Neoclassical economics

        Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by income-constrained firms employing available information and factors of production, in accordance with rational choice theory.

        Neoclassical economics dominates microeconomics, and together with Keynesian economics forms the neoclassical synthesis, which dominates mainstream economics today.

Overview

Neoclassical economics is characterized by several assumptions common to many schools of economic thought.

Neoclassical economics rests on some assumptions, although certain branches of neoclassical theory may have different approaches:

1.      People have rational preferences among outcomes that can be identified and associated with a value.

2.      Individuals maximize utility and

3.      Firms maximize profits.

4.      People act independently on the basis of full and relevant information.

        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,

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.

Neoclassical economics emphasizes equilibria, where equilibria are the solutions of agent maximization problems.

Origins

        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.

        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 to the consumer.

        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 they are 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 Marginal Revolution

Neoclassical economics is frequently dated from William Stanley Jevons's Theory of Political Economy (1871), Carl Menger's Principles of Economics (1871), and Leon Walras's Elements of Pure Economics (1874–1877). These three economists have been said to have begun “the Marginal Revolution”. Historians of economics and economists have debated:

·Whether utility or marginalism was more essential to this revolution

·Whether there was a revolutionary change of thought or merely a gradual development and change of emphasis from their predecessors

·Whether grouping these economists together disguises differences more important than their similarities.^[14]

        Marshall explained price by the intersection of supply and demand curves.

        The introduction of different market "periods" was an important innovation of Marshall's:

·Market period. The goods produced for sale on the market are taken as given data, e.g. in a fish market. Prices quickly adjust to clear markets.

·Short period. Industrial capacity is taken as given. The level of output, the level of employment, the inputs of raw materials, and prices fluctuate to equate marginal cost and marginal revenue, where profits are maximized. Economic rents exist in short period equilibrium for fixed factors, and the rate of profit is not equated across sectors.

·Long period. The stock of capital goods, such as factories and machines, is not taken as given. Profit-maximizing equilibria determine both industrial capacity and the level at which it is operated.

·Very long period. Technology, population trends, habits and customs are not taken as given, but allowed to vary in very long period models.

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.

Criticism

        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 "utopia" in which Pareto optimality applies.

        The response to this is that neoclassical economics is descriptive and not normative. It addresses such problems with concepts of private versus social utility.

        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.