Neoclassical Economic Theory

A Neoclassical Economic Theory says that a product or a services governed is valued above or

below the production cost, whilst it is a theory that considers the flow of various goods, services,
outputs, and income distribution through demand-supply theory which assumes unity of
customers in the economy and their main objective is to get satisfaction from the products or
services.

Neoclassical economics is a broad approach that attempts to explain the production, pricing,
consumption of goods and services, and income distribution through supply and demand. It
integrates the cost-of-production theory from classical economics with the concept of utility
maximization and marginalism. Neoclassical economics includes the work of Stanley Jevons,
Maria Edgeworth, Leon Walras, Vilfredo Pareto, and other economists.

Neoclassical economics emerged in the 1900s. In 1933, imperfect competition models were
introduced into neoclassical economics. Some new tools, such as indifference curves and
marginal revenue curves, were used. The new tools were instrumental in improving the
sophistication of its mathematical approaches, boosting the development of neoclassical
economics.

In the 1950s, Keynesian macroeconomic theories and neoclassical microeconomic theories were

combined. The combination led to the neoclassical synthesis, which has dominated economic
reasoning since then.

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 that
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 believes that a
product’s value is derived as the cost of materials plus the cost of labor, whereas the neoclassical
experts say that an 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 have achieved their
respective goals. The competition within an economy leads to the 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.
Key Concepts of Neoclassical Economics

 Efficient allocation of limited productive resources: Neoclassical economics is

primarily concerned with the efficient allocation of limited productive resources. It also
considers the growth of the resources in the long term. The growth will allow for
expanding the production of goods and services. It emphasizes that market equilibrium is
the key to an efficient allocation of resources. Thus, market equilibrium should be one of
the primary economic priorities of a government.
 Neoclassical economics also developed studies about utility and marginalism. Utility
measures the satisfaction received by consuming goods and services. It states that
people’s decision-making over consumption depends on their evaluation of utility. People
allocate their incomes to maximize their levels of utility. Thus, utility is a key factor
driving the value of a product or service. Marginalism explains the change in the value of
a product or service with an additional amount. Combining the two concepts brings us to
the “marginal utility.” Marginal utility refers to the change in utility as a result of an
increase in consumption. The law of diminishing marginal utility states that as the
quantity consumed increases, the marginal utility decreases. The marginal utility can
even turn negative beyond a certain level of quantity. Thus, the total utility maximizes at
the quantity where the marginal utility equals zero.

Difference between Classical vs Neoclassical Economics

Particulars –
Classical vs
Neoclassical Classical economics Neoclassical economics
economic
theory
Neoclassical economics focus on how
Classical economics focus on what makes
individuals operate within an
an economy expand and contract. With
Analysis economy. With this, it emphasizes how
this, the production of goods and services
and why the exchange of goods and
is the prime focus of economic analysis.
services takes place.
Holistic approach by taking into Focused approach by taking into view
Approach  consideration the wider perspective on the how individuals behave within an
economy as a whole. economy.
Reference History comes in as a handy reference Neoclassical economic theory is based
 Particulars –
Classical vs
Neoclassical Classical economics Neoclassical economics
economic
theory
point when we think of how an economy on mathematical models and how an
Point
expands and contracts. individual’s reaction to certain events.
Neoclassical economic theory is based
It is based on the inherent value of goods
on the variable value of goods and
Factors and services, where the goods and services
services, as it believes in the
Responsible are worth some value regardless of who
implications of who produces them
produces them and end-users of it.
and the end user’s perspective.

Criticisms Against Neoclassical Economics 

1. Unrealistic assumptions

One of the most common criticisms of neoclassical economics is its unrealistic assumptions. The
assumption of rational behaviors ignores the vulnerability and irrationality in human nature.

Behavioral economics focuses on studying irrational behaviors in economic decision-making.

The study provides empirical evidence of human behaviors in an economy. It is also argued
whether utility or profit maximization is the only goal of an individual or company.

2. Overdependence on its mathematical approaches

Neoclassical economics is criticized for its over-dependence on its mathematical approaches.

Empirical science is missing in the study. The study, overly based on theoretical models, is not
adequate to explain the actual economy, especially on the interdependence of an individual with
the system. It can also lead to normative bias.

3. Overdependence on complex, unrealistic mathematical models

Neoclassical economics is also considered overly dependent on complex, unrealistic

mathematical models. The complex models are not applicable to describe the real economy. In
response to the criticism, American educator and economist Milton Friedman claimed that a
theory should be judged by its ability to predict. The complexity of the model or realism of the
assumptions is not a standard to judge a theory.

Conclusion

The theory of Neoclassical economics is based on the premise that market forces of demand and
supply are driven by customers, who intend 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 an equilibrium between market forces of
demand and supply. It is ‘neo’ in the sense that it advances from the classical viewpoint.

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 a 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.

Summary

 Neoclassical economics is primarily concerned with the efficient allocation of limited

productive resources. It also considers the growth of the resources in the long term,
which will allow for expanding the production of goods and services.

 Neoclassical economics integrates the cost of production theory from classical

economics with the concepts of utility maximization and marginalism.

 Classical economics states that the cost of production drives the value of a good or
service. Neoclassical economics emphasizes demand as a key driver of the value of a
product or service.