7 Differences between Classical and Neoclassical Economics

Classical and neoclassical economics are two distinct approaches to economics definition. The foundations of classical economics were laid by eminent economists such as Adam Smith, David Ricardo, and John Stuart Mill. The authors and scholars such as William Stanley Jevons, Carl Menger, and Leon Walras were said to have developed neoclassical economics. 

 

You can further read our introductory blog on economics. 

 

Since classical economics was formed historically, the two ideas are very different. In contrast, neoclassical economics covers the economic ideas and notions that are currently followed and recognised. The following blog provides a concise overview of classical and neoclassical economics, their underlying assumptions, criticisms, and main points of disagreement.

 

What is Classical Economics?

 

Classical economic theory holds that a self-regulating economy is the most efficient and successful because individuals adjust to meet one another's demands as they arise. According to classical economic theory, government intervention is unnecessary since the economy's citizens will efficiently distribute scarce resources to suit individuals and enterprises' needs.

 

Prices in a classical economy are determined by the cost of raw materials, labour, electricity, and other expenses incurred in producing a final product. Government spending is regarded as minimal in classical economics. However, consumer spending on goods and services and company investment are considered the most important ways to generate economic activity.

 

Assumptions to Classical Economics

 

• A free-market capitalist economic system is one that self-regulates through natural rules of production and exchange.

 

• The rule of supply and demand enables the business cycle to self-regulate. It fosters a laissez-faire system where the government plays a minor role in defining the economy's path.

 

• Smith maintained that a nation's wealth is determined not by the gold in its monarch's coffers but by its national revenue. You might want to learn more about a country’s Gross National Product.

 

• Unrestricted competition and free trade without government intervention or control would benefit economic progress. 

 

• The country's economy will thrive if society enables individuals to pursue their interests, most notably by abandoning class-based social structures favouring meritocracies.

 

• The chaos generated by competitive selling and purchasing would gradually give way to an orderly system of economic cooperation defined by economic actors collaborating to meet one another's needs.

 

• A comparative advantage enables a country to become an efficient producer by concentrating on a particular field of expertise. Additionally, countries benefit by importing from countries that manufacture a commodity lower than the home market. You can learn more about taking comparative advantages via our blog What is Globalization?

 

 

Criticisms to Classical Economics

 

• Classical economists' theories, concepts, and declarations, particularly their beliefs or understanding of markets, were inconsistent.

• Marxian economics and the associated conceptions of socialism and communism contradict traditional economic principles, advocating for free competition and capitalism.

 

(Related Reading: Capitalism vs Socialism)

 

• Keynes emphasised that capitalist and free-market economic systems are nonetheless subject to underconsumption and underspending.

 

• Keynesians argue for the promotion and subsequent implementation of economic policies involving government intervention in the economy.

 

(Must Check: What is Economics? Keynesian And Behavioural Economics)

 

• Unlike Keynesian economics, classical economics was unable to explain why the Great Depression occurred. Additionally, it made no recommendations for alleviating economic downturns.

 

 (Related Reading: What is Austrian Economics? Austrian Economics V/S Keynesian Economics)

 

What is Neoclassical Economics?

 

Neoclassical economics is a comprehensive approach that uses supply and demand to describe the production, pricing, consumption, and distribution of products and services. It combines classical economics' cost-of-production theory and also the concepts of utility maximisation. Stanley Jevons, Maria Edgeworth, Leon Walras, Vilfredo Pareto, and other economists contributed to neoclassical economics.

 

Neoclassical economics arose in the early twentieth century. In 1933, neoclassical economics adopted imperfect competition models. We used several novel methods, including indifference curves and marginal revenue curves. The new tools aid in the sophistication of its mathematical approaches, hence fostering the growth of neoclassical economics.

 

Economists integrated Keynesian macroeconomic and neoclassical microeconomic ideas in the 1950s. The result of this synthesis was the neoclassical synthesis, which has dominated economic reasoning ever since.

 

Assumptions of Neoclassical Economics

 

• Markets that are free : According to Neoclassical economics, markets should be free of government involvement; a market with minimal government intervention will self-adjust according to the rules of demand and supply. Additionally, free markets provide customers with more options.

 

(Related Reading: Market Research and Data Science: Two Faces of a Single Coin)

 

• Savings generates investment opportunities  : Neoclassicals think that a high-interest rate encourages saves, which in turn results in increased investment. When consumers are offered a higher rate of return on their savings, they will invest.

 

• Consumers are Rational Agents : According to Neoclassical economics, customers are rational agents that purchase items based on their usefulness. Consumers weigh numerous considerations such as price, utility, and satisfaction before making a purchasing decision.

 

(Must Check: 5 Factors Influencing Consumer Behavior)

 

• The Perceived Value of Goods and Services : The neoclassical school of thought holds that consumers have a perceived value for a particular product or service. Consumers, they argue, develop their perceptions of a product or service. Typically, a consumer's perception of a product outweighs its actual value. Additionally, they believe that a product's price is determined by its "perceived value" rather than its "cost of production."

 

• Law of Diminishing Marginal Utility  : The Law of Diminishing Marginal Utility states that consumer  satisfaction decreases with each additional unit consumed. 

 

(Related Reading: Marginal Utility Theory: Types and Applications)

 

For instance, if a consumer is exceedingly thirsty and purchases his first bottle of water to alleviate his thirst, he will experience maximum happiness. Additional bottles of water will satisfy him, but only to a lesser extent than the satisfaction gained from the first bottle of water. Before creating items, the producer determines the marginal cost.

 

• Market Stability : According to neoclassical economists, market equilibrium is attained when both consumers and producers fulfil their respective objectives. When sellers sell their commodities at the price at which they are willing to sell them and consumers purchase items at a price acceptable to them, the market is in equilibrium.

 

• Access to Relevant Information : According to Neoclassicals, consumers have access to all pertinent information about a product. Additionally, consumers might make decisions based on the availability of data.

 

Criticisms to Neoclassical Economics:

 

• Irrational assumptions : One of the most frequent criticisms addressed about neoclassical economics is its dependence on unreasonable assumptions.  The presumption of rational behaviour obscures human nature's susceptibility and irrationality. Behavioural economics is concerned with the study of irrational economic decision-making. The research demonstrates human behaviour in an economy through actual evidence. Additionally, it is debated whether an individual or business's sole objective should be utility or profit maximisation.

 

• Excessive dependency on mathematical approaches : Neoclassical economics has been criticised for its excessive reliance on mathematical techniques. The study is devoid of empirical science. The study, which is unduly reliant on theoretical models, is insufficient to explain the actual economy, particularly an individual's interaction with the system. Additionally, it can result in normative bias.

 

• Excessive emphasis on complicated, unreasonable mathematical models : Additionally, neoclassical economics is criticised for being unduly reliant on sophisticated, unrealistic mathematical models. Complex models are useless for describing the real economy. Milton Friedman, an American educator and economist, asserted that a theory should be judged on its predictive abilities in response to the critique. The model's complexity or the assumptions' realism is not sufficient criteria for evaluating a theory.

 

 

Classical Economics vs. Neoclassical Economics:

---

BASIS OF COMPARISON	CLASSICAL ECONOMICS	NEOCLASSICAL ECONOMICS
Description	The value of a commodity or service is determined by its manufacturing cost. The production element, which includes labour, capital, land, and entrepreneurship, determines the cost of production.	The term "neoclassical economics" refers to a comprehensive theory that emphasises supply and demand as the primary forces that drive the production, price, and consumption of commodities and services.
Period of Domination	The classical economics school of thought flourished in the late 18th and early-to-mid 19th centuries, especially in Britain.	Neoclassical economics dominated microeconomics between the 1950s and the 1970s. It led to dominated mainstream economics as Neo-Keynesian economics.
Main Thinkers	The primary philosophers are Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Roberto Malthus, and John Stuart Mill.	Neoclassical economics was influenced by economists such as Stanley Jevons, Maria Edgeworth, Leon Walras, Vilfredo Pareto, and others.
Objective	The classical school of economics is concerned with describing how economic systems expand and contract. All assessments and projections are made with a broad view of the economy in mind.	The neoclassical school of thought explains individual or company behaviours in terms of a more extensive system. The neoclassical technique takes a segmented view of a single small component of a more practical approach.
Focus	Classical economics is a more empirical subject. Its primary objective is to explain capitalism's system of production through social and historical analysis.	Mathematical models are necessary for the study of neoclassical economics. It takes a mathematical approach rather than a historical one.
Equilibrium	Equilibrium occurs in classical economics when savings equal investment. (Related Reading: A Guide to Price Ceiling and Price Floor)	The equilibrium is a function of demand and supply across all markets in neoclassical economics. Balance exists at the point where the supply and demand curves cross. (Related Reading: 10 Different Types of Pricing Strategies)
Profit	Profit, in classical economics, is a remuneration paid to a capitalist for performing a socially beneficial function.	Profit, according to neoclassical economists, is just the difference between profits and expenses.

---

 

Bottom Line

 

Neoclassical economics and classical economics are two very different schools of thought that describe economic concepts in vastly different ways than one another.

 

Under classical economic theory, a self-regulating economy is the most efficient and effective because individuals can adjust to satisfy the demands of one another as they arise. 

 

Neoclassical economics is premised on the idea that individuals will strive to maximise utility. The firms will maximise profits in a market system where individuals are rational creatures with complete access to all available information.