Neoclassical Economics – The Assumptions and Criticisms

In the late 18th and early 19th centuries, the Classical Theory of Economics predominated in the field of economics. Classical economics prioritized the “laissez faire” approach to growth and development, but a new theory that placed a strong emphasis on “consumer centric approach” swiftly gained popularity. The term “Neoclassical Economics” refers to this idea.

The founding figure of neoclassical economics is Alfred Marshall. Around 1900, the Neoclassical Economics theory was developed, and at the time, it fiercely rivaled the theories and viewpoints of Classical economists. The foundation for this idea was created by Vilfredo Pareto, David Ricardo, and Adam Smith.

Neoclassical economists diverged from classical economists and centered their attention on the “demand side” as opposed to the “supply side.” Before the rise of neoclassical economics, economics was more theoretical. To gauge customer happiness, neoclassicals developed mathematical formulae.

Simply put, Neoclassicals hold that the supply and demand for goods and services always determines their production and consumption. Neoclassicals also emphasized how a product’s pricing will change in response to market demand.

According to neoclassicals, “utility” is a factor that predominantly affects whether a good will be priced higher or cheaper. Any product will be in high demand if it offers the consumer some benefit.

This notion says that a consumer’s primary goal is to feel satisfied after making a purchase. The “utility theory of value” is used by neoclassicals to determine marginal utility.

The Features

  • Capital Accumulation: The population and the capital theory were studied independently by the Neoclassicals. They held the opinion that a rise in capital requirements might occur without an increase in population. The national income rises when capital demand rises without a corresponding rise in population. To encourage consumer savings, neoclassicals pushed for an interest rate that was positive. According to them, an increase in “consumer savings” will result from a positive rate of interest.
  • Impact of Population Growth: According to Neoclassicals, population growth increases the labor supply. They linked technology advancements that raise national revenue together as well. New technologies reduce manufacturing costs and offer innovative strategies for making the best use of resources, which helps to raise the GDP as a whole.
  • The Ongoing Development: Neoclassicals believe that development is an ongoing activity. According to Alfred Marshall, the growth of an economy takes place gradually. No economy develops in a single stage; instead, it must pass through several stages before achieving its main objective. The growth of an economy happens gradually and steadily.
  • Harmonious and Cumulative Process: Neoclassicals think that the development of an economy is a cumulative process, and that an economy expands at a steady rate. “Cumulative” denotes steady increase. According to them, the process of economic development benefits every member of the population equally. It contributes to the improvement of the “labor and working class,” as rising per capita income follows an increase in a nation’s national income.
  • International Trade: The growth of an economy is fundamentally influenced by international trade. It enables trade across nations and encourages healthy rivalry between already established businesses. The larger the market, the more opportunities it provides for local businesses. The need for “protective tariffs” (compulsory duties placed on imports to raise their prices) was also promoted by neoclassicals. According to them, protective tariffs serve to restrain global competition.

The Assumptions

  • Open merchandise – Neoclassical economics holds that the government should not intervene in the market; a market with little government involvement will spontaneously adjust in accordance with the rules of supply and demand. Furthermore, consumers have more options because to free markets.
  • Investments follow savings – Neoclassicals think that a high interest rate will encourage saves, which will then increase investments. When given a better rate of return on investment, consumers will be more inclined to invest their saved funds.
  • Buyers are reasonable agents – According to Neoclassicals, customers are rational actors that make decisions based on the utility of a product. Before making a decision to buy a certain product, consumers consider a number of criteria, including price, utility, and satisfaction derived.
  • Appreciation of goods and services – Neoclassicals think that customers have an idea of what a certain good or service is worth. They contend that customers form their own opinions about a product or service. Typically, consumers’ perceptions of a product’s value prevail over its real value. They also contend that a product’s price is determined by its “perceived value” rather than its cost of manufacturing.
  • The law of diminishing margins – According to the Law of Diminishing Marginal Utility, consumer happiness will decline as more units are consumed. For instance, a customer would be most satisfied if they bought their first bottle of water when they were incredibly thirsty. He will feel satisfied after drinking more bottles of water, but the satisfaction will be less than it was after drinking the first bottle. Prior to creating items, the producer determines the marginal cost.
  • Market stability – Neoclassicals contend that market equilibrium will be reached once consumers’ and producers’ respective objectives have been met. The market will be in balance when producers will sell their items at the price they are willing to accept and when customers will have made purchases at the price that suits them.
  • Availability of information that is relevant – Consumers have access to all necessary information about the product, according to Neoclassicals. Additionally, consumers can base their choices on the information that is readily available.

The Criticism

  1. Unrealistic expectations are created by neoclassical economics.
  2. An excessive reliance on mathematical formulas characterizes neoclassical economics
  3. Complex mathematical models are unduly reliant on in neoclassical economics.

The classical school of economics came before neoclassical economics. Neoclassicals placed a strong emphasis on the supply and demand theory when estimating a product’s value. They also concentrated on maximizing earnings (both at the individual and market value levels). This idea ignores all other forms of competition in favor of focusing on price competition. According to this economic theory, maximum consumer pleasure can be achieved with the least amount of government involvement.

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