Neoclassical Economics: What It Is and Why It's Important

What Is Neoclassical Economics?

Neoclassical economics is a broad theory that focuses on supply and demand as the driving forces behind the production, pricing, and consumption of goods and services. It emerged in around 1900 to compete with the earlier theories of classical economics.

One of the key early assumptions of neoclassical economics is that utility to consumers, not the cost of production, is the most important factor in determining the value of a product or service. This approach was developed in the late 19th century based on books by William Stanley Jevons, Carl Menger, and Léon Walras.

Neoclassical economics theories underlie modern-day economics, along with the tenets of Keynesian economics. Although the neoclassical approach is the most widely taught theory of economics, it has its detractors.

Understanding Neoclassical Economics

Neoclassical economics emerged as a theory in the 1900s. Neoclassical economists believe that a consumer's first concern is to maximize personal satisfaction, also known as utility. Therefore, they make purchasing decisions based on their evaluations of the utility of a product or service. This theory coincides with rational behavior theory, which states that people act rationally when making economic decisions. In other words, people make a logical choice between two options based on their perception of which one is better for them.

Further, neoclassical economics stipulates that a product or service often has value above and beyond its production costs. While classical economic theory assumes that a product's value derives from the cost of materials plus the cost of labor, neoclassical economists say that consumer perceptions of the value of a product affect its price and demand.

Finally, this economic theory states that competition leads to an efficient allocation of resources within an economy. The forces of supply and demand create market equilibrium.

In contrast to Keynesian economics, the neoclassical school states that savings determine investment. It concludes that equilibrium in the market and growth at full employment should be the primary economic priorities of government. 

These principles can be summed up in three assumptions that underpin neoclassical economic theory:

1. Rational thinking: People make rational choices between options based on the value that they identify in each choice.
2. Maximizing: Consumers aim to maximize utility, while businesses aim to maximize profits.
3. Information: People act independently based on having all the relevant information related to a choice or action.

Criticisms of Neoclassical Economics

Critics of neoclassical economics believe that the neoclassical approach cannot accurately describe actual economies. They maintain that the assumption that consumers behave rationally in making choices ignores the vulnerability of human nature to emotional responses.

Other critiques of neoclassical economics include:

• Distribution of resources: Resource distribution impacts how people make decisions, but resources are not distributed equally. There are important differences, especially between those whose income comes from performing labor and those whose income comes from owning capital.
• Appropriation of resources: Resources are often claimed by those with economic or military power, regardless of whether they were previously owned by people or groups with less power.
• Available choices: People may attempt to make rational decisions, but they can only choose between the available choices. For example, choosing between a job that endangers your health or losing your family home is not the same as choosing between a dangerous job and a safe one.
• Irrational decisions: People do not always make the most rational decision, or only consider the benefit to themselves as an individual when making choices. They may be influenced by social pressure, the needs of others, available choices, income restraints, imperfect information, or existing power structures to make choices that don't maximize utility to themselves.
• Pursuit of profit: Maximizing profit is not the only or best way for markets to function, as this can exacerbate inequality, exploit workers, and damage the environment or community. Markets or businesses structured around solving a problem, such as non-profit organizations or single-payer healthcare systems, can often function with equal levels of efficiency and effectiveness.
• Standards of living: Producing more goods and services (having a higher GDP) does not always equal a higher standard of living. Neoclassical economics equates standards of living with "amount of goods and services consumed," but consuming more does not always improve measures such as health, life expectancy, social equality, economic stability, or other factors in quality of life.

Some critics also blame neoclassical economics for inequalities in global debt and trade relations because the theory holds that labor rights and living conditions will inevitably improve as a result of economic growth.

Neoclassical Economics In the Real World

Neoclassical economic theory is important because of how it affects both markets and economic policy.

Business

The principles of neoclassical economics can be used by companies to set prices and grow their business.

A business that understands neoclassical economics, for example, won't just look at the cost of making a product when setting a price. It will also consider what competitors are charging, what customers are willing to pay, and how to use branding to increase what customers are willing to pay. A savvy business owner, for example, could create a marketing campaign that positions their product as the favorite choice of popular figures on social media. By influencing customer perception of their brand, the business will be able to charge more for their products.

Governments and Banks

Governments and banks can also follow neoclassical principles, which will impact economic policy and market regulation. Followers of neoclassical economics believe that there is no upper limit to the profits that can be made by smart capitalists since the value of a product is driven by consumer perception. This difference between the actual costs of the product and the price it is sold for is termed the economic surplus.

This type of thinking was evident in the lead-up to the 2008 financial crisis. Modern economists believed that synthetic financial instruments had no price ceiling because investors in them perceived the housing market as limitless in its potential for growth. As a result, many investment banks and lenders continued to grow the market for subprime mortgages, assuming that continued growth in the market would prevent investment instruments that included these mortgages from losing value. These financial instruments were mostly unregulated by the federal government, allowing lenders and investors to drive growth in the subprime mortgage market.

Both the economists and the investors were wrong, and the market for those financial instruments crashed. The housing market did eventually stop growing and begin to decline. Subprime lenders found themselves underwater on mortgages that they could not afford. They began to default in large numbers. This not only left huge numbers of borrowers unable to afford their homes, but it also undermined the stability of the banks and lenders who had backed their mortgages. The entire global economy suffered and required government intervention to stabilize.

The Bottom Line

Unlike classical economists, who believe the cost of production is the most important factor in a product's price, neoclassical economists state that prices should be based on how consumers perceive the value of a product. They also believe that consumers make rational decisions to maximize utility.

Under neoclassical theory, markets are self-regulating. Competition leads to efficiently allocated resources. The interaction of supply and demand creates equilibrium, which allows markets to adjust to changes without needing to be rebalanced by fiscal or monetary policy.

Critics of neoclassical economics argue that it does not take into account real-world factors that influence consumer decisions. These can include limited access to information, unequal distribution of resources, social constraints, and emotional thinking. Critics also point to the dangers of businesses attempting only to maximize profit or looking at GDP as the best indicator of standard of living.