an Englishman (William Stanley Jevons) wrote that instead of the value of goods or services reflecting the labor that produced them, value reflects the usefulness (utility) of the last purchase (before the "margin" at which people find things useful no longer). This meant that an equilibrium of people's preferences determined prices, including the price of labor, so there was no question of exploitation. In a competitive economy, said the marginalists, people get what they had paid, or worked for.

Menger, Jevons, and Walras

William Stanley Jevons, one of the leaders of the Marginal revolution

Carl Menger (1840-1921), an Austrian economist stated the basic principle of marginal utility in Grundsätze der Volkswirtschaftslehre (Menger 1871). Consumers act rationally by seeking to maximize satisfaction of all their preferences. People allocate their spending so that the last unit of a commodity bought creates no more than a last unit bought of something else. William Stanley Jevons (1835-1882) was his English counterpart. He emphasized in the Theory of Political Economy (1871) that at the margin, the satisfaction of goods and services decreases. An example of the theory of diminishing returns is that for every orange one eats, the less pleasure one gets from the last orange (until one stops eating). Then Leon Walras (1834-1910), again working independently, generalized marginal theory across the economy in Elements of Pure Economics (1874). Small changes in people's preferences, for instance shifting from beef to mushrooms, would lead to a mushroom price rise, and beef price fall. This stimulates producers to shift production, increasing mushrooming investment, which would increase market supply leading to a new lower mushroom price and a new price equilibrium between the products.

Alfred Marshall

Alfred Marshall wrote the main alternative textbook to John Stuart Mill of the day, Principles of Economics (1882).
Main article: Alfred Marshall

Alfred Marshall (1842-1924) was the first Professor of Economics at the University of Cambridge and his work, Principles of Economics (1890) coincided with the transition of the subject from "political economy" to his favored term, "economics." Coming after the marginal revolution, Marshall concentrated on reconciling the classical labor theory of value, which had concentrated on the supply side of the market, with the new marginalist theory that concentrated on the consumer demand side. Marshall's graphical representation is the famous supply and demand graph, the "Marshallian cross." He insisted it is the intersection of both supply and demand that produce an equilibrium of price in a competitive market. Over the long run, argued Marshall, the costs of production and the price of goods and services tend towards the lowest point consistent with continued production.

Francis Ysidro Edgeworth

Francis Y. Edgeworth

Francis Ysidro Edgeworth (1845–1926) was an Irish polymath, a highly influential figure in the development of neo-classical economics, who contributed to the development of statistical theory. He was the first to apply certain formal mathematical techniques to individual decision making in economics. Edgeworth developed utility theory, introducing the indifference curve and the famous "Edgeworth box," which have become standards in economic theory. His "Edgeworth conjecture" states that the core of an economy shrinks to the set of competitive equilibria as the number of agents in the economy gets large. The high degree of originality demonstrated in his most work was matched only by the difficulty in reading his writings. Edgeworth was often regarded as “Marshall's man," referring to his support of Alfred Marshall. It was Edgeworth who greatly contributed toward the establishment of the Marshallian Neoclassical hegemony and the decline of any alternative approach.

John Bates Clark

John Bates Clark
Main article: John Bates Clark

John Bates Clark (1847-1938) pioneered the marginalist revolution in the United States. Having studied in Germany, his ideas were different from those of the classical school and also the Institutional economics of Thorstein Veblen. Together with Richard T. Ely and Henry Carter Adams, Clark was cofounder of the organization that later became the American Economic Association. Clark sought to discover economic relationships, such as the relationship between distribution of income and production, which he argued would occur naturally in a market based on perfect competition. He believed that his "marginal productivity theory of income distribution" scientifically proved that market systems could generate a just distribution of income.

He took marginal productivity theory further than others, and applied it to the business firm and the maximization of profits. He also argued that people were motivated not only by self-centered desire, but also considered the interests of society as a whole in their economic decision making. In his Distribution of Wealth Clark (1899) developed his utility theory, according to which all commodities contain within them “bundles of utilities”—different qualitative degrees of utility. It is this utility that determines the value of a commodity:

If we were here undertaking to present at length the theory of value, we should lay great stress on the fact that value is a social phenomenon. Things sell, indeed, according to their final utilities; but it is their final utilities to society (Clark 1899).

Collapse

Alfred Marshall was still working on his last revisions of his Principles of Economics at the outbreak of the First World War (1914-1918). The new twentieth century's climate of optimism was soon violently dismembered in the trenches of the Western front, as the civilized world tore itself apart. For four years the production of Britain, Germany, and France was geared entirely towards the war economy's industry of death. In 1917 Russia crumbled into revolution led by Vladimir Lenin's Bolshevik party. They carried Marxist theory as their savior, and promised a broken country "peace, bread and land" by collectivizing the means of production. Also in 1917, the United States of America entered the war on the side of France and Britain, President Woodrow Wilson carrying the slogan of "making the world safe for democracy." He devised a peace plan of Fourteen Points. In 1918 Germany launched a spring offensive which failed, and as the allies counter-attacked and more millions were slaughtered, Germany slid into revolution, its interim government suing for peace on the basis of Wilson's Fourteen Points. Europe lay in ruins, financially, physically, psychologically, and its future with the arrangements of the Versailles conference in 1919.

John Maynard Keynes was the representative of Her Majesty's Treasury at the conference and the most vocal critic of its outcome. During the Great Depression, Keynes published his most important work, The General Theory of Employment, Interest, and Money (1936). The depression had been sparked by the Wall Street Crash of 1929, leading to massive rises in unemployment in the United States, leading to debts being recalled from European borrowers, and an economic domino effect across the world. Orthodox economics called for a tightening of spending, until business confidence and profit levels could be restored. Keynes by contrast, argued in A Tract on Monetary Reform (1923) that a variety of factors determined economic activity, and that it was not enough to wait for the long run market equilibrium to restore itself. As Keynes famously remarked:

...this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again (Keynes 1923).

From this point, Keynesian economics began its ascension and the neoclassical approach faltered.

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 conceptualizes the agents as rational actors. Agents were modeled as optimizers who were led to "better" outcomes. 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 (Weintraub 1985). 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:

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 (Huberman and 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 (Samuelson 1947).

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 (Samuelson 1947).

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 (Samuelson 1947).

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 (Tversky and Kahneman 1986).

The dilemma is that the assumption of rationality as intertemporally optimizing is often confused with, and regularly presented as, real, purposive behavior. 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 maximize 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, 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 (Thompson 1997).

One neoclassical defense 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 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-optimizing 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 (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 analyzed by focusing on the individuals whose actions brought it about; understanding fully their ‘workings’ at the individual level; and, finally, synthesizing 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 (Varoufakis and Arnsperger 2006).

Methodological individualism

The first feature of neoclassical theory 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.

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 modeled as a function of sectoral unemployment, and micro-strategies of corporations 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 (Varoufakis and Arnsperger 2006).


Methodological instrumentalism

The second feature of neoclassical economics can be called "methodological instrumentalism." This is the notion that all behavior is preference-driven or, more precisely, it is to be understood as a means for maximizing 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 (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! (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.

Continuing influence

According to Varoufakis and Arnsperger, neoclassical economics continues to impact economic thought, research, and teaching, despite its practical irrelevance as evidenced by its failure to describe or predict real-world occurrences:

Neoclassical economics, despite its incessant metamorphoses, is well defined in terms of the same three meta-axioms on which all neoclassical analyses have been founded since the second quarter of the nineteenth century. Moreover, its status within the social sciences, and its capacity to draw research funding and institutional prominence, is explained largely by its success in keeping these three meta-axioms well hidden. ... it is to be explained in evolutionary terms, as the result of practices which reinforce the profession’s considerable success through diverting attention from the models’ axiomatic foundations to their technical complexity and diverse predictions (Varoufakis and Arnsperger 2006).

References
ISBN links support NWE through referral fees

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