Neoclassical economics

Neoclassical economics is grouping of a number of schools of thought in
economics. There is not complete agreement on what is meant by neoclassical
economics -- in particular, vision, problem domains, and particular concerns
vary among neoclassical economists.

Neoclassical theories often revolve around utility and profit maximization.
Profit maximization lies behind the neoclassical theory of the firm, the
derivation of supply curves for consumer goods, and the derivation of demand
curves for 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 factor supply curves and reservation
demand.

Neoclassical economists define economics as the study of the allocation of
scarce resources among alternative ends. Here's how William Stanley Jevons
presented the economic problem:

     Given, a certain population, with certain needs and powers of
     production, in possession of certain lands and other sources of
     material: required, the mode of employing their labour which will
     maximize the utility of their produce.

Neoclassical economics emphasizes equilibria, where equilibria are the
solutions of individual maximization problems. Regularities in economies are
explained by methodological individualism, the doctrine that all economic
phenomena can be ultimately explained by aggregating over the behavior of
individuals. The emphasis is on microeconomics. Institutions, which might be
considered as prior to and conditioning individual behavior, are
de-emphasized. Economic subjectivism accompanies these emphases. See also
general equilibrium.

Origins of neoclassical economics

Neoclassical economics is conventionally dated from William Stanley Jevons'
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 promulgated the marginal utility
revolution, or Neoclassical Revolution. Historians of economics and
economists have debated

   * Whether utility or marginalism was more essential to this revolution
     (whether the noun or the adjective in the phrase "marginal utility" is
     more important)

   * 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.

In particular, Walras was more interested in the interaction of markets than
in explaining the individual pysche through a hedonistic psychology. Jevons
saw his economics as an application and development of Jeremy Bentham's
utilitarianism and never had a fully developed general equilibrium theory.
Menger emphasized disequilibrium and the discrete. Menger had a
philosophical objection to the use of mathematics in economics, while the
other two modeled their theories after 19th century mechanics.

Alfred Marshall's textbook, Principles of Economics (1890), was the dominant
textbook in England a generation later. Marshall's influence extended
elsewhere; Italians would compliment Maffeo Pantaleoni by calling him the
"Marshall of Italy". Marshall thought classical economics attempted to
explain prices by the cost of production. He asserted that the neoclassicals
went too far in correcting this imbalance by overemphasizing utility and
demand. Marshall thought the question of whether supply or demand was more
important was analogous to the pointless question of which blade of a
scissors did the cutting.

Marshall explained prices by the intersection of supply and demand curves.
The introduction of different market "periods" was an important innovation
in Marshall:

   * 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 determinate of price
in the very long run.

Further developments

An important change in neoclassical economics occurred around 1933. Joan
Robinson and Edward H. Chamberlin, with the near simultaneous publication of
their respective books, The Economics of Imperfect Competition (1933) and
The Theory of Monopolistic Competition (1933), introduced models of
imperfect competition. Theories of market forms and Industrial Organization
grew out of this work. They also emphasized certain tools, such as the
marginal revenue curve.

Joan Robinson's work on imperfect competition, at least, was a response to
certain problems of Marshallian partial equilibrium theory highlighted by
Piero Sraffa. Anglo-American economists also responded to these problems by
turning towards general equilibrium theory, developed on the European
continent by Walras and Vilfredo Pareto. J. R. Hicks' Value and Capital
(1939) was influential in introducing his English-speaking colleagues to
these traditions. He, in turn, was influenced by the Austrian School
economist Friedrich Hayek's move to the London School of Economics, where
Hicks then studied.

These developments were accompanied by the introduction of new tools, such
as indifference curves and the theory of ordinal utility. The level of
mathematical sophistication of neoclassical economics increased. Paul
Samuelson's Foundations of Economic Analysis (1947) contributed to this
increase in formal rigor.

The interwar period in American economics has been argued to have been
pluralistic, with neoclassical economics and institutialism competing for
allegiance. Frank Knight, an early Chicago school economist attempted to
combine both schools. But this increase in mathematics was accompanied by
greater dominance of neoclassical economics in Anglo-American universities
after World War II.

Hicks' book had two main parts. The second, which was arguably not
immediately influential, presented a model of temporary equilibrium. Hicks
was influenced directly by Hayek's notion of intertemporal coordination and
paralleled by earlier work by Lindhal. This was part of an abandonment of
disaggregated long run models. This trend probably reached its culmination
with the Arrow-Debreu model of intertemporal equilibrium. The Arrow-Debreu
model has canonical presentations in Gerard Debreu's Theory of Value (1959)
and in Arrow and Hahn.

Criticisms of neoclassical economics

Neoclassical economics is frequently criticised 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 obtains. Key assumptions
of neo-classical economics which are widely criticised as unrealistic include:

   * The focus on individuals in the economy may obscure analysis of wider
     long term issues, such as whether the economic system is desirable and
     stable on a finite planet of limited natural capital.
   * The assumption that individuals act rationally may be viewed as
     ignoring important aspects of human behavior. Mnay see "economic man"
     as being demonstrably different to a real man on the real earth. Large
     corporations might perhaps come closer to the neoclassical ideal of
     profit maximisation, but this is not necessarily viewed as desirable if
     this comes at the expense of a "locust-like" neglect of wider social
     issues. But they are not human, and are increasingly criticized for not
     being human. The assumption of rational expectations which has been
     introduced in more modern neo-classical models (sometimes also called
     new classical) may also be strongly criticised on the grounds of
     realism.
   * Problems with making the neoclassical general equilibrium theory
     compatible with an economy that develops over time and includes capital
     goods. This was explored in a major debate in the 1960s - the Cambridge
     Capital Controversy - about the validity of neoclassical economics,
     with an emphasis on the theory of growth, capital, aggregate theory,
     and the marginal productivity theory of distribution. There were also
     internal attempts by neoclassical economists to extend the Arrow-Debreu
     model to disequilibrium investigations of stability and uniqueness.
     Some think the Sonnenschein-Mantel-Debreu results put paid to these
     attempts.

In the opinion of some, these developments have found fatal weaknesses in
neoclassical economics. Economists, however, have continued to use highly
mathematical models, and many equate neoclassical economics with economics,
unqualified. Mathematical models include those in game theory, linear
programming, and econometrics, many of which might be considered
non-neoclassical. So economists often refer to what has evolved out of
neoclassical economics as "mainstream economics".

The critique of the assumption of rationality is not confined to social
theorist and ecologists. Many economists, even contemporaries, have
criticized this vision of economic man. Thorstein Veblen put it most
sardonically:

     lightning calculator of pleasures and pains, who oscillates like a
     homogeneous globule of desire of happiness under the impulse of stimuli
     that shift about the area, but leave him intact.

Herbert Simon's theory of bounded rationality has probably been more
influential. Is economic man a first approximation to a more realistic
psychology, an approach only valid in some sphere of human lives, or a
general methodological principle for economics? Early neoclassical
economists often leaned toward the first two appoaches, but the latter has
become prevalent.

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.
Many see an attempt to model a system as complex as a modern economy by a
mathematical model as unrealistic and doomed to failure.

Critics of neoclassical models accuse it of copying of 19th century
mechanics and the "clockwork" model of society which seems to justify elite
privileges as arising "naturally" from the social order based on economic
competititions. This is echoed by modern critics in the anti-globalization
movement who often blame the neoclassical theory, as it has been applied by
the IMF in particular, for inequities in global debt and trade relations.
They assert it ignores the complexity of nature and of human creativity, and
seeks mechanical ideas like equilibrium:

     And in Poinset's Elements de Statique..., which was a textbook on the
     theory of mechanics bristling with systems of simultaneous equations to
     represent, among other things, the mechanical equilibrium of the solar
     system, Walras found a pattern for representing the catallactic
     equilibrium of the market system. (William Jaffe)