What is neo-classical economics? Definition and meaning

The definition and meaning of Neo-classical economics is a theory – a school of economics – that believes that the customer is ultimately the driver of market forces – price and demand – because the consumer’s aim is customer satisfaction or utility maximization, while the company’s goal is profit maximization. It is a theory that concentrates on how the perception of usefulness or efficacy of products influences supply and demand.

The word ‘neo-classical’ can also be written without the hyphen, as in ‘neoclassical’. If you are writing a text, you must stick to one type of spelling throughout that document.

It is an economics approach that relates supply and demand to individuals’ rationality and their ability to maximize utility and profit. It also increases the use of mathematical equations from its predecessor, classical economics.

Neo-classical economicsNeo-classical economists say that the flow of resources, goods, services, and money are driven by the rational behaviors and goals of the sellers and consumers in the marketplace – their objectives and actions lead to market equilibrium.

In neo-classical economics, economists developed the free-market ideas of classical economics into a full-scale model showing how an economy functions.

Alfred Marshall (1842-1924), a British economist – the ‘father of marginal analysis’ – is the best-known neoclassical economist. He took economics to a more mathematically rigorous level.

Although Marshall’s economics was advertised as refinements and extensions of the work of the classical economists, such as Adam Smith and David Ricardo, he extended economics away from the classical market economy focus and made it popular by focusing on human behavior.

A major part of microeconomics is neo-classical economics, and alongside Keynesian economics forms the neo-classical synthesis which dominates current mainstream economics.

Even though classical economics has become widely accepted by current economists, a considerable number have also criticized it, and frequently created new versions of it.

Neolassical economics 19th centuryAccording to EconomicsDiscussion.net: “Marshall frequently uses biological analogies to explain the organic and evolutionary character of the economic system. He says that the Mecca of the economist lies in economic biology rather than in economic dynamics. Emphasizing that economic development is a gradual and continuous process.”

In contrast with Keynesian economists, neo-classical economists believe that savings determine investment (not that investment determines savings). They are concerned mainly with market equilibrium and growth at full employment, rather than with the under-employment of a country’s resources.

Neo-classical economics gained prominence at Cambridge University during the second half of the 19th century. It gave the classical economists’ ideas analytical depth by developing the theories of elasticity, monopoly and equilibrium.

After WWII, it was supplanted by Keynesian economics, but became fashionable again with monetarism during the late 1970s and 1980s, thanks to economists such as Milton Friedman who advised US President Ronald Reagan and British Prime Minister Margaret Thatcher.

According to BusinessDictionary.com, neo-classical economics by definition is:

“‘Classical’ in the sense that it based on the belief that competition leads to an efficient allocation of resources, and regulates economic activity that establishes equilibrium between demand and supply through the operation of market forces.”

“It is ‘neo’ in the sense that it departs sharply from the classical viewpoint in its analytic approach that places great emphasis on mathematical techniques.”

Neo-classical economics – free markets

Followers of neo-classical economics believe strongly that markets must be free. This means that the state – the government – should refrain from creating too many rules and regulations about types of businesses, who may make things, business’ behavior, who may sell things, who may purchase things, prices, what types of goods and services may be sold and bought, and how much.

Neo-classical economists claim that if government intervention is kept to a minimum, citizens enjoy a higher standard of living, receive better wages, have longer average life expectancies, and the country’s GDP (gross domestic product) grows faster.

Steve Keen - neoclassical economics quoteProfessor Steve Keen is an Australian-born, British-based economist and author. He says he is a post-Keynesian, neo-classical economics critic. Middlesex University in London said that he: “Accurately predicted the Great Recession, which applies to both the US recession –from December 2007 to June 2009 – and the global recession in 2009.” (Image: cdn.kingston.ac.uk/)

They believe that there should be some legislation to make sure business behavior is ethical, and that consumers are not victims of commercial abuse. That is why we have regulatory bodies in even the world’s most laissez-faire economies.

Without some degree of oversight in the banking industry, for example, there is a greater risk of frequent and extremely severe financial crises.

Markets are an abstract idea, say neo-classical economists, with all the players – businesses or individuals – selling goods and services, and the consumers purchasing them.

If all the sellers who want to sell at or below a given price have sold to all the consumers who are willing to purchase at or above a given price, there is ‘market equilibrium’. The prices of goods and services are determined by the free-functioning market.

Roger Keesing - neo-classical economics quoteRoger Martin Keesing (1935-1993) was an American anthropologist and linguist, famous for his fieldwork in Kwaio (Solomon Islands). He wrote widely on religion, politics, history, cognitive anthropology, kinship, and language. He is seen as one of the major contributors in the field of anthropology. (Image: perspectivasculturalesunad2015.blogspot.mx)

Classical vs neo-classical economics

Classical economics was founded by David Ricardo, Adam Smith, and John Stuart Mill – all famous economists. Neo-classical economics was developed by scholars and authors including French mathematical economist and Georgist Leon Walras (1834-1910), Austrian economist and founder of he Austrian School of Economics Carl Menger (1840-1921), British economist and logician William Stanley Jevons (1835-1882), and Alfred Marshall (1842-1924), one of the most influential economists of his time.

Classical economics focuses on or emphasizes the production of products and services. Neo-classical economics concentrates on how individual players operate in an economy – it emphasizes the exchange of goods and services as the main focus of economic analysis.

The transformation from classical economic theory to neo-classical economic theory is often referred to as the ‘Marginal Revolution’ – although the change in economy theory took longer than the word ‘revolution’ implies.

The Marginal Revolution is commonly dated from 1871, when Jevons published Theory of Political Economy, Carl Menger’s Principles of Economics came out (1871), to the publication of Walras’ Elements of Pure Economics (1874-1877).

Marginalism is a method of analysis that economists used in microeconomics, which sought to explain economic phenomena through mathematical functions (consumption, production, etc.)

Economic historians still disagree on whether there was a revolutionary change of thought during this period, or simply a gradual development and change of emphasis. There is also disagreement on whether the transformation spanned just one decade or longer.

Alfred Marshall quoteAlfred Marshall (1842-1924) was born in London. He is known as one of the founders of neo-classical economics and probably the most influential economist of his time He played a major role in shaping mainstream economic thought during his life. According to TheFamousPeople.com: “He is credited with the development of the demand-supply graph and for popularizing the use of diagrams in teaching economics. He also played an important role in the “marginalist revolution.” (Image: economicsonline.co.uk)

Keynesian economics vs. neo-classical economics

Keynesian economists assume that there are frictions in markets. Prices do not adjust rapidly to fluctuations in demand or supply, they argue, so any shock to the market will become evident with relatively large shifts in quantities.

Keynesian economists believe that quantities are relatively flexible, while prices are relatively inflexible.

Neo-classical economics founding fathersWalras pioneered the development of general equilibrium theory. Jevons’ book – ‘A general Mathematical Theory of Policital Economy (1862) – was described by American economist Irving Fisher as the start of the mathematical method in economics. Menger contributed to the development of the theory of marginal utility (marginalism). (Images: Leon Walras – biografiasyvidas.com.  Stanley Jevons – socialsciences.manchester.ac.uk. Carl Menger – en.wikipedia.org)

Neo-classical economists assume the opposite. They say that markets have few frictions, i.e. prices adjust rapidly and simply, which means that quantities do not change when there is a shock to demand or supply.

In the school of neo-classical economics, quantities are not flexible while prices are.

Video – Neo-classical economics – Definition and Meaning

In this Henry George School of Social Science video, economists Steve Keen and Andrew Mazzone discuss neo-classical economics.