Economics, Neoclassical

THE METAPHYSICS OF NEOCLASSICAL ECONOMICS

THE METHODOLOGY OF INDIVIDUALISM

THE POSSIBLE LIMITATIONS OF NEOCLASSICAL ECONOMICS

BIBLIOGRAPHY

Mainstream economics is often characterized as neoclassical economics, usually to distinguish it from classical economics which had its origin in the rationalist era of the eighteenth century and in particular the work of the patriarch of economics, Adam Smith. The early-twentieth-century critic of economics, Thorstein Veblen, is usually credited with creating the term neoclassical. The obvious reason for the “neo” was that the economics being taught after 1890 somehow went beyond the economics of Smith. While classical economics was concerned with the broad questions facing nations such as growth and development, neoclassical economics instead focused on the decisions of independent and autonomous individuals who participate in the economy.

There are two fundamental ideas that characterize neoclassical economics: A metaphysical one about what motivates individuals to choose one option rather than another and a methodological one about the essential elements of any neoclassical explanation.

THE METAPHYSICS OF NEOCLASSICAL ECONOMICS

The primary and only behavioral assumption of neoclassical economics is that an individual is motivated to do what is best for him or her. To keep in touch with its eighteenth-century roots, this is commonly stated as: People are rational. While many economists mistakenly see this as a proposition about psychology, in reality it has nothing to do with psychology. A choice (or decision) is rational only if one can state a rational argument that entails the choice at issue. As such, rationality is always an attribute of the argument, not the mind.

Usually, an argument consists of several statements identifying explicit assumptions or reasons that are asserted to be true. These are connected by means of ordinary logic to form a logical structure defined by logical connective words (and, or, if ) and words formed from the verb “to be.” Usual arguments include quantitative relational words (some, all, and at least one ). To be a rational argument, two conditions must be met. Everyone who accepts the truth of all of the assumptions of a logically valid argument must accept the truth of all statements entailed (or predicted) by the argument. The first essential condition involves the term anyone. That is, rationality is universal and it is its universality that makes it useful as an explanation of a choice made by an individual. The second essential condition is that each statement entailed by the argument is unique. When the entailed statement represents the one choice an individual makes as in the case of every neoclassical explanation, that choice must be unique. That is, anyone who accepts the truth status of all of the assumptions of the economic theorist’s explanation will reach exactly the same conclusion concerning the individual’s choice made.

While these conditions of universality and uniqueness likely were taken for granted in the eighteenth-century conception of rationality, neoclassical economics of the late nineteenth century chose to express rationality as maximization (which historians of economic thought call marginalism). The idea of a maximizing choice captures the necessary ingredients of any rational argument. For example, it says that whenever choosing how much to consume of some good, individuals are motivated to maximize their level of satisfaction subject to three things: the limitations of the budget, the going price of the good, and the personal “utility function” (which is the mathematical relation that indicates the quantitative level of satisfaction obtained when consuming each possible total amount of that good). While everyone faces the same price, each individual has a personally specific utility function as well as a specific budget. Thus, a maximizing individual will be said to choose that singular quantity of the good that yields the maximum level of satisfaction. Moreover, the explanation also implies that any individual who has specifically the same utility function, facing the same budget and price will make exactly the same choice. As such then, the maximization explanation fulfills the conditions of a rational explanation as it is both universal and unique. And one can always construct an analogous explanation of the choices made by the producers of the product where their motivation may be assumed to be profit maximization.

THE METHODOLOGY OF INDIVIDUALISM

In neoclassical economics things do not decide, only individuals do. This is called methodological individualism. It means that in neoclassical economics any social event must be explained as being the unintended aggregative consequence of the maximizing decisions and choices made by the independent and autonomous individuals participating in the economy or society. Of course, individuals are constrained by existing institutions and laws but this does not invalidate the neoclassical conception of individualism. Instead, it just says that whatever constrains individuals other than nature-given constraints such as weather and resource endowments must be explained. All institutions and laws are the consequence of decisions made by other individuals and thus can and must be explained in any complete neoclassical explanation.

It is the explicit mathematical analysis of the individual decision maker that primarily distinguishes neoclassical from classical economics and the latter’s focus on the nation as a whole. But in principle the end result cannot be different, only the emphasis is different. Whatever the nation is, it is the result of decisions made by all of its constituents both past and present. So, when one explains how each and every individual makes or made their choices, one has explained the whole economy.

The two writers credited with promoting this individualist economics were the Cambridge economist Alfred Marshall and the French economist Léon Walras. Marshall focused on the method of partial equilibrium analysis which recognizes that individuals must take things like prices and product availability as given and do the best they can with the few things they can decide or choose; Walras was instead concerned with general equilibrium analysis for the whole economy and in particular the logical requirements for the determination of a system of prices that would allow all individuals to be maximizing simultaneously. Specifying the necessary mathematical requirements for such a general equilibrium is not trivial and remains a puzzle even in the twenty-first century. While it is always possible to specify assumptions that are sufficient to produce such equilibria, it is another thing to specify assumptions that are necessary.

It is important to note that going beyond the narrow confines of equilibrium analysis, the maximizing individual is still a useful concept even when explaining change or disequilibrium. Specifically, individuals are motivated to change whenever they think they are not maximizing. If the amount of a good an individual would want to buy is not available, that individual could offer to pay a higher price. Thus change, too, is compatible with methodological individualism. So, with this in mind, even a changing world could be seen to be amenable to neoclassical analysis.

THE POSSIBLE LIMITATIONS OF NEOCLASSICAL ECONOMICS

It is easy to see why anyone would think neoclassical economics could be used to explain every social fact or event. Examples are marriage decisions, career decisions, voting patterns, and so on. A generalized form of neoclassical economics can be found in other social sciences under the name of rational choice theory. The philosopher Karl Popper called it “situational analysis.” But critics of neoclassical economics still find it reasonable to doubt the usefulness of such explanations. The primary criticism is based on asking the troublesome question: What must a rational decision maker know in order to make a successful maximizing choice? As Friedrich Hayek in 1937 argued, at minimum, the theorist must identify how the decision makers come to know their choice is the maximizing one. For the most part neoclassical economists have been slow in taking-up Hayek’s suggestion. Instead, neoclassical economists have continued by knowingly making conceivably false assumptions about the economy, usually assuming that all participants in the economy are successfully maximizing with all decisions and choices, and on that basis construct social policies concerning tax rates, interest rates, trade policies, and the like. And critics of such policies continue claiming it is unrealistic to assume everyone is capable of such successful behavior.

Such criticism is not new, however. In the early 1940s, critics such as Richard Lester claimed that empirical evidence did not support the assumption that decision makers in manufacturing firms consciously did the intricate calculations needed to maximize profit as required by the calculus of maximization. In response to such criticism, Armen Alchian in a social-Darwinian fashion argued in 1950 that conscious maximization (and hence deliberate calculation) is unnecessary for success. His argument was based on the notion that if the economy is in a long-run equilibrium—that is, not only are all markets cleared but there has been sufficient time for every producer to have made the optimum decision concerning which markets to enter—then every firm is making what neoclassical economists call zero excess profit. Zero excess profit merely means that the price charged for the product just covers all costs including the normal rate of return expected by owners and investors. In such a world, Alchian notes, the only survivors are those firms maximizing profit—whether or not they deliberately set about applying calculus. That is, in a state of long-run equilibrium, the maximum (excess) profit is zero and thus any firm not maximizing cannot cover all costs and hence cannot survive.

The question of the acceptability of knowingly employing false assumptions when forming economic policy has been a continuing object of dispute since 1953 when Milton Friedman made his argument in favor of an instrumentalist methodology in his famous essay. His argument simply said that as long as the theory works when put to practical use as a tool, the truth status of the constituent assumptions does not matter. Since 1953 economists can be divided into two groups: those that agree with Friedman’s essay and those that do not. While most methodologists are critical of Friedman’s essay or instrumentalism in general, economists who are engaged in practical policy issues are often willing to accept false assumptions as approximations and thus push on with their practical efforts. And as long as the practical uses of such assumptions are seen to yield successful policies, methodologists who demand realism will likely find an audience only among the many critics of neoclassical economics who object to its emphasis of individual maximization as the sole motivation for decision making.

SEE ALSO Economic Methodology; Economics

BIBLIOGRAPHY

Agassi, Joseph. 1960. Methodological Individualism. British Journal of Sociology 11: 244–270.

Alchian, A. 1950. Uncertainty, Evolution, and Economic Theory. Journal of Political Economy 58: 211–221.

Boland, Lawrence. 1979. A Critique of Friedman’s Critics. Journal of Economic Literature 17: 503–522.

Boland, Lawrence. 1988. Situational Analysis beyond Neoclassical Economics. Philosophy of the Social Sciences 28:515–521. http://www.sfu.ca/~boland.

Boland, Lawrence. 2003. The Foundations of Economic Method: A Popperian Perspective. London: Routledge.

Friedman, M. 1953. Methodology of Positive Economics. In Essays in Positive Economics, 3–43. Chicago: University of Chicago Press.

Hayek, Friedrich. 1937. Economics and Knowledge.Economica 4: 33–54.

Lester, R. 1946. Shortcomings of Marginal Analysis for Wage-Employment Problems. American Economic Review 36:63–82.

Popper, Karl. 1994. The Myth of the Framework: In Defense of Science and Rationality. London: Routledge.

Lawrence A. Boland FRSC