What is Neoclassical Economics

Neoclassical economics is an approach to economics that relates supply and demand to an individual's rationality and his ability to maximize utility or profit. Neoclassical economics also uses mathematical equations to study various aspects of the economy. This approach was developed in the 19th century, based on books by William Stanley Jevons, Carl Menger and Léon Walras, and became popular in the early 20th century.

BREAKING DOWN Neoclassical Economics

The term neoclassical economics was officially coined in 1900. Neoclassical economists believe that a consumer's number one concern is to maximize personal satisfaction, and that everyone makes decisions based on fully informed evaluations of utility. This theory coincides with the idea of rational behavior theory, which states that people act rationally when making economic decisions.

Further, neoclassical economics stipulates that a good or service often has value that goes above and beyond its input costs. For example, while classical economics believes that a product's value is derived as the cost of materials plus the cost of labor, neoclassical practitioners say that consumers have a perceived value of a product that affects its price and demand.

Finally, this economic theory states that competition leads to an efficient allocation of resources within an economy. This resource allocation establishes market equilibrium between supply and demand.

As opposed to Keynesian economics, this school of economics states that savings determine investment and is primarily concerned with equilibrium in the market and growth at full employment rather than the underemployment of resources. 

Arguments Against Neoclassical Economics

Since its inception, neoclassical economics has grown to become the primary take on modern-day economics. Although it is now the most widely taught form of economics, this school of thought still has its detractors. Most criticism points out that neoclassical economics makes many unfounded and unrealistic assumptions that do not represent real situations. For example, the assumption that all parties will behave rationally overlooks the fact that human nature is vulnerable to other forces, which can cause people to make irrational choices.

Therefore, many critics believe that this approach cannot be used to describe actual economies. Neoclassical economics is also sometimes blamed for inequalities in global debt and trade relations because the theory holds that matters such as labor rights will improve naturally, as a result of economic conditions.

An Example of Neoclassical Economics

Followers of neoclassical economics believe that since the value of a product is driven by consumer perception, there is no upper bound to income or profits that can be made by smart capitalists. This difference between the actual costs of the product and the price it is sold for is called the "economic surplus."

However, this thinking led in part to the 2008 financial crisis. During this time, modern economists believed that synthetic financial instruments had no ceiling and that they insured the market against risk and uncertainty. These economists were wrong, and the same financial products that they lauded led to the housing market crash of 2008.