Neoclassical Economics

By the middle of the nineteenth century, English-speaking economists generally shared a perspective on value theory and distribution theory. The value of a bushel of corn, for example, was thought to depend on the costs involved in producing that bushel. The output or product of an economy was thought to be divided or distributed among the different social groups in accord with the costs borne by those groups in producing the output. This, roughly, was the “Classical Theory” developed by Adam Smith, David Ricardo, Thomas Robert Malthus, John Stuart Mill, and Karl Marx.

But there were difficulties in this approach. Chief among them was that prices in the market did not necessarily reflect the “value” so defined, for people were often willing to pay more than an object was “worth.” The classical “substance” theories of value, which took value to be a property inherent in an object, gradually gave way to a perspective in which value was associated with the relationship between the object and the person obtaining the object. Several economists in different places at about the same time (the 1870s and 1880s) began to base value on the relationship between costs of production and “subjective elements,” later called “supply” and “demand.” This came to be known as the Marginal Revolution in economics, and the overarching theory that developed from these ideas came to be called neoclassical economics. (The first to use the term “neoclassical economics” seems to have been the American economist Thorstein Veblen.)

The framework of neoclassical economics is easily summarized. Buyers attempt to maximize their gains from getting goods, and they do this by increasing their purchases of a good until what they gain from an extra unit is just balanced by what they have to give up to obtain it. In this way they maximize “utility”—the satisfaction associated with the consumption of goods and services. Likewise, individuals provide labor to firms that wish to employ them, by balancing the gains from offering the marginal unit of their services (the wage they would receive) with the disutility of labor itself—the loss of leisure. Individuals make choices at the margin. This results in a theory of demand for goods, and supply of productive factors.

Similarly, producers attempt to produce units of a good so that the cost of producing the incremental or marginal unit is just balanced by the revenue it generates. In this way they maximize profits. Firms also hire employees up to the point that the cost of the additional hire is just balanced by the value of output that the additional employee would produce.

The neoclassical vision thus involves economic “agents,” be they households or firms, optimizing (doing as well as they can), subject to all relevant constraints. Value is linked to unlimited desires and wants colliding with constraints, or scarcity. The tensions, the decision problems, are worked out in markets. Prices are the signals that tell households and firms whether their conflicting desires can be reconciled.

At some price of cars, for example, I want to buy a new car. At that same price others may also want to buy cars. But manufacturers may not want to produce as many cars as we all want. Our frustration may lead us to “bid up” the price of cars, eliminating some potential buyers and encouraging some marginal producers. As the price changes, the imbalance between buy orders and sell orders is reduced. This is how optimization under constraint and market interdependence lead to an economic equilibrium. This is the neoclassical vision.

Neoclassical economics is what is called a metatheory. That is, it is a set of implicit rules or understandings for constructing satisfactory economic theories. It is a scientific research program that generates economic theories. Its fundamental assumptions are not open to discussion in that they define the shared understandings of those who call themselves neoclassical economists, or economists without any adjective. Those fundamental assumptions include the following:

1. People have rational preferences among outcomes.

2. Individuals maximize utility and firms maximize profits.3. People act independently on the basis of full and relevant information.

Theories based on, or guided by, these assumptions are neoclassical theories.

Thus, we can speak of a neoclassical theory of profits, or employment, or growth, or money. We can create neoclassical production relationships between inputs and outputs, or neoclassical theories of marriage and divorce and the spacing of births. Consider layoffs, for example. A theory which assumes that a firm’s layoff decisions are based on a balance between the benefits of laying off an additional worker and the costs associated with that action will be a neoclassical theory. A theory that explains the layoff decision by the changing tastes of managers for employees with particular characteristics will not be a neoclassical theory.

What can be contrasted to neoclassical economics? Some have argued that there are several schools of thought in present-day economics. They identify (neo-)Marxian economics, (neo-)Austrian economics, post-Keynesian economics, or (neo-)institutional economics as alternative metatheoretical frameworks for constructing economic theories. To be sure, societies and journals promulgate the ideas associated with these perspectives. Some of these schools have had insights that neoclassical economists have learned from; the Austrian insights on entrepreneurship are one example. But to the extent these schools reject the core building blocks of neoclassical economics—as Austrians reject optimization, for example—they are regarded by mainstream neoclassical economists as defenders of lost causes or as kooks, misguided critics, and antiscientific oddballs. The status of non-neoclassical economists in the economics departments in English-speaking universities is similar to that of flat-earthers in geography departments: it is safer to voice such opinions after one has tenure, if at all.

One specific attempt to discredit neoclassical economics developed from British economist Joan Robinson and her colleagues and students at Cambridge in the late nineteen-fifties and early sixties. The so-called Two Cambridges Capital Controversy was ostensibly about the implications, and limitations, of Paul Samuelson and Robert Solow’s aggregating “capital” and treating the aggregate as an input in a production function. However, this controversy really was rooted in a clash of visions about what would constitute an “acceptable” theory of the distribution of income. What became the post-Keynesian position was that the distribution of income was “best” explained by power differences among workers and capitalists, while the neoclassical explanation was developed from a market theory of factor prices. Eventually the controversy was not so much settled as laid aside, as neoclassical economics became mainstream economics.

How did such an orthodoxy come to prevail? In brief, the success of neoclassical economics is connected to the “scientificization” or “mathematization” of economics in the twentieth century. It is important to recognize that a number of the early Marginalists, economists like William Stanley Jevons and F. Y. Edgeworth in England, Leon Walras in Lausanne, and Irving Fisher in the United States, wanted to legitimize economics among the scholarly disciplines. The times were optimistic about a future linked to the successes of technology. Progress would be assured in a society that used the best scientific knowledge. Social goals would be attainable if scientific principles could organize social agendas. Scientific socialism and scientific management were phrases that flowed easily from the pens of social theorists.

Neoclassical economics conceptualized the agents, households and firms, as rational actors. Agents were modeled as optimizers who were led to “better” outcomes. The resulting equilibrium was “best” in the sense that any other allocation of goods and services would leave someone worse off. Thus, the social system in the neoclassical vision was free of unresolvable conflict. The very term “social system” is a measure of the success of neoclassical economics, for the idea of a system, with its interacting components, its variables and parameters and constraints, is the language of mid-nineteenth-century physics. This field of rational mechanics was the model for the neoclassical framework. Agents were like atoms; utility was like energy; utility maximization was like the minimization of potential energy, and so forth. In this way was the rhetoric of successful science linked to the neoclassical theory, and in this way economics became linked to science itself. Whether this linkage was planned by the early Marginalists, or rather was a feature of the public success of science itself, is less important than the implications of that linkage. For once neoclassical economics was associated with scientific economics, to challenge the neoclassical approach was to seem to challenge science and progress and modernity.

The value of neoclassical economics can be assessed in the collection of truths to which we are led by its light. The kinds of truths about incentives—about prices and information, about the interrelatedness of decisions and the unintended consequences of choices—are all well developed in neoclassical theories, as is a self-consciousness about the use of evidence. In planning for future electricity needs in my state, for example, the Public Utilities Commission develops a (neoclassical) demand forecast, joins it to a (neoclassical) cost analysis of generation facilities of various sizes and types (e.g., an 800-megawatt low-sulfur coal plant), and develops a least-cost system growth plan and a (neoclassical) pricing strategy for implementing that plan. Those on all sides of the issues, from industry to municipalities, from electric companies to environmental groups, all speak the same language of demand elasticities and cost minimization, of marginal costs and rates of return. The rules of theory development and assessment are clear in neoclassical economics, and that clarity is taken to be beneficial to the community of economists. The scientificness of neoclassical economics, on this view, is not its weakness but its strength.

E. Roy Weintraub is an economics professor at Duke University and associate editor of History of Political Economy.

Related Links

Russell Roberts, Where Do Prices Come From? Econlib, June 2007.

The Classical School of Political Economy Collection at the Online Library of Liberty.

Israel Kirzner, The Economic Point of View: An Essay in the History of Economic Thought.

Margins and Thinking at the Margin, Econlib College Economics Guides.

Steven Horwitz, Adam Smith on the Labor Theory of Value, AdamSmithWorks, September 18, 2019.