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Neoclassical economics is an approach to economics focusing on the determination of goods, outputs, and income distributions in markets through supply and demand. This determination is often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by firms facing production costs and employing available information and factors of production, in accordance with rational choice theory, a theory that has come under considerable question in recent years.
Neoclassical economics dominates microeconomics and, together with Keynesian economics, forms the neoclassical synthesis which dominates mainstream economics today. Although neoclassical economics has gained widespread acceptance by contemporary economists, there have been many critiques of neoclassical economics, often incorporated into newer versions of neoclassical theory, but some remaining distinct fields.
The term was originally introduced by Thorstein Veblen in his 1900 article 'Preconceptions of Economic Science', in which he related marginalists in the tradition of Alfred Marshall et al. to those in the Austrian School.
No attempt will here be made even to pass a verdict on the relative claims of the recognized two or three main "schools" of theory, beyond the somewhat obvious finding that, for the purpose in hand, the so-called Austrian school is scarcely distinguishable from the neo-classical, unless it be in the different distribution of emphasis. The divergence between the modernized classical views, on the one hand, and the historical and Marxist schools, on the other hand, is wider, so much so, indeed, as to bar out a consideration of the postulates of the latter under the same head of inquiry with the former. – Veblen
It was later used by John Hicks, George Stigler, and others to include the work of Carl Menger, William Stanley Jevons, Léon Walras, John Bates Clark, and many others. Today it is usually used to refer to mainstream economics, although it has also been used as an umbrella term encompassing a number of other schools of thought, notably excluding institutional economics, various historical schools of economics, and Marxian economics, in addition to various other heterodox approaches to economics.
Neoclassical economics is characterized by several assumptions common to many schools of economic thought. There is not a complete agreement on what is meant by neoclassical economics, and the result is a wide range of neoclassical approaches to various problem areas and domains—ranging from neoclassical theories of labor to neoclassical theories of demographic changes.
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, which 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.
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.
However, some economists gradually began emphasizing the perceived value of a good to the consumer. They proposed a theory that the value of a product was to be explained with differences in utility (usefulness) to the consumer. (In England, economists tended to conceptualize utility in keeping with the utilitarianism of Jeremy Bentham and later of John Stuart Mill.)
The third step from political economy to economics was the introduction of marginalism and the proposition that economic actors made decisions based on margins. For example, a person decides to buy a second sandwich based on how full he or she is 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.
The change in economic theory from classical to neoclassical economics has been called the "marginal revolution", although it has been argued that the process was slower than the term suggests. It is frequently dated from William Stanley Jevons's Theory of Political Economy (1871), Carl Menger's Principles of Economics (1871), and Léon Walras's Elements of Pure Economics (1874–1877). Historians of economics and economists have debated:
In particular, Jevons saw his economics as an application and development of Jeremy Bentham's utilitarianism and never had a fully developed general equilibrium theory. Menger did not embrace this hedonic conception, explained diminishing marginal utility in terms of subjective prioritization of possible uses, and emphasized disequilibrium and the discrete; further Menger had an objection to the use of mathematics in economics, while the other two modeled their theories after 19th century mechanics. Jevons built on the hedonic conception of Bentham or of Mill, while Walras was more interested in the interaction of markets than in explaining the individual psyche.
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 earlier marginalists went too far in correcting this imbalance by overemphasizing utility and demand. Marshall thought that "We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production".
Marshall explained price 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 determinant of price in the very long run.
An important change in neoclassical economics occurred around 1933. Joan Robinson and Edward H. Chamberlin, with the near simultaneous publication of their respective books, The Economics of Imperfect Competition (1933) and The Theory of Monopolistic Competition (1933), introduced models of imperfect competition. Theories of market forms and industrial organization grew out of this work. They also emphasized certain tools, such as the marginal revenue curve.
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 mathematical modelling.
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. Some argue that outside political interventions, such as McCarthyism, and internal ideological bullying played an important role in this rise to dominance.
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 Gérard Debreu's Theory of Value (1959) and in Arrow and Hahn's "General Competitive Analysis" (1971).
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.
Perhaps the best way to frame a criticism of Neoclassical Economics is in the terms offered by Leijonhufvud in the contention that "Instead of looking for an alternative to replace it, we should try to imagine an economic theory to transcend its limitations." The contention also points to the need to bring in empirical science... testing and re-testing Neoclassical Economics propositions... in order to nudge the Framework and Theory toward a foundation of empirical reality. It is with such empirical reality we might transcend limitations. Leijonhufvud is speaking from the perspective of Experimental Economics; Behavioral Economics, too, uses experimental techniques, but also relies on surveys and other observations of what drives economic choice, also seeking ways to bring economic reality into the Framework and Theory. For overviews of the many empirical findings in both Experimental and Behavioral Economics, some supporting Neoclassical Economics and many suggesting changes needed in the Framework and Theory, see Altman and Tomer.. Also, for an overview of the empirical findings relating to conservation (and recycling) behavior, as in the notion of Empathy Conservation, see Lynne et al.. Neoclassical Economics Framing and Theory has a history of not being able to adequately explain choices related to the interdependence of a person with the natural system.
Neoclassical economics is sometimes criticized for having a normative bias. In this view, it does not focus on explaining actual economies, but instead on describing a theoretical world in which Pareto optimality applies.
Perhaps the strongest criticism lies in its disregard for the physical limits of the Earth and its ecosphere which are the physical container of all human economies. This disregard becomes hot denial by neoclassical economists when limits are asserted, since to accept such limits creates fundamental contradictions with the foundational presumptions that growth in scale of the human economy forever is both possible and desirable. The disregard/denial of limits includes both resources and "waste sinks", the capacity to absorb human waste products and man-made toxins. Ecological Economics sees interdependent Travelers on a Spaceship Earth, a Spaceship having limits. Neoclassical Economics, instead, sees each Traveler as independent of every other Traveler, and with the natural systems that make Travel on the Spaceship Earth possible, which are presumed (without empirical test) to be unlimited, or, at best limited only by knowledge. The empirical reality that people are interdependent with one another and with nature (i.e. the Spaceship Earth systems) is also recognized in Humanistic Economics, Buddhist Economics and Metaeconomics.
Neoclassical Economics addresses the reality of interdependence through the notion of an externality, which is only occasional, and of no real consequence in that the market can always resolve it. Just change the property rights, privatizing the resource or good in question. Empirical reality points to the matter of interdependence being far more complex than can be fixed only with changing to private property rights, seeing the essential need, pragmatically speaking, for a good mix of both private and public property, a major theme in Institutional Economics.
The assumption that individuals act rationally may be viewed as ignoring important aspects of human behavior. Many see the "economic man" as being quite different from real people, the Econ different from the Human.  Many economists, even contemporaries, have criticized this model of economic man... with empirical evidence (as noted, especially in Behavioral Economics) growing in support of representing a person as a Human rather than an Econ. Thorstein Veblen put it most sardonically that 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.
As a result, neoclassical economics has extreme difficulty explaining such things as voting behavior, or someone running into a burning building to save a complete stranger, perhaps even perishing in the process. Clearly such choices are not much, if at all, in the self-interest. Such "non-rational" decision making has been examined deeply and widely in Behavioral Economics. Perhaps most importantly, Behavioral Economics has empirically demonstrated that while the Econ almost exclusively pursues only self-interest, the Human pursues a Dual Interest. The Dual Interest includes both the Ego-based self-interest and the Empathy-based other (shared with others, yet internalized within the own-self)-interest.. And, most importantly, it is quite rational to seek balance in Self&Other-interest, even sacrificing a bit in the domain of Self-interest in order to do so.
Voting behavior, as well as running into a burning building, is rational in that it produces payoff in the realm of shared other-interest... as in the right-thing-to-do... which often requires a bit of sacrifice in the domain of self-interest. Rationality is all about maximizing a joint, non-separable and interdependent self&other-interest, which represents the own-interest. Maximizing own-interest generally means a bit of sacrifice in both domains of self-interest and other-interest, with own-interest all about finding balance. The Dual Interest analytical system now represents the analytical engine of a Metaeconomics... the Meta pointing to bringing considerations of both ethics and the moral dimension...the right-thing-to-do... back into the formal structure of Neoclassical Economics. The Moral Dimension was there at the beginning, in the Moral Philosophy of Adam Smith. It is also quite rational to seek a balance in the Own-interest, with the Moral Dimension tempering the Self-interest.
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 wider social issues are represented in the shared other-interest while profit maximization is represented in the self-interest. Balance is needed.
Problems exist 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 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 ensure that equilibrium is stable and unique are quite restrictive.
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. A 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 realism of their assumptions. Mathematical models also include those in game theory, linear programming, and econometrics. Some see mathematical models used in contemporary research in mainstream economics as having transcended neoclassical economics, while others disagree. Critics of neoclassical economics are divided into 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.
In general, allegedly overly unrealistic assumptions are one of the most common criticisms towards neoclassical economics. 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 modeling non-rational decision making). Its disregard for social reality and its alleged role in aiding the elites to widen the wealth gap and social inequality is also frequently criticized.
It has been argued within the field of Ecological Economics that the Neoclassical Economics system is by nature dysfunctional. It considers the destruction of the natural world through the accelerating consumption of non-renewable resources as well as the exhaustion of the "waste sinks" of the ecosphere as mere "externalities." Such externalities, in turn, are viewed as occurring only occasionally, and easily rectified by shifting public property to private property: The Market will resolve any externalitity, given the opportunity to do so; so, there is no need for any kind of Government, or any other kind of Community "intervention." The Spaceship Earth system is viewed as a subset of the Human Economy, and fully subject to control (which is essential in order to have independence). Neoclassical Economics sees independence between the Human Economy and the Spaceship, between each Human and Nature. Ecological Economics points, instead, to the Human Economy as being embedded in the Spaceship Earth system, so everything is internal: It sees interdependence between each Human and Nature. In effect, there are no externalities, except for some material and energy exchange beyond the atmosphere of the Spaceship. So, a Framework and Theory is needed to transcend the limitation of the Neoclassical Economics presumption of independence, transcending the focus on only the Ego-based Self-interest of an independent person, in both consumption and production. The inherent interdependence of each person and nature, as well as each person with every other person, is recognized in Frameworks and Theory that see the role of Empathy in forming a shared Other-interest in the outcomes on the Spaceship. The essential need to consider Empathy, in order to address the matter of achieving sustainability on this Spaceship Earth, is also becoming a theme in the natural and environmental sciences.