Neoclassical Economics

Neoclassical economics is the approach to economics that explains prices, output and the distribution of income through the choices of individuals and firms, each weighing extra benefits against extra costs, with markets settling where supply and demand balance. It began with the "marginal revolution" of the early 1870s and, in a much-developed form, still underlies most university teaching of microeconomics.

The name was coined by the American economist Thorstein Veblen around 1900 to describe Alfred Marshall's blend of the new marginal analysis with older classical economics. It is often contrasted with Keynesian economics on questions of demand and employment, although the post-war "neoclassical synthesis" combined the two. Heterodox schools, including Marxism, post-Keynesian economics and parts of the Austrian school, define themselves partly against it.

Imagine deciding how many slices of pizza to eat. The first slice is wonderful, the third is fine, and by the fifth you would not pay for another. Neoclassical economics says people make most choices like this, comparing the benefit of "one more" with what it costs, and stopping when the extra benefit no longer covers the extra cost.

Firms do the same with production: they keep making more until the next unit costs more to produce than it brings in. When millions of buyers and sellers make these small comparisons, prices adjust until the amount people want to buy roughly matches the amount others want to sell.

Three economists, working separately, published the key ideas within a few years: William Stanley Jevons in England and Carl Menger in Austria in 1871, and Léon Walras in Switzerland in 1874. All three argued that value comes from marginal utility, the satisfaction from one more unit, rather than from the labor cost stressed by the labor theory of value. Alfred Marshall's Principles of Economics (1890) joined utility-based demand with cost-based supply in the familiar crossing curves and introduced the idea of elasticity.

Walras built the first model of general economic equilibrium, in which all markets clear at once. Kenneth Arrow and Gérard Debreu proved in 1954 that such an equilibrium can exist under strict conditions, and Arrow and John Hicks shared the 1972 Nobel Memorial Prize in Economic Sciences partly for this line of work.

• Rational choice. People have stable preferences and choose the best option they can afford.
• Optimization at the margin. Consumers maximize utility, firms maximize profit.
• Equilibrium. Prices move until plans are consistent; the benchmark case is perfect competition.
• Efficiency as a yardstick. Outcomes are judged by Pareto efficiency, where no one can be made better off without someone being made worse off.

The profit-maximizing rule for a firm is:

Here $\text{MR}$ is marginal revenue, the extra income from selling one more unit, and $\text{MC}$ is marginal cost, the extra cost of producing it. Example: a bakery sells loaves at $4. The 100th loaf costs $3 to make, so it adds $1 to profit and should be baked; the 140th costs $4.50, so it loses 50 cents and should not. Output rises until the cost of the next loaf reaches $4.

Neoclassical tools shape most applied work. Competition authorities use them in antitrust cases, tax analysts use them to judge who bears a tax, and central banks' New Keynesian models are built on optimizing households and firms. Its treatment of market failure, externalities and public goods also provides the main justification for regulation and corrective taxes, so the approach is not tied to any single political position: both the Chicago school and many interventionist economists work inside it.

The method has also spread well beyond markets for goods. Economists have applied the same logic of costs, benefits and constrained choice to education, health, crime, marriage and voting, and Paul Samuelson's Foundations of Economic Analysis (1947) set the mathematical style that most of the profession still follows.

• Unrealistic people.Behavioral economics documents systematic departures from rational choice, such as loss aversion and limited attention.
• Equilibrium and crises. Critics argue that a focus on equilibrium left economists unprepared for the 2008 financial crisis; defenders reply that later models added banks, frictions and sticky prices.
• Capital and distribution. The "Cambridge capital controversy" of the 1950s–60s challenged how neoclassical theory measures capital and explains profits.
• Method. Some critics accuse the field of physics envy: favoring mathematical elegance over realism and history.

• The Nobel Prize: Prize in Economic Sciences 1972 (Hicks and Arrow)
• The Nobel Prize: Prize in Economic Sciences 1970 (Samuelson)