What is meant by neoclassical theory?
Neoclassical economics was developed in the last three decades of the 19th century. The critical shift from classical economics to neoclassical economics change the direction of economics and it was facilitated by a new set of analytical tools. To some extent, neoclassical can be considered as the hair of classical school. It appears that that the term “neoclassical economics” was coined by American economist Thorstein Veblen in 1990.
It is important to note that the emergence of neoclassical ideas is different in Microeconomics and Macroeconomics.
- In Microeconomics, classical refers to the period from Adam Smith to Alfred Marshal and neoclassical refers to the period starting from Alfred Marshall (Post-marginalist period when marginal concepts such as marginal utility/revenue/cost became the central features).
- In Macroeconomics, classical refers to the period before Keynes (roughly pre 1936) and neoclassical to the period when Keynes views were challenged by economists who accepted Classical thinking (post-1936).
Neoclassical Economics Founders
The Marginalist Revolution was the main course behind the emergence of neoclassical ideology. Roughly around the 1870s, the concept of diminishing marginal utility was introduced by three different scholars;
- William Stanley Jevons (1835-1882)
- Carl Menger(1840-1921)
- Léon Walras (1834-1910)
Their work was independent of each other but they came up with similar theories at the same time period. Later, the marginal concept was established in the field of economics with Alfred Marshall’s publication of “Principles of Economics” in 1890. The term Marginalist revolution illustrates the sudden change in economic ideology from the classical theory of value to marginal utility.
The Neoclassical economics school consists of many doctrines and schools such as
- Austrian School
- The Lausanne School
- Cambridge school
- Walrasian School
- Chicago school, etc.
However, all these schools had the same underlying theoretical principles therefore all these schools were considered as parts of the neoclassical school. The main advocates of this school are Alfred Marshall, Francis Y. Edgeworth, Arthur C. Pigou, Vilfredo Pareto, and Irving Fisher.
Evolution of Neoclassical Economics
Neoclassical transition changed the name of the discipline from political economy to economics. The term first came into literature by Alfred Marshalls in Principles of Economics (1890). Later Jevons argued the necessity of using the term “economics” in the preface of his Theory of Political economy (second edition). And they quickly became the dominant force in the subject. The Neoclassical school prevails until today and is considered as the “mainstream” or “orthodox” or “conventional” theory of economics.
What are the characteristics of neoclassical economics?
With this transition from political economy to economics, the scope of the discipline was also contracted. As mentioned earlier classical economic ideas were surrounded by a broader social, political, historical, and institutional setting and therefore they were interested to look at macroeconomic issues such as production, development, and growth.
However, with the Marginalist revolution, economists started to investigate the optimum allocation of available resources to satisfy the needs of the individuals. And subject priorities of economics were changed to microeconomic issues such as individual choices, marginal utility, marginal cost, and production function. As a result, economics became a separate science detached from social sciences and tend to become more a pure science. With these transformations use of mathematics was necessary to support their theories. For them, mathematics was not an exemplary tool rather an inescapable tool for construct theories. Later, Econometrics and other rigorous mathematical analysis came into economics and it helped the neoclassical economists to prove their theories with data. With all these alterations the connections between economics and other disciplines such as politics, history, and philosophy were disconnected to a larger extent and economics became a more abstract science.
Neoclassical economics vs classical economics
Neoclassical schools accept several core conclusions of the classical school. Both schools accept that even though the economic actors are driven by self-interest the competition in the market ensures that their actions jointly produce the best interest of society. And both schools assume that the economy can automatically move to equilibrium and therefore it is better to leave it alone.
What is difference between classical and neoclassical economics?
Theory of Value
One of the major differences between these two schools is their idea of “theory of value”. According to the classical school value of a good or service is depend on the costs involved in producing it (on Supply conditions). Basically, the cost of labor in it, which was measured by the number of labor hours used in the production. This idea was known as the Labour theory of value, which stated that the value of all reproducible goods comes from labor input. On the contrary, neoclassical ideology is that the value of a good depends on the consumer’s perception of the value of the good or else on the value given to that good by a potential consumer (on-demand conditions). Hence, more difficult to produce does not indicate that it is more valuable, but non-reproducible goods such as art and antiques were exemptions. According to Alfred Marshall, demand conditions are important in the determination of the price of a good in the short run because supply is fixed.
Utility , law of demand and supply
The neoclassical economics school introduced the ideas of utility, the law of demand, and supply. According to their view, individuals are aiming for utility maximization and firms are aiming to profit maximization through cost minimization. Hence, people make choices on marginal values. Individuals make choices considering the marginal satisfaction of marginal utility and they increase their purchase until incremental until gives disutility. On the other hand, firms increase their production until the cost of producing a marginal unit is equal to the revenue it generates. The individual demand curve is downward sloping and the individual supply curve is upward sloping and the equilibrium price of a good is determined at the intersection of the quantities demanded and supplied for that good.
Utility maximization vs Production
Neoclassical viewed the economy as being made from a collection of individuals who are trying to maximize the satisfaction or else utility and the minimization of pain (disutility) whereas classical school asserts that the economy is being made up by “three classes”, Capitalists, workers, and landlords. In addition, the classical school mainly focused on production. The school, especially Adam Smith was keen on the evolution of society from a hunter stage to a feudal society and lastly to the modern society. This evolution was mainly characterized by the changes in the dominant form of production. Therefore, the classical school had a main emphasis on production. However, the main domain under the neoclassical schools was exchange and consumption.