Neoclassical Economics Theory

Updated on April 30, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Neoclassical Economics Theory?

A Neoclassical Economics Theory says that a product or service governed is valued above or below the production cost. At the same time, it is a theory that considers the flow of various goods, services, outputs, and income distribution through the demand-supply approach.

What Is Neoclassical Economics Theory

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The theory assumes the unity of customers in the economy and their main objective is to get satisfaction from the products or services. It is based on the premise that market forces of demand and supply are driven by customers intending to maximize their satisfaction by choosing amongst the best available alternatives.

Key Takeaways

  • Neoclassical economics is a theory that examines how goods and services are valued relative to production costs. 
  • It also considers the flows of goods, services, outputs, and income distribution through a demand-supply approach, with a focus on achieving customer satisfaction from goods and services. 
  • The theory relies on seven key assumptions: rational agents, marginal utility, relevant information, perceived value, savings-derived investment, market equilibrium, and free markets. 
  • Neoclassical economics emphasizes profit maximization, similar to how companies aim to optimize their profits within the economic framework.

Neoclassical Economics Theory Explained

The neoclassical economics theory is a method that is used to explore the areas of the market concerned with production, consumption, pricing and distribution of income through the influence of supply and demand. It came into existence in the 1900s and drives the process of efficient usage and allocation of productive resources that are limited.

The neoclassical theory of economics states that the resources grow within an economy, it leads to expansion of production in every sector and all-round growth of the economy.  The cost of production influences that value of products and services where the key driver is the demand.

According to the theory, the equilibrium in the market is an important factor which government should pay special attention to because this is the one that helps in proper resource allocation and economic expansion and growth within limited resources.

The theory also emphasises on customer satisfaction received from consuming the products and services because based on this satisfaction level, people take decisions related to how much income should be allotted from what products. Income allocation should be able to derive maximum benefits from use of those products and services.

It gives a lot of importance to rational behavior while making economic decisions. It states that consumers select goods and services logically and spend their income on them. However, the various assumptions of the theory are argued to be only sometimes realistic or possible in the real world, which has given rise to many other economic theories over time.

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Assumptions

The theory is a widely taught and a dominant part of economics that continues to influence the financial world. It has various assumptions. Let us study the assumptions used in the neoclassical theory of economics in details.

Neoclassical Economics Theory Assumption

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Below are the top 7 assumptions of neoclassical economic theory:

#1 – Rational Agents

An individual rationally selects products and services considering their usefulness. Furthermore, according to the neoclassical economic development theory people make choices that provide optimum satisfaction, advantage, and outcome.

#2 – Marginal Utility

Individuals make choices at the margin, meaning marginal utilityMarginal UtilityA customer's marginal utility is the satisfaction or benefit derived from one additional unit of product consumed. It could be calculated by dividing the additional utility by the amount of additional units.read more. Marginal utility refers to the utility of any good or service that increases with its specific use and decreases gradually as the usage ceases.

Let us consider an example. John chooses to have a chocolate ice cream at the nearby outlet; his marginal utility is maximum with the first ice cream and decreases with more until he pays and balances out his satisfaction or consumption. Likewise, a producer’s production estimation involves calculating marginal costMarginal CostMarginal cost formula helps in calculating the value of increase or decrease of the total production cost of the company during the period under consideration if there is a change in output by one extra unit. It is calculated by dividing the change in the costs by the change in quantity.read more vs. the marginal benefitMarginal BenefitMarginal benefits refer to the highest amount the consumer can and are willing to pay for acquiring the additional unit of goods or service. It denotes the utility or satisfaction a consumer gets from purchasing the extra unit of the goods or service.read more (in this case, the added profit it may earn) of producing one additional unit.

#3 – Relevant information

Individuals act independently based on complete, relevant, and readily available information without bias.

#4 – Perceived Value

Neoclassical economists believe that consumers have a perceived value of goods and services more than input costs. For example, classical economics believes that a product’s value is derived from the cost of materials plus labor. In contrast, neoclassical experts say that an individual perceives a product’s value, influencing its price and demand.

#5 – Savings derives Investment

Savings determine investment, but it is not the other way round. For example, if you have enough saved for a car throughout a time frame, you might think of such an investment.

#6 – Market Equilibrium

Market equilibrium is achieved when individuals and companies have reached their respective goals. The competition within an economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more leads to the efficient allocation of resources, which helps attain market equilibrium between supply and demand, according to the neoclassical economic development theory.

#7 – Free markets

The markets should be free, meaning the state should refrain from imposing too many rules and regulations. If government intervention is minimal, people may have a better standard of living. For example, they may have better wages and a longer average life expectancy.

Even though the theory continues to influence the financial market and modern economic approaches, it has its own disadvantages as well. Economists argue that many of the above assumptions are not possible in the real worlds, like that of rationality or perfect competition. The assumption of rational choices ignores that fact that human nature is vulnerable and can be influenced by various external factors.

Even optimum distribution and utilization of resource is often not possible because power and ability is not equal for all. Income earned or distributed are different between a labor and a person having a high social status. This in turn influences the choice of allocating income on different products and services. Also, the idea of profit maximization is not always used in a productive way. Often businesses damage environment and exploit workers to maximise their own profit.

Due to these assumptions, it is difficult to derive dependable results from the theory. This thought process has given rise to many more economic theories that have different perspectives on how the market works.

Example

One of the important facets of neoclassical economics is “consumer perception,” as goods or services derive economic value, free trade, and marginal utility. The theory has been significant in instances where consumer perception has proven to play a role. For example, you desire to purchase designer apparel because of the attached brand label. Besides, the clothing production cost may be insignificant. Here, the perceived value of the brand label exceeded its input cost, creating an ‘economic surplus.’ At the same time, this theory also looks flawed when recalling the 2008 financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more, where the synthetic financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more with no ceiling were assumed to be insured against risk. Although, it proved to be responsible for an unforgettable crisis.

If we think of globalizationGlobalizationGlobalization is defined as the extension of trade, commerce and culture of an economy across different nations.read more, free trade and marginal utility seem to have a good presence. The integration between the world economy and the trade-off between nations due to many goods and services available for exchange has led to emerging economies like India and China. In other words, prices have been determined with efficient resource allocation and limited governmentLimited GovernmentLimited government is defined as a political structure where laws limit the powers of the government to avoid abuse.read more regulation. However, the flip side of this is anti-globalization, where free trade and marginal utility could not build an optimal set of parameters for a wider group of people. In turn, the world economy is confined in the hands of a few major economies and multinationals, where poverty has a status quo.

Neoclassical Economics Theory Vs Classical Economics Theory

Even though both the above concepts fall under economic theory, they differ in terms of approach, reference or factors influencing them. Let us study the differences between them in details, as given in the table below.

Particulars – Classical vs. Neoclassical economic theoryClassical economicsNeoclassical economics
AnalysisClassical economics focuses on what makes an economy expand and contract. With this, the production of goods and services are the prime focus of economic analysis.Neoclassical economics focuses on how individuals operate within an economy. It emphasizes how and why the exchange of goods and services takes place.
Approach A holistic approach by considering the wider perspective on the economy.Focused approach by taking into view how individuals behave within an economy.
Reference PointHistory comes in as a handy reference point when we think of how an economy expands and contracts.Neoclassical economic theory is based on mathematical models and an individual’s reaction to certain events.
Factors ResponsibleIt is based on the inherent value of goods and services which they are worth buying regardless of who produces them and their end-users.Neoclassical economic theory is based on the variable value of goods and services, as it focuses on the implications of who produces them and the end user’s perspective.

Thus, we see that the former puts more importance on the choices of consumers which leads to decisions related to demand and supply, whereas the latter is similar to the way a company aims to maximize its profits. It may be called ‘classical’ based on the belief that competition efficiently allocates resources and establishes a balance between demand and supply market forces. It is ‘neo’ in that it advances from the classical viewpoint.

So, whether to foster the theory or pull it down draws serious measures on how an individual perceives the operational world around it. It focuses on how free trade builds growth, and marginal utility is subjected to satisfaction. However, neoclassical economic theory is mostly applied in various forms in our daily lives that we may fail to notice. For example, while choosing a dream home, one may encounter a scarcity of resources like money and therefore choose an alternative that meets their requirements. It calls for consumer perception, as a bungalow might be pricey in the eyes of the middle class. Still, the same may stand affordable for another segment of society.

Frequently Asked Questions (FAQs)

1. What is neoclassical economics vs. Keynesian economics? 

Neoclassical economics emphasizes rational decision-making by individuals and firms in a market-driven economy. It assumes perfect competition and emphasizes equilibrium. In contrast, Keynesian economics, developed by John Maynard Keynes, focuses on the role of government intervention in stabilizing the economy during economic downturns. It advocates for fiscal policies like government spending and monetary policies to manage aggregate demand and achieve full employment.

2. What are the features of neoclassical economics? 

Neoclassical economics assumes that individuals are rational and utility-maximizing, firms aim to maximize profits, and markets reach equilibrium through supply and demand forces. It relies on mathematical modeling and emphasizes free markets, efficiency, and scarcity as the basis for resource allocation. Neoclassical economists believe in the efficacy of self-regulating markets and minimal government intervention.

3. What is neoclassical economics criticism? 

Neoclassical economics has faced criticism for several reasons. Critics argue that it’s rationality and perfect competition assumptions do not accurately reflect real-world behavior and market conditions. Additionally, it is criticized for neglecting factors like income distribution, power imbalances, and institutional dynamics that influence economic outcomes. Critics also question its focus on GDP growth as the sole measure of economic success and its limited consideration of environmental and social concerns.

This article is a guide to what is Neoclassical Economics theory. We explain it with example, assumptions and differences with classical economics theory. You can learn more from the following articles: –

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