Neoclassical Theory of Economics Definition
The theory of Neoclassical economics is based on the premise that market forces of demand and supply are driven by customers, who intends to maximize his or her own satisfaction by choosing amongst the best available alternatives. It is similar to how a company aims to maximize its profits. It is ‘classical’ in the sense that it is based on the belief that competition leads to an efficient allocation of resources, and establishes equilibrium between market forces of demand and supply. It is ‘neo’ in the sense that it advances from the classical viewpoint.
Assumptions of Neoclassical Economics Theory
Below are the top 7 assumptions of Neoclassical economic theory.
#1 – Rational Agents
An Individual selects product and services rationally, keeping in mind the usefulness thereof. To further this, human beings make choices that give them the best possible satisfaction, advantage, and outcome.
#2 – Marginal Utility
Individuals make choices at the margin, meaning marginal utility is the utility of any good or service which increases with the specific use of it and similarly decreases as the specific use gradually ceases. Let’s consider an example, John chooses to eat a chocolate ice cream at the nearby outlet, his marginal utility is maximum with the very first ice cream and decreases with each more of it until the amount he paid for it balances out his satisfaction or consumption. Similarly, a producer’s estimation of how much to produce involves the calculation of marginal cost versus the marginal benefit (in this case, the added profit it may earn) of producing one additional unit.
#3 – Relevant information
Individuals act independently on the basis of full and relevant information. And information which is readily available without any bias.
#4 – Perceived Value
Neoclassical economists believe that consumer has a perceived value of goods and services which is more than its input costs. For example, while classical economics believe that a product’s value is derived as the cost of materials plus the cost of labor, whereas the neoclassical experts say that individual has a perceived value of a product that influences its price and demand.
#5 – Savings derives Investment
Savings determine investment, it is not the other way round. For example, if you have saved enough for a car throughout a time frame, you may think of such an investment
#6 – Market Equilibrium
Market Equilibrium is achieved only when individuals and the company has achieved their respective goals. The competition within an economy leads to efficient allocation of resources, which in turn helps in achieving market equilibrium between supply and demand.
#7 – Free markets
The markets must be free, meaning that 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.
Example of Neoclassical Economics
One of the important facets of neoclassical economics is “consumer perception” as goods or services derive economic value from it, free trade and marginal utility. The theory has been significant in instances where consumer perception has proven to play a role – for example, the designer wears you so wanted to purchase because of the label attached to it, besides the cost of production of the clothing may be minuscule. Here, the perceived value of the label exceeded its input cost, creating ‘economic surplus’. But the same theory looks flawed when we recall the 2008 financial crisis, where the synthetic financial instruments with no ceiling were assumed to be insured against risk. Although, it proved to be responsible for an unforgettable crisis.
Now, free trade and marginal utility seem to have a good presence if we think of globalization. With the integration between the world economy and the interplay of trade between nations as more goods and services are available for exchange, has led to emerging economies such as India and China. In other words, prices have been determined with efficient resource allocation and with limited government regulation. Although, the flip side of this is anti-globalization, where free trade and marginal utility could not succeed in building an optimal set of parameters for a wider group of people. In turn bringing the world economy being confined in the hands of few major economies and multinationals, where poverty has a status quo.
Difference between Classical vs Neoclassical Economics
|Particulars – Classicial vs Neoclassical economic theory
||Classical economics||Neoclassical economics|
|Analysis||Classical economics focus 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 focus on how individuals operate within an economy. With this, it emphasizes how and why the exchange of goods and services takes place.|
|Approach||Holistic approach by taking into consideration the wider perspective on the economy as a whole.||Focused approach by taking into view how individuals behave within an economy.|
|Reference point||History 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 how an individual’s reaction to certain events.|
|Factors responsible||It is based on the inherent value of goods and services, where the goods and services are worth some value regardless of who produces them and end users of it.||Neoclassical economic theory is based on the variable value of goods and services, as it believes in the implications of who produces them and the end user’s perspective.|
So, whether we foster the theory or pull it down, it does draw some serious measures on how an individual perceives the operational world around it, how free trade builds growth and how marginal utility is subjected to satisfaction. Neoclassical economic theory is mostly applied in various forms in our daily lives, which we may fail to take notice, for example, while choosing a dream home, we encounter scarcity of resources like money and therefore choose an alternative that best meets our requirement. This calls for consumer perception, as a bungalow may be pricy in the eyes of a middle class but the same stands affordable for another segment of the society in large.
This has been a guide to Neoclassical Economics and its definition. Here we discuss the top 7 assumptions of neoclassical economic theory and its difference with Classical Economics along with examples. You can learn more from the following articles –