Neoclassical Economics

What is Neoclassical Economics?

Neoclassical economics is a dominant economic theory emphasizing rational decision-making, market competition, and supply-demand dynamics to explain individual and aggregate economic behavior within a capitalist framework.

In the past, with stricter governance, rationalism was a taboo topic, and it was not encouraged. 

Regarding neoclassical economics, people will choose based on what they value more and what they think will increase their satisfaction. The cost of making a certain object will not tell you its true value. Why? Because all of us see value differently, and we all have our preferences.

This is why NE was created to reiterate that consumption and the overall market are driven by what people demand based on value and what people can offer as a service.

People will focus on buying things that give them a lot of satisfaction. According to NE, companies want to focus on increasing the amount of money they can make. 

Understanding Neoclassical Economics

Neoclassical economics (NE) is known by many people as a significant economic theory that started a new way of thinking in economics-related matters. NE is a dominant theory known for supporting the idea of a free market. It also believes in the idea of allocating resources equally within society.

It became widely recognized between the 1900s and 2000s as a response to classical economics. When wondering how goods are produced, spread around, and consumed, NE tells us that supply and demand are the biggest factors.

If you are trying to think about the price of something, think of how much that item is demanded! Not how much it costs to make it.

Let’s say you are in a scenario where your friend Josh approaches you and asks: What would you say is the value of that product you are holding? How would you determine that object’s value?

Your instincts might tell you you must determine the cost of producing that object. But, according to NE, this is the wrong and outdated way of thinking.

Instead, neoclassical economics teaches us to ask how much satisfaction this object gives us. What is the utility that comes with it?

When we go to a store to buy something, we see many things that attract us and make us open our eyes! We pick up an item and start wondering with ourselves and thinking if this item is useful for us and if it will bring any value to our life. 

Another way of thinking is this: We want to consume certain things that we think will satisfy us the most, and being satisfied means satisfying our daily needs and wants. This is a popular way of thinking because nowadays, we respect ourselves more and condone the idea of rationalism.

Neoclassical Economics Market

The free market is very important to neoclassical economics. This means that competition is encouraged. Why? Well, NE emphasizes the idea that for a market to flourish, we need to leave it alone and not allow the government to have control over it.

By saying leave it alone, we mean that the market will adjust by itself naturally, and as mentioned above, the supply and demand factors will decide what direction the market will take.

In response, resources will be spread around for everyone efficiently. Demand and supply need to meet and be equal. We can call this market equilibrium.

A natural market that behaves according to people's needs and wants will limit the government's power over our resources and allow things to flow freely. This means people will start making more money and improving their lifestyles, including affording better houses, food, and education.

Regarding market competition, neoclassical economists think it is important because it will strengthen the economy. Why? Think of this logically. Imagine several companies producing and selling the same type of object. Let’s say this object is a washing machine.

Their goal is to attract customers. But how can they do that when several other companies sell the same product?

To do that, they must try to be innovative and stand out against competitors. NE believes this is the main reason for having a free market with competition, as it can lead to innovation, new ideas, and great and improved products. 

Criticisms of Neoclassical Economics

As you can imagine, all theories receive negative feedback since everyone has different beliefs and interests. 

Not only that, but many theories assume how the world works, which can lead to more criticism overall. Over time, your environment changes, and so do your social context and beliefs.

Many economic theories have been applied in our world, leading to the division of groups based on their beliefs.

People worldwide have different political views and demand different things based on their interests. The same applies when it comes to the economic views of neoclassical economics.

Below are some of the criticisms of NE:

False assumptions

Many people have been vocal in expressing that NE tends to make too many assumptions. One of those main assumptions involves people being “rational.”

How can you assume that someone is rational? Many possible factors in life affect the way we think and make choices.

Let’s say there is an investor Ryan. Ryan wants to buy stocks from company Z. Company Z has experienced growth in stock value as their business is succeeding.

If Ryan were rational, he would invest in stocks from company Z due to their success. But, we cannot forget the emotional element. In the past, Ryan has experienced failure in terms of stock earnings.

Due to his negative past experiences, Ryan might hesitate to invest. However, it would be rational for him to invest in a successful company and not let his emotions take over his decision-making. 

In this case, rationality cannot always be assumed when people make decisions that drive the supply and demand of an economy. Realistically, even emotions aside, many people act irrationally for many reasons. 

Another assumption that NE makes is the idea that competition is always perfect. Perfect competition limits the power of specific individuals or businesses to control the market.

But critics make it a point that monopolies exist, and many firms and people have too much control over the market, which means we can’t always assume perfect competition. 

Unequal resource distribution

Neoclassical economics believes the market structure without government intervention will spread goods and resources equally among everyone.

Critics disagree because they think more resources are given to people with specific positions or high authority. This includes people that work in the army.

That tells us if you have power in your country or economic power, like a monopolist, you are likely to receive more resources than the rest.

Other critics also think that resources and goods are not spread fairly because all neoclassical economists think of growth and profit, meaning they don’t pay enough attention to equality. 

Unequal distribution of goods can lead to problems in society. People might revolt against the government to change their policies and bring more fairness into society.

On top of that, the unequal spread of goods will lead to a bigger power gap between social classes and less equality.

Heavy focus on GDP

Many critics think NE places too much value on growth and overall GDP. In doing so, they care less about other important societal variables, such as social balance, justice, and the environment's health.

According to critics, there should be some form of sacrifice, and not everything is about how to increase the performance of your country. Instead, worry about the people within the country and their needs.

Not only that, neoclassical economics focuses too much on short-term growth, according to critics. 

Too much focus on short-term growth in businesses and markets is not sustainable. Not carefully planning for the future will lead to plenty of failure in many companies and markets.

If you only focus on one thing, you will leave out many important variables in a society that need constant care and attention. 

Critics also point to the fact that when business or industry owners focus so much on GDP and profit, this can lead to unfair treatment and exploitation of laborers. 

Lack of power division

Regarding neoclassical economics, you have no power or absolute power.

Critics argue that NE does not pay enough attention to the importance of having several types of institutions with control or separation of power.

Institutions can work together to improve the quality of life of everyone. The same applies to the health of the economy. NE always has one goal: improving the economy's performance.

Critics argue that having several institutions with individual roles can be great for an economy and increase overall GDP.

The same goes for power. Having power separated among different groups or people, including the government, can also help the economy and the overall country. 

Separating power can also help focus on important areas of life that NE tends to ignore slightly, according to critics, such as society and equality.

This means more people will be held accountable, and there will be fewer social and economic power gaps.

Neoclassical Economics Vs. Classical Economics

Neoclassical and classical economics share many similarities and differences. 

Below are some of the similarities and differences between the two:

Although these two theories have had their fair share of differences, there is no question that both NE and CE have had a great impact on economics still to this day.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Allocational Efficiency
• Automatic Stabilizer
• Capitalism
• Equilibrium
• Market Structure