Neoclassical Economics Theory

Neoclassical Theory of Economics Definition

Neoclassical Economic 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, which assumes the unity of customers in the economy and their main objective is to get satisfaction from the products or services.

Neoclassical Economics-Theory

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Assumptions of Neoclassical Economics Theory

Below given are the top 7 assumptions of neoclassical economic theory:

#1 – Rational Agents

An individual rationally selects products and services considering their usefulness. Furthermore, 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 very first ice cream and decreases with more of it until he pays and balances out his satisfaction or consumption. Likewise, a producer’s production estimation involves calculating marginal cost 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 economy leads to the efficient allocation of resources, which helps attain market equilibrium between supply and demand.

#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.

Example of Neoclassical Economics

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 instruments with no ceiling were assumed to be insured against risk. Although, it proved to be responsible for an unforgettable crisis.

If we think of of globalizationOf GlobalizationGlobalization 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 much goods and services 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 limited government regulation. However, 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, the world economy is confined in the hands of a few major economies and multinationals, where poverty has a status quo.

Difference between Classical vs Neoclassical Economics

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 is 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 as a whole.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 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.

Conclusion

The theory of neoclassical economics 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. It 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 an equilibrium 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, it 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. This calls for consumer perception, as a bungalow might be pricey in the eyes of the middle class, but the same may stand affordable for another segment of the society at large.

This article has been a guide to Neoclassical Economics and its definition. Here, we have discussed 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: –

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