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Chapter Outline

8Neoclassical

School

PART III MODERN ECONOMIC SCHOOLS OF THOUGHT

Neoclassical economics

Definition

Basic Theories

General Equilibrium Theory

Neoclassic Theory of value/utility

Marginal Analysis

Pareto’s optimum

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2. Neoclassical Assumptions

It is an economic theory that argues for:

Markets to be free: Markets will 'reach equilibrium' if all the sellers who want to sell at a given price have sold to all the buyers who are willing to buy at that given price.

• The price is worked out in the market according to the supply and demand.

• Governments should generally not make rules about types of businesses, businesses' behavior, who may make things, who may sell things, who may buy things, prices, quantities or types of things sold and bought.

The theory argues that allowing individual actors (people or businesses) freedom, creates better economic outcomes.

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2. Neoclassical Assumptions

Classical is more capitalist, whereas Neoclassical is more humanitarian, because it takes into account human tendencies:

• People have rational preferences among outcomes that can be identified and associated with a value.

• Individuals maximize utility and firms maximize profits.

• People act independently on the basis of full and relevant information.

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1. General Equilibrium Theory

2. Neoclassic Theory of value/utility

3. Marginal Analysis

4. Pareto’s optimum

Thursday, October 15, 2015Chapter 4 - NeoClassical economic theories4

3. Basic theories

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1. GENERAL EQUILIBRIUM

Firm and Household Decisions

Input and output markets

cannot be considered

separately or as if they

operated independently. While

it is important to understand

the decisions of individual

firms and households and the

functioning of individual

markets, we now need to add it

all up, to look at the operation

of the system as a whole.

The theory dates to the 1870s, particularly the

work of French economist Léon Walras.

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PARTIAL EQUILIBRIUM VS. GENERAL EQUILIBRIUM

partial equilibrium analysis The

process of examining the equilibrium conditions in individual markets and for households and firms separately.

general equilibriumThe condition that exists when all markets in an economy are in simultaneous equilibrium.

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GENERAL EQUILIBRIUM ANALYSISAN EARLY TECHNOLOGICAL ADVANCE:

THE ELECTRONIC CALCULATOR

Cost Saving Technological Change in the calculator industry

A significant technological

change in a single industry

affects many markets:

• Households face a different

structure of prices and must

adjust their consumption of

many products.

• Labor reacts to new skill

requirements and is

reallocated across markets.

• Capital is also reallocated.

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GENERAL EQUILIBRIUM ANALYSIS

Economic theorists have struggled with the question of whether a set of prices that equates supply and demand in all markets simultaneously can actually exist when there are literally thousands and thousands of markets. If such a set of prices were not possible, the result could be continuous cycles of expansion, contraction, and instability.

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2. Theory of VALUE/UTILITY

Classical economics, developed in the eighteenth and nineteenth centuries, included a value theory and distribution theory. The value of a product was thought to depend on the costs involved in producing that product. The explanation of costs in Classical economics was simultaneously an explanation of distribution. A landlord received rent, workers received wages, and a capitalist tenant farmer received profits on their investment.

By the middle of the nineteenth century, English-speaking economists generally shared a perspective on value theory and distribution theory. The value of a bushel of corn, for example, was thought to depend on the costs involved in producing that bushel. The output or product of an economy was thought to be divided or distributed among the different social groups in accord with the costs borne by those groups in producing the output. This, roughly, was the "Classical Theory".

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2. Theory of VALUE/UTILITY

But there were difficulties in this approach. Chief among them was that prices in the market did not necessarily reflect the "value" so defined, for people were often willing to pay more than an object was "worth." The classical "substance" theories of value, which took value to be a property inherent in an object, gradually gave way to a perspective in which value was associated with the relationship between the object and the person obtaining the object.

Several economists in different places at about the same time (the 1870s and 1880s) began to base value on the relationship between costs of production and "subjective elements," later called "supply" and "demand." This came to be known as the Marginal revolution in economics, and the overarching theory that developed from these ideas came to be called neoclassical economics.

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2. UTILITY

UtilityIs the satisfaction, or reward, a product yields relative to its alternatives. Utility is the basis of choice.

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3. Marginal Analysis

Marginal utility (MU) The additional satisfaction gained by the consumption or use of one more unit of something.

DIMINISHING MARGINAL UTILITY

Total utility The total amount of satisfaction obtained from consumption of a good or service.

Law of diminishing marginal utility The more of any one good consumed in a given period, the less satisfaction (utility).

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• The paradox of water and diamonds

Commonly associated with Adam Smith.

Human beings cannot even survive without water, whereas diamonds are mere ornamentation.

Yet water have a very low price, and diamonds a very high price.

Marginalism explains that the marginal usefulness of any given quantity determines its price, rather than its usefulness.

For most people, water was sufficiently abundant that the loss or gain of a gallon would withdraw or add only some very minor use if any; whereas diamonds were in much more restricted supply, so that the lost or gained use would be much greater.

• Individuals are willing to trade based upon the respective marginal utilities of the goods that they have or desire (with these marginal utilities being distinct for each potential trader), and therefore, prices would thus develop constrained by these marginal utilities.

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Total Utility and Marginal Utility of Trips

to the Club Per Week

TRIPS

TO CLUB

TOTAL

UTILITY

MARGINAL

UTILITY

1 12 12

2 22 10

3 28 6

4 32 4

5 34 2

6 34 0

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THE BASIS OF CHOICE: Marginal Analysis

Graphs of Total and Marginal Utility

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Allocation of Fixed Expenditure per Week Between Two Alternatives

(1)

TRIPS

TO CLUB

PER WEEK

(2)

TOTAL

UTILITY

(3)

MARGINAL

UTILITY

(MU)

(4)

PRICE

(P)

(5)

MARGINAL UTILITY

PER DOLLAR

(MU/P)

1 12 12 $3.00 4.0

2 22 10 3.00 3.3

3 28 6 3.00 2.0

4 32 4 3.00 1.3

5 34 2 3.00 0.7

6 34 0 3.00 0

(1)

BASKETBALL

GAMES

PER WEEK

(2)

TOTAL

UTILITY

(3)

MARGINAL

UTILITY

(MU)

(4)

PRICE

(P)

(5)

MARGINAL UTILITY

PER DOLLAR

(MU/P)

1 21 21 $6.00 3.5

2 33 12 6.00 2.0

3 42 9 6.00 1.5

4 48 6 6.00 1.0

5 51 3 6.00 .5

6 51 0 6.00 0

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THE BASIS OF CHOICE: Marginal Analysis

ALLOCATING INCOME TO MAXIMIZE UTILITY

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4. PARETO EFFICIENCY

Pareto efficiency or Pareto optimality A condition in which no change is possible that will make at least one member of society better off without making some other member of society worse off.

An economy is efficient when we have a Pareto optimality. This efficiency, according to Pareto, is better reached through free markets.

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5. Criticism

Critiques of this approach involve:- its separation from the real world, both in terms of the time-

frame for an economy to return to equilibrium through market forces,

- and in the "rational" behavior of the people and organizations that is assumed.

Indeed, neoclassical economics has not been entirely successful in predicting the actual behavior of people, markets, and economies in the world so far, nor does it offer a view of a society in which people are able to express their uniquenesses as part of a society of peace, harmony, and prosperity.

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Modern legacy of the Neoclassical economics

Neoclassical economics dominates today microeconomics: Despite much criticism, however, mainstream economics remains largely neoclassical in its assumptions, at least at the microeconomic level.

Together with Keynesian economics, it forms the mainstream economics today.

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NEOCLASSICAL THEORY

Read thoroughly and discuss Article No 8:

Neoclassical Theory

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