Neoclassical Economics

Authors: Lara Boerger and the Exploring-Economics-Team | 18th of December 2016
Patron and academic review: Prof. Dr. Michael Roos

1. Core elements

The term ‘neoclassical economics’ is imprecise and is used in different ways. Most mainstream economists do not identify themselves as members of the neoclassical school. The term ‘neo-classical’ was already coined by Thorstein Veblen in 1900. It describes the synthesis of the subjective and objective theory of value in a diagram of supply and demand, which was developed by Alfred Marshall. Marshall combined the classical understanding that the value of a commodity results from the costs of production with the new findings of marginalism, stating that the value is determined by individual utility. Until today, the market diagram representing the intersection of (objective) supply and (subjective) demand is a central element of neoclassical economics.

The paradigmatic core of neoclassical theory forms today's economic ‘mainstream’ and dominates economics education and research. According to the neoclassical perspective, the central economic problem is the organization and allocation of scarce resources. This implies that efficiency – understood as the optimal usage of the available resources in order to maximize individual utility and consequently the welfare of a country – becomes the most relevant evaluation criterion. The central research domains of neoclassical economics are: microeconomics, which analyses the behaviour of households and firms; macroeconomics, which examines economic aggregates and the interaction of markets; and econometrics, which serves as an analytical tool. Overall, mostly mathematical models are used in the analysis of the economic system. These models, according to neoclassical economists, are best suited to uncover causal relationships.

Like every school of thought, neoclassical economics is subject to continuous change and development (Box 1 gives an overview of past attempts to pin down the neoclassical perspective). Over the past few decades, neoclassical economics has become increasingly diverse and integrated emerging critique into its hypotheses. An example of this development is the ‘de-rationalization’ of human actors in behavioural economics, a sub-school of neoclassical economics. Therefore, it is challenging to present a coherent picture of the current field of neoclassical economics. Nevertheless, in the following, a delineation from other economic schools of thought is attempted by presenting (1) the elementary assumptions or axioms and (2) the standard methods of neoclassical economics.

Different definitions of neoclassical economics

Colander (2000) defines a historical neoclassical economics which does not correspond anymore to the current research in (mainstream) economics:

• Focus on the allocation of resources at a certain point in time
• Utilitarianism
• Focus on marginal trade-offs
• Far-sighted rationality
• Methodological individualism
• General equilibrium

Colander, Rosser and Holt (2004) argued that fundamental to neoclassical economics was the ‘Holy Trinity’ of:

• Rationality
• Selfishness
• Equilibrium

Arnsperger and Varoufakis (2006) argue that three axioms constitute the paradigmatic core of neoclassical economics:

• methodological individualism
• methodological instrumentalism
• methodological equilibration

2. Terminology, analysis and conception of the economy

According to neoclassical economics, the central economic problem is the limited nature of social resources. Due to this scarcity, economics as science should study the organization of an economy in order to establish welfare by the optimal allocation of resources. Simply put, the economy can be understood as an exchange economy in which rational actors with exogenously determined resource allocations interact in markets. Those actors trade with each other since the interaction generates mutual utility. Productivity is seen as the source for the functioning of the economy and the determinant of the wealth of a nation.

In the neoclassical conception of the economy, individuals can choose between different alternatives and the aim of their decisions is to maximize their own utility. Thereby, they act following the principle of rationality (also called ‘economic principle’) according to which an output is maximized for a given input or an input is minimized for a given output. In order to reach an optimal outcome, economic subjects base their decisions on a comparison of costs and benefits whereby marginal units – pursuant to the postulates of marginalism – serve as important factors. The term ‘marginal utility’ refers to the marginal increase in utility due to an extra unit; and the term ‘marginal costs’ describes the marginal costs of this additional unit. ‘A rational decision maker only decides to take a certain action if the marginal utility of the action is bigger than the marginal costs’ (Mankiw 2004, S.7, own translation). In this context, the abstract concept of the homo economicus is often used. It represents an ideal individual who acts rationally, i.e. is utility maximizing, while focusing on his/her personal utility.

By aggregating all the individual utility functions, aggregate demand can be derived. On the market, the latter meets aggregate supply. By means of the price mechanism, which itself is not further modelled, supply and demand converge towards an equilibrium where supply equals demand and where the market is cleared. This property makes the price mechanism an optimal instrument of allocation. Elaborating on the prerequisites of such a price mechanism, in his definition of neoclassical economics, Arne Heise (2007, 3) highlights the axiom of gross substitution according to which all goods (and services) are generally mutually exchangeable. Only by means of this axiom can it be assured that the price mechanism works as an instrument of allocation and that the market equilibria can exist. As long as there is no market failure – e.g. external effects or the creation of monopoly or oligopoly structures – the market mechanism leads to the economic optimum by self-organization. This is called a Pareto-efficient state, since no party can improve its own situation without worsening the one of others.

While microeconomics mainly analyses the behaviour of households and firms on different markets and types of markets, macroeconomics focuses on economic aggregates such as the gross domestic product, the unemployment rate or the inflation rate as well as on the interaction of markets (in particular the commodity market, the labour market and the money market). Macroeconomic analyses of key economic aggregates are increasingly based on microeconomic foundations. The argument underlying the need for such microfoundations is that the rules for individual decision making do not remain stable, for example, in the case of a policy-induced change of the economic conditions (cf. Lucas 1976, whose intervention became known as the ‘Lucas Critique’). The particular form of modelling of neoclassical economics offers the statistical and mathematical tools for the testing of mathematical models and economic phenomena. The approach focuses on the development of quantitative methods for empirical data analysis.

3. Ontology

As already mentioned above, there is no single definition of neoclassical economics since it became increasingly diverse and since other approaches were integrated into the perspective. Nevertheless, according to neoclassical understanding, the central economic problem remains the scarcity of resources. According to Arnsperger and Varoufakis (2006), there are three axioms which can be found in all neoclassical models and sub-schools and therefore constitute the paradigmatic core of neoclassical economics: (1) methodological individualism, (2) methodological instrumentalism and (3) methodological equilibration.

The first axiom, methodological individualism, implies that processes at the macro level can only be ascribed to the actions of individuals at the micro level. Therefore, all economic phenomena can be described and explained by referring to individual actions. Furthermore this implies that only the individual can be the source of moral values: nobody except the individual knows what is best for the individual. Hence the influence or the setting of values by external institutions such as religion is rejected. This description can on the one hand be interpreted as an ontological fixation on individuals which means that the existence of economic phenomena and structures that cannot be ascribed to the individual (emergence) is rejected. On the other hand, the axiom can be understood methodologically. In this case, the explanation of social phenomena can only take place with reference to the individual (Hodgson et al. 1994, 64). The behaviour of actors, according to the second axiom, is a result of fixed preferences or preference bundles. The satisfaction of those preferences generates utility. Individuals continuously strive for the maximization of this utility but are restricted (e.g. due to a budget constraint).

The emphasis on individualism and instrumental rationality leads to the following conception of humans: on the one hand, humans and their preferences are taken as a black box, i.e. as relatively autonomous and independent of external influences; on the other hand, it is assumed that persons act according to an instrumental rationality and aim to reach their goal – i.e. the maximization of utility – as efficiently as possible. While the maximization logic is taken as a universal feature of all human beings, the content of those preferences is variable. Accordingly, individuals may not only strive for the maximization of consumption bundles but also for the achievement of social or ethical preferences (e.g. Akerlof and Kranton 2000).

All in all, decisions and actions at the micro level lead to an overall equilibrium at the macro level. The market itself normally tends towards a state of equilibrium, which is why it is considered to be generally stable. However, this does not mean that the market permanently remains in equilibrium, but that it moves towards a static, stable state in the long run. Nevertheless, it can be concluded from this understanding of the market that neoclassical economics generally assumes that there are general economic laws which exist independently from time and space. The conception of time aims at identifying, comparing and assessing static states rather than at understanding and reconstructing sequences of dynamic processes. Mark Blaug (2003, 146) goes even further by arguing that due to the formalistic revolution in the 1950s, the in-part process-oriented analyses of comparative statics were replaced by the definition of an entirely static endpoint.

A further ontological premise of neoclassical economics can be characterized with regards to closed and open systems. A closed system is defined by the connection of all (atomistic and independent) elements of a system, as well as by the absence of any external impacts. Furthermore, the elements follow deterministic and probabilistic laws (Lawson 2006, 494; Heise 2016, 10). In an open system, however, neither all elements are connected with all the other elements nor is it possible to clearly describe their interactions. Moreover, the system can take on different configurations, i.e. it is not only complicated but complex (Heise 2016 10–11). In contrast to many other perspectives, neoclassical economics assumes that the economy is a closed system. Critics therefore accused neoclassical economics of having an ontological understanding that fails to describe reality adequately or that does so only in a reductionist way (e.g. Chick and Dow 2001; Lawson 2006; Heise 2016).

4. Epistemology

Neoclassical economics cannot be unambiguously assigned to realism or to instrumentalism. On the one hand, neoclassical economics claims to generate ‘optimal knowledge’ about the object under scrutiny in terms of the criteria plausibility, simplicity and empirical adequacy. This claim implies that there exists an observable external world as well as appropriate instruments for its analysis. Also, the postulate that neoclassical research is value-free (cf. Friedman 1953) and the conception that scientists are neutral observers indicate a proximity to epistemological realism. Since neoclassical economics always judges findings of other schools of thoughts by its own standards, a scientific monism results in which alternative ways of understanding are excluded ex ante or are considered outdated.

On the other hand, the use of models which are based on highly idealized and abstracted axioms are justified with the argument that the decisive factor is not the realism of axioms but the predictive power of a model and consequently the empirical adequacy of a drawn conclusion (cf. Friedman’s ‘Methodology of Positive Economics’). Thus, neoclassical economics can be considered to be instrumentalist. Furthermore, large parts of neoclassical economics can be described as highly ‘perspective-driven’. The characteristics of the object are less important for neoclassical model and theory building than the method which is predetermined by the perspective.

The mathematical formal method of neoclassical economics relies on the premise that the interdependencies and causalities of the economic reality can be modelled by means of mathematical descriptions. It is based on the assumption that economic phenomena and actors react and interact according to observable regularities. Furthermore, it is assumed that actors act atomistically, i.e. that they can be isolated causally and are not fundamentally interdependent (cf. Lawson 2013, 8). The operation of models consists of two steps: first, the logical consistency of a model is tested deductively. Then, the model is measured against the empirical reality. Note however that within the past few years, a pragmatic view on models became popular, in which empirical adequacy is the most important criterion rather than dogmatic coherence and mathematical aesthetic.

5. Methodology

As explained in the preceding section, neoclassical economics builds mathematical formal models in order to describe economic relations. The latter are assumed to follow regularities which can be formalized in models. Often, the use of mathematical explanation is considered a strength when compared with other social sciences, since the findings of formalistic models seem to be more trustworthy than verbal analyses. Proponents argue that in contrast to verbal arguments, mathematical formulations are unambiguously defined and, in contrast to classical economics, cannot be interpreted arbitrarily (Rodrik 2015, 31). Neoclassical economics mainly works in the deductive research tradition. Based on axioms, hypotheses are derived from theoretical considerations. This does, however, not mean that hypotheses are not revised and linked to empirical findings. For instance, econometrics aims at further developing and improving models in order to ensure empirical adequacy.

A central concept of economic analyses is the mathematical formulation and solution of optimization problems under constraints by means of static and dynamic optimization methods, such as the approaches developed by Lagrange, Kuhn and Tucker, or Hamilton. Classically, with these methods, the utility maximization of individuals, which is subject to constraints, can be modelled. Also, environmental economists use this approach in order, for example, to calculate the optimal taxation of greenhouse gas emissions. Thereby, economic growth is described as the target function and emission limits as the constraint (cf. van der Ploeg and de Zeeuw 2014). A further method is the comparative and exogenous, causal analysis of changes using the ‘ceteris paribus condition’. For instance, instead of taking economic development as an endogenous process in historical time, the causal relations of dependent variables are analysed by holding other factors constant. Even while some research does focus on dynamic modelling (e.g. dynamic stochastic general equilibrium [DSGE] models), those methods are still applied in neoclassical teaching and research.

6. Ideology and political goals

According to the neoclassical perspective, ethical questions are not an object of fundamental economic analyses but only come into play when explicitly normative issues are considered. For Quaas and Quaas (2010), the increase of wealth is the primary goal of mainstream economics. This self-conception explains the neoclassical macroeconomic focus on economic growth as the target variable. In this context, the categories, terms and relations as well as the heuristics are presented as value-free. Most neoclassical economists differentiate between facts and norms, where the latter are only an issue in explicitly normative fields of neoclassical economics such as welfare economics or economic policy, which provide guidance and analysis for binding, normative decisions. Following this understanding, an author of one of the leading economic textbooks argues as follows: ‘For the treatment of economic questions, we have to carefully differentiate between facts and moral concepts. Positive economics describes the facts of an economy while normative economics deals with value judgements’ (Samuelson and Nordhaus 2010, S. 28, own translation). This conception of positive economics often identifies itself with the – misinterpreted and simplified – claim of Max Weber to ban value judgements from scientific analyses.

However, the assumptions of neoclassical economics do have a normative basis which results from the definition of its fundamental problem: the allocation of scarce resources. Neoclassical economics assumes that humans have the goal to maximize their utility and that this maximization can be modelled. Since only individuals know their own preferences, the market is considered to be the best instrument to satisfy them. State intervention is only considered to be economically reasonable in case of a market failure, while the perfect market is taken as the normal case and perfect competition as ideal state.

Ideologically, neoclassical economics only discusses negative freedom, i.e. the freedom from interference by others (such as state intervention), as opposed to positive freedom, i.e. the freedom to act on one’s will. Negative freedom is argued to be best realized in a market system. These categorizations and terms imply a certain faith in markets which is why neoclassical economists are often associated with a market liberal worldview. This is illustrated by the approach of environmental economics: this considers environmental damage as external effects that need to be made scarce and tradable on the market. Therefore, critics like Thielemann (2003) reproach neoclassical economists’ commodification of the objects of analysis. A further criticism points out that neoclassical economics is biased towards specific normative aims in its questions and analyses: this can be seen in its treatment of the pursuit of personal benefit as the sole aim of entrepreneurial action; or in the application of the insights of behavioural economics as vehicle for profit maximization.

7. Current debates and analyses

Generally speaking, the dynamic, New Keynesian DSGE models can be considered the current standard of macroeconomic analyses of economic growth and business cycles (cf. Heer and Maussner 2005). Yet, macroeconomic research partially changed in particular since the financial crisis. One could highlight the integration of financial markets that evolved in the context of the development of the sub-school ‘macro finance’ (cf. Brunnermeier and Sanikov 2013). At the edges of neoclassical economics, new theoretical fields have emerged, such as behavioural economics and complexity economics, which soften and modify the traditional neoclassical assumptions such as the rationality of agents, perfect information or the isolation of actors. While the use of mathematical tools increased despite broad critique within the past years, some points of critique were integrated into the analyses. Hence, neoclassical economics starts crumbling from the edges (Quaas 2014, 14). In particular in macroeconomics, there is a variety of unconventional research projects which are however developed within the framework of standard neoclassical economics. The basic system of axioms, terms and categories, i.e. the paradigmatic foundation, remains untouched by these changes.

A general trend is the already mentioned focus on empirical adequacy and, as a consequence, the increasing importance of econometrics. At the same time, an increasing interest of economists in other research objects more or less outside the economy can be observed. The application of the economic principle to the analysis and description of phenomena outside the economic field of analysis is commonly called economic imperialism (cf. Milonakis and Fine 2009).

8. Delineation: sub-schools, other economic paradigms, and other disciplines

A large number of economic theories are related to neoclassical economics. It needs to be differentiated between theories that apply the neoclassical methodology to new fields (e.g. environmental economics, health economics) and theories that further develop neoclassical methods (e.g. behavioural economics, information economics). This section aims to provide an overview of the most important sub-schools.

Environmental and resource economics

Environmental and resource economics deals with problems and solutions concerning the environment and sustainable development from an economic perspective. In comparison with the heterodox perspective of ecological economics , environmental and resource economics consider environmental problems as an incorrect allocation of resources due to externalities. Therefore, solutions aim at integrating the environment into the market by assigning a price to environmental impacts and at generating incentives that reduce the use of resources in the production process (cf. van der Ploeg and Withagen 2013; van der Ploeg and de Zeeuw 2014). Representatives of environmental economics share the opinion that steady and sustainable growth (‘green growth’) is not only theoretically possible but should also be the aim of environmental economic research in order to ensure long-term investment in sustainable wealth as well as short-term poverty alleviation by economic growth (Smulders et al. 2014). This can be realized by the relative or absolute decoupling of resource consumption or environmental damage and economic growth. The main premises underlying this approach are (1) the substitutability of natural resources and human capital (2) the solution of the problem of decreasing marginal returns and a therefore necessary (3) technological change (Smulders 2000, Bowen and Hepburn 2012).

Game theory

Game theory comprises several analyses and concepts that model the strategic interaction of several actors in interdependent situations (i.e. at least one actor is dependent on the action of another actor). Game theoretic approaches are used in many social sciences and were first developed by John von Neumann (1928, von Neumann and Morgenstern 1944). In a game, players are assigned certain payoffs depending on the strategy and the game. The analysis starts with the payoffs and subsequently goes back to the starting point. In some games (e.g. the Prisoner’s Dilemma), there is one dominant strategy that is always chosen by rational actors. This leads to a so-called Nash Equilibrium, which however does not have to be the best outcome in objective terms. A differentiation is drawn between zero-sum games, in which the gains of one actor are equal to the losses of the other actor, and non-zero-sum games, in which the sum of payoffs is not equal to zero. In economics, game theory can be applied to the interactions between firms (e.g. in an oligopolistic market) as well as to problems with collective goods (e.g. the overuse of resources).

Moreover, in behavioural economics, theories of acting rationally and utility-maximizing actors were tested using games such as the ultimatum game, the trust game or the dictator game. Experiments in which participants played these games provide evidence that humans consider fairness more important than monetary gain and thus falsify the concept of the strictly maximizing actor (Weber and Dawes 2010, 94–95).

Information economics

Information economics deals with the role of knowledge and information in economic contexts and thereby problematizes the assumption of perfect information. In information economics, information is often presented as being asymmetrically distributed and as expensive to purchase or receive. Those informational asymmetries can lead to inefficiencies. The latter become apparent, for instance, in shrinking markets or in the disappearance of high-quality products, which compete with worse products, since the poor quality of the latter cannot be identified by consumers (cf. Akerlof 1995).

Further questions and analyses in the field of information economics are risk aversions of banks in times of crisis, reputational effects, the role of intermediaries and brokers as well as the role of signals and publicity (cf. Stiglitz http://www.econlib.org/library/Enc/Information.html)

New Institutional Economics

New Institutional Economics (NIE) mainly deals with the role of transaction costs and the institutional structures that actors establish to regulate these. Even if NIE assumes utility maximizing and individual actors, who structure and reduce uncertainty and transaction costs by building institutions, these assumptions do not necessarily imply an optimal resource allocation. Instead, suboptimal institutional structures are possible. These can emerge out of historical processes and represent the interests of a powerful group, which consequently receives higher rents (cf. North 1990). The focus on individual actors and utility maximization distinguishes NIE from the ‘Original Institutionalist Economics’ even if this difference might seem less striking due to the incorporation of cultural and social aspects in NIE's analyses (Khalil 1994, 259–261).

Behavioural economics

Behavioural economics takes up the critique of the homo economicus and tries to conceptualize the economy as the interaction of individuals, who are conceived as actors with bounded rationality. The research therefore focuses on the questions: which decisions do economic subjects make; and what motivations lead to their action. In capital market theories in particular, models and parameters of behavioural economics are currently used (Behavioural finance).

9. Delineation of neoclassical economics from classical economics

Neoclassical theory can be considered a paradigm since it is a (more or less) closed, extensive perspective which researches and interprets economic interactions (Heine and Herr 2013, 5). It can also be perceived as the economic perspective which was able to take over from classical economics and establish itself as today's mainstream. Even if some core assumptions and ideas from classical economics were incorporated and modified, the current state of neoclassical economics can only partially be seen as a new edition of classical economics; hence, the name can be misleading. The difference between these paradigms starts with the definition of what is economic activity. While for neoclassical economics, the task of the economy is to allocate scarce resources, for classical economics guaranteeing survival and therefore the organization of work and reproduction are paramount. Also, the marginalist approach in neoclassical theories on growth and distribution and the consequent understanding of capital differs from the surplus approach of Smith, Ricardo or later Marx. According to the latter, it is only labour that generates the surplus value of production in the process of accumulation. This labour determines the value of goods (see labour theory of value). Additionally, the concept of natural prices, which are determined by the production costs and which differ from the demand- and supply-dependent market price was not incorporated into neoclassical economics.

10. Institutions

Founders:

Alfred Marshall, William Stanley Jevons, Léon Walras, Carl Menger

Journals:

American Economic Review, Econometrica, Quarterly Journal of Economics, Journal of Finance, Journal of Financial Economics, Journal of Monetary Economics, Journal of Political Economy

Associations and organisations

Verein für Sozialpolitik (germanspeaking)

American Economic Association (international)

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