Neoclassical Economics

What It Means

More than a century after its principles were developed, neoclassical economics remains the overwhelmingly dominant theoretical paradigm, or framework, in modern economics. Neoclassical economics uses the principles of supply and demand to explain how prices for goods and services are established, how outputs (the amount of goods and services produced) are determined, and how income is distributed among people who participate in market transactions. As it is used here, the term market refers not to one specific store where a person might buy strawberries or light bulbs but rather to any arrangement that allows producers and consumers to exchange goods and services for money.

A competitive free market is one where there is little or no government intervention and producers and consumers interact freely, with the producers vying for a limited number of consumer dollars and the consumers trying to obtain a limited amount of goods and services. In such a market, the price of a good or service will create a balance between the quantity of goods and services available (the supply) and the quantity of goods and services purchased (the demand). This balance is called economic equilibrium.

Neoclassical economists assume that all the participants in the market (often referred to as economic agents) are trying to obtain the best possible circumstances for themselves in the face of market-imposed constraints. Buyers seek to optimize (or maximize) utility (the satisfaction they receive from the goods and services they buy). Meanwhile, producers seek to maximize their profits (the money they make from the goods and services they sell). Both agents employ the information at their disposal (such as advertisements and product reviews, for consumers, and market research and trend forecasts, for producers) and exercise their rational preferences in their decision-making. Both agents’ economic decisions are also governed by the fundamental constraint known as scarcity (the conflict between limited resources and unlimited desires). Consumers may not have enough money to purchase all of the goods they want, or the goods they desire may not be available to them. Producers may have limited access to the resources they need to produce their goods, or they may not have enough customers purchasing their products and services to render the profits they wish to gain. According to the neoclassical model, all these dilemmas are eventually resolved in markets, where consumers and producers respond to fluctuating prices.

This neoclassical framework is often referred to as a metatheory, meaning that its principles stand as the foundation upon which other, more specialized economic theories—for example, the neoclassical theory of production or wealth distribution—are constructed. Indeed for twentieth and twenty-first century economists, the premises of neoclassical economics have been so widely accepted that rejecting them is a little bit like a physicist rejecting the law of gravity.

When Did It Begin

Most economic historians agree that there were three founding fathers of neoclassical economics: William Stanley Jevons (1835–82), author of The Theory of Political Economy (1871); Carl Menger (1840–1921), author of Principles of Economics (1871); and Léon Walras (1834–1910), author of Elements of Pure Economics (1874–77). Working independently of one another in England, Austria, and Switzerland, respectively, these pioneers launched what is commonly referred to as the neoclassical revolution. The movement was called “neoclassical” because it was not a complete departure from the principles of classical economics. This new generation of thinkers agreed with the founders of classical theory—most notably Adam Smith (1723–90)—that markets should be guided by an invisible hand (that is, should be left to develop by themselves) rather than controlled through government intervention. But Jevons, Menger, and Walras—and later, Alfred Marshall (1842–1924), author of the influential Principles of Economics (1890)—disagreed with Smith on the concept of value.

Smith’s theory of how the value of a good or service is determined was called the labor theory of value. According to this idea, the value of a given item was a function of all the costs involved in producing the item and putting it on the market. In other words, the final price of a product was dictated solely by what it cost to make and distribute it. Neoclassicists argued that this was simply not true, because prices often fluctuated according to how valuable buyers perceived a given product to be—that is, how much utility, or satisfaction, they expected to derive from buying it. Thus, they conceived the utility theory of value, which stipulates that prices depend on a combination of the costs of production and the utility of the product to potential buyers.

More Detailed Information

Perhaps the most significant aspect of the neoclassical revolution and the reason for its enduring primacy in economic thought is that it provided economists with scientific methods for conducting economic analysis. Although the classicists were certainly aware of the interplay between supply and demand, it remained a rudimentary, intuitive idea until the late 1800s, when the neoclassicists refined it as a set of system dynamics whose interacting components could be measured, graphed, and used to make specific predictions about the outcomes of various economic situations. Indeed, the neoclassicists used the rhetoric of contemporary physics as a metaphor in their conception of economic law, whereby value (or utility) in economics functioned much like energy, and economic agents functioned like atoms.

In their effort to legitimize economics as a hard science, the neoclassicists also introduced mathematics, especially differential calculus, to solve so-called constrained optimization problems—that is, any situation where an agent’s effort to optimize utility is constrained by scarcity, and the answer to the question “What is best?” can be expressed as a numerical value. The process by which the economist solves the problem of what is best (or how to optimize) is called marginal analysis.

According to the utility theory of value, the value of a product must be measured not by its total utility (that is, the satisfaction the consumer derives from the total units of that product he or she buys) but instead by its marginal utility (that is, the additional satisfaction the consumer derives from buying an extra unit of the product). If the marginal utility of buying one more unit is greater than the price of that unit, the consumer is likely to do so. Similarly, a producer’s estimation of how much product he or she should produce involves a calculation of the marginal cost versus the marginal benefit (in this case, the added profit he or she stands to earn) of producing one more unit. Marginal analysis defines economic efficiency, or equilibrium, as the point where marginal cost and marginal utility (or benefit) are equal. The emphasis on marginal value was another defining aspect of neoclassicist theory, so much so that the neoclassicist revolution is also widely referred to as the marginalist revolution.

Recent Trends

Since the late twentieth century there has been a growing debate about the role of neoclassical economic principles in the development of a global economy, a process commonly referred to as globalization. Because of globalization, more goods and services are available in more markets throughout the world, and there is a growing economic interdependence among nations, which, some say, has allowed countries such as India and China to emerge as leading economies. Many economists and political leaders maintain that globalization has developed according to the neoclassical economic principles of free trade and marginal utility. In other words, resources have been allocated, prices have been set, and money has been distributed in the best possible way and with limited government regulation.

Since 1995 there has been a burgeoning antiglobalization movement, which has two main criticisms of the above view of globalization. First, some in the group argue that the neoclassical principles of free trade and marginal utility that have driven globalization have not created an optimal set of conditions for a wide range of people. Rather, they say, free trade has produced a group of large multinational corporations, such as Microsoft, Wal-Mart Stores, Inc., and Sony, that have profited from employing the world’s poorest citizens and paying them low wages. Many people have become rich as a result of globalization, they argue, but the majority of people in the world are still poor, with no hope of improving their circumstances. Second, another group in the antiglobalization movement contends that globalization has in fact not developed according to the principles of free trade and marginal utility. Instead, these critics maintain, leading economic powers such as the United States, Japan, and members of the European Union have steered the process of globalization and controlled prices to their advantage.