What is Neoclassical Economics? Assumptions and Criticism

The Classical Theory of Economics dominated the economic realm in the late 18th and early 19th century. Classical economics focused on the “laissez faire” approach of growth and development but a new theory quickly rose to the fame which emphasized on “consumer centric approach”. This theory is known as Neoclassical Economics. Lets understand it in a little more detail through this blog. 

 

Neoclassical Economics

 

Alfred Marshall, is the father of neoclassical economics. The theory of Neoclassical Economics originated around 1900; at the time it gave a tough competition to the ideas and beliefs of Classical economists. Adam Smith, David Ricardo, Vilfredo Pareto laid the groundwork for this theory. 

 

The Neoclassical thinkers broke from the classical economists and shifted their focus from “supply side” to the “demand side”. Economics was more theoretical before the advent of neoclassical economics. Neoclassicals created mathematical equations to measure consumer satisfaction. 

 

In simple terms Neoclassicals believe that production and consumption of goods and services is always dependent on its supply and demand. Further neoclassicals laid emphasis on the fact the price of a good will be adjusted according to its market demand.

 

Neoclassicals believe that “utility” is a factor that plays a dominant role in determining whether a good will be priced higher or lower. If any particular good (let’s say a packet of chips, or a can of orange juice) provides utility to the consumer; it will be in high demand (keeping supply of the good constant). 

 

(Related Reading: What is Managerial Economics? Definition, Types, Nature, Principles, and Scope)

 

According to this theory the main focus of a consumer is to get satisfaction from their purchased commodity. Neoclassicals employ the “utility theory of value” to calculate the marginal utility (marginal utility means the satisfaction attained from having an extra unit of a product). 

 

Neoclassicals believed in “consumer preferences” and “productive abilities” determine whether a particular good’s demand will be high or low. Let's move further with the features of neoclassical economics. 

 

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

 

Features of Neoclassical Economics

 

(Please note Economicsdiscussion.net is used as reference for this section)

 

1. Capital Accumulation: Neoclassicals treated the population and the capital theory separately. They believed that the requirement of capital can increase without an increase in the population. 

 

An increase in demand for capital without an increase in population leads to an increase in the national income. Neoclassicals demanded a positive rate of interest to promote consumer savings. As per them a positive rate of interest will lead to an increase in “consumer savings”. 

 

(Related Blog: Capital in Economics - Characteristics, Types and Functions)

2. Impact of Population Increase: As per Neoclassicals an increase in population leads to an increase in the labour supply. They also interlinked technological improvements that lead to an increase in national income.

 

 New technologies cut down the cost of production, it presents new ways for optimum utilization of resources thus contributing to an overall increase in the GDP. 

 

3. The Continuous Process of Development: As per Neoclassicals development is a continuous process. According to Alfred Marshall development of an economy is a gradual process.

 

No economy achieves development in a single stage; it has to go through multiple stages to reach its major goal. Development of an economy takes place in a slow and steady manner. 

 

4. Harmonious and Cumulative Process: “Cumulative” means steady increase, Neoclassicals believe that development of an economy is a cumulative process, an economy grows at a steady rate. As per them the process of development is harmonious for every individual of the economy. 

 

It helps in the upliftment of the “labour and working class”, when the national income of a country will increase it will automatically lead to the increase in “per capita income”. 

 

5. International Trade: International Trade plays an integral role in the development of an economy. It lets a country trade outside its borders and further stimulate healthy competition among existing firms. 

 

The larger size of a market open new avenues for the local firms. Neoclassicals also advocated the need for “protective tariff”(compulsory duty imposed on imports to increase their prices). As per them protective tariffs helps to keep the international competition in check. 

 

(Related Reading: What is Globalization? Globalization vs Internationalization)

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Features of Neoclassical Economics

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Assumptions of Neoclassical Economics

 

(Please note WallstreetMojo is used as a reference for this section)

 

• Free Markets

 

As per Neoclassical economics the markets should be free from government interventions, a market that involves minimum government control will adjust itself automatically as per the laws of demand and supply. 

 

Free markets also provide consumers with better choices.

 

• Savings leads to Investments

 

Neoclassicals believe that a high rate of interest will promote savings, which will further lead to higher investments. Consumers will be willing to invest their saved money when they are offered a higher rate of return on investments. 

 

• Consumers are Rational Agents

 

As per Neoclassicals consumers are rational agents i.e. they purchase products keeping in consideration their utility. Consumers analyze various factors like price, usefulness, satisfaction derived before moving forward with the decision to purchase a particular product. 

 

• Perceived Value of Goods and Services

 

Neoclassicals believe that consumers have a perceived value for a respective product or service. According to them, consumers create their own perception of a good or a service. Consumers' own perception usually overrides the actual value of a product.

 

They further believe that the price of a product is not dependent upon its cost of production  but rather on its “perceived value”. 

 

• The Law of Diminishing Marginal Utility 

 

The Law of Diminishing Marginal Utility states that with the intake of an additional unit the consumer satisfaction will decrease. For example when a consumer is extremely thirsty and purchases his first bottle of water as a means to quench his thirst, his satisfaction would be maximum.

 

Further additional bottles of water will provide him satisfaction but that will be lower compared to the satisfaction derived from the first bottle of water. Producer calculates the marginal cost prior to producing goods. 

 

• Market Equilibrium 

 

Neoclassicals believe Market equilibrium will be achieved when both the consumers and producers have achieved their respective goals. When sellers will sell their goods at the price they are willing to sell and when consumers have purchased products at the price suitable to them, the market will be in equilibrium.

 

(Related Reading: A Guide to Price Ceiling and Price Floor)

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                                                                            Market equilibrium

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• Availability of Relevant Information

 

As per Neoclassicals all the relevant information related to the product is available to consumers. Consumers can further take their decisions based on the availability of information. 

 

Classical Economics V/s Neoclassical Economics

 

Points of Difference	Classical Economics	Neoclassical Economics
Main Focus	Classical Economics focuses on maximize production and surplus in the economy.	Neoclassical Economics focuses on exchange of goods and services via the theories of demand and supply.
Determination of Product Value	In the classical model product value is the sum total of cost of materials and the cost of labour.	In the neoclassical model product value is determined by the influences in products prices and demand.
Approach	Classical economics follows an economy centric approach.	Neoclassical Economics follows a consumer centric approach.

 

Neoclassical Economics Labour Migration Theory

 

The core of neoclassical economics lies in “utility”; and hence key assumption of the labour migration theory is “utility maximization”. The Neoclassical Migration theory states that labourers migrate from one region to another in order to attain higher wages.

 

Most of the labourers migrate from rural areas to urban areas for better opportunities and more money. Neoclassicals view labour migration as an “adjustment process”; where labourers migrate from one place to another so that the market reaches “equilibrium”.

 

Labourers migrate from regions of low wages and high rate of unemployment to regions of high wages and low rates of unemployment. They usually respond to the regional differences. In the theory of migration; all the other factors are kept constant. 

 

Wages and unemployment are explanatory variables in the labour theory. Neoclassical theory treats migrants as “rational individuals”; the decision of migration is usually taken at an individual level. There are multiple risks associated with migration though; these risks are later covered up in the long run, according to this theory. 

 

(Related Reading: The Economic Effects of Social Security)

 

 

Criticism of Neoclassical Economics

 

 

1. Neoclassical Economics sets unrealistic expectations

2. Neoclassical Economics is overly dependent on mathematical formula

3. Neoclassical Economics is overly dependent on complex mathematical models

 

Conclusion

 

 

Neoclassical economics ... has uncovered important truths about the nature of money and markets because its fundamental model of rational self-interested human behavior is correct about 80% of the time.  - Francis Fukuyama

 

Neoclassical economics preceded the classical school of economics. Neoclassicals emphasized on the supply and demand theory for determining the value of a product. They further focused on the maximization of profits (both at the individual level and the market value). This theory focuses on price competition and discards all other kinds of competition. This economic theory believes that minimum government intervention can lead to maximum consumer satisfaction.