# Understanding Neoclassical Economics: Key Concepts and Impact

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## What Is Neoclassical Economics?

Neoclassical economics, emerging as a successor to classical economics in the 1900s, focuses on the roles of supply and demand in determining prices and consumer behavior. It emphasizes consumer perception of utility over production costs in valuing goods and services, impacting how economic policies and business strategies are developed today.

### Key Takeaways

*   Neoclassical economics emphasizes that consumer perception of value, not production costs, determines pricing.  
    
*   The theory assumes that consumers make rational decisions to maximize satisfaction, known as utility.  
    
*   Critics argue that neoclassical economics overlooks real-world complexities like emotional consumer behaviors and resource inequalities.  
    
*   Neoclassical economics principles shape both business strategies and government policies by emphasizing market self-regulation.  
    
*   The 2008 financial crisis highlighted the limitations of relying solely on neoclassical assumptions of market growth and regulation.  
    

Neoclassical economics assumes that consumer utility, not production cost, mainly determines a product's value. This approach was developed in the late 19th century based on books by William Stanley Jevons, Carl Menger, and Léon Walras.

Neoclassical economics, along with Keynesian economics, forms the foundation of modern economics, but it has its critics. Although the neoclassical approach is the most widely taught theory of economics, it has its detractors.

## The Impact of Neoclassical Economics on Market Dynamics

Neoclassical economics emerged as a theory in the 1900s. Neoclassical economists believe that a consumer's first concern is to maximize personal satisfaction, also known as utility. Therefore, they make purchasing decisions based on their evaluations of the utility of a product or service. This theory coincides with [rational behavior](https://www.investopedia.com/terms/r/rational-behavior.asp) theory, which states that people act rationally when making economic decisions. In other words, people make a logical choice between two options based on their perception of which one is better for them.

Further, neoclassical economics stipulates that a product or service often has value above and beyond its production costs. While classical economic theory assumes that a product's value derives from the cost of materials plus the cost of labor, neoclassical economists say that consumer perceptions of the value of a product affect its price and demand.

Finally, this [economic theory](https://www.investopedia.com/articles/economics/12/nobel-prize-winning-economic-theories.asp) states that competition leads to an efficient allocation of resources within an economy. The forces of supply and demand create market equilibrium.

In contrast to Keynesian economics, the neoclassical school states that savings determine investment. It concludes that equilibrium in the market and growth at full employment should be the primary economic priorities of government. 

These principles can be summed up in three assumptions that underpin neoclassical economic theory:

1.  **Rational thinking**: People make rational choices between options based on the value that they identify in each choice.
2.  **Maximizing**: Consumers aim to maximize utility, while businesses aim to maximize profits.
3.  **Information**: People act independently based on having all the relevant information related to a choice or action.

## Addressing the Limitations of Neoclassical Economics

Critics say neoclassical economics doesn't reflect real economies. They argue it ignores how [emotions affect consumer choices](https://www.investopedia.com/ask/answers/08/homo-economicus.asp).  

> **Important**
>
> Neoclassical economists believe supply and demand efficiently allocate resources.

Other critiques of neoclassical economics include:

*   **Distribution of resources**: Resource distribution impacts how people make decisions, but resources are not distributed equally. There are important differences, especially between those whose income comes from performing labor and those whose income comes from owning capital.
*   **Appropriation of resources**: Resources are often claimed by those with economic or military power, regardless of whether they were previously owned by people or groups with less power.
*   **Available choices**: People may attempt to make rational decisions, but they can only choose between the available choices. For example, choosing between a job that endangers your health or losing your family home is not the same as choosing between a dangerous job and a safe one.
*   **Irrational decisions**: People do not always make the most rational decision, or only consider the benefit to themselves as an individual when making choices. They may be influenced by social pressure, the needs of others, available choices, income restraints, imperfect information, or existing power structures to make choices that don't maximize utility to themselves.
*   **Pursuit of profit**: Maximizing profit is not the only or best way for markets to function, as this can exacerbate inequality, exploit workers, and damage the environment or community. Problem-solving organizations like nonprofits or single-payer healthcare systems can be just as efficient.
*   **Standards of living**: Producing more goods and services (having a higher GDP) does not always equal a higher standard of living. Neoclassical economics equates standards of living with "amount of goods and services consumed," but consuming more does not always improve measures such as health, life expectancy, social equality, economic stability, or other factors in quality of life.

  
Critics say neoclassical economics leads to global trade and debt inequalities, assuming labor rights improve with economic growth.

## Applying Neoclassical Economics in Practical Scenarios

Neoclassical theory is important because it influences markets and economic policy.

### Neoclassical Economics in Business Strategies

Companies can use neoclassical economics to set prices and expand.

Businesses informed by neoclassical economics don't just consider production costs when pricing. It will also consider what competitors are charging, what customers are willing to pay, and how to use branding to increase what customers are willing to pay. A savvy business owner, for example, could create a marketing campaign that positions their product as the favorite choice of popular figures on social media. By influencing customer perception of their brand, the business will be able to charge more for their products.

### Policy Implications of Neoclassical Economics

Governments and banks can use neoclassical principles to shape economic policy and regulationt. Followers of neoclassical economics believe that there is no upper limit to the profits that can be made by smart [capitalists](https://www.investopedia.com/terms/c/capitalism.asp) since the value of a product is driven by consumer perception. This difference between the actual costs of the product and the price it is sold for is termed the economic surplus.

Such thinking was evident before the [2008 financial crisis](https://www.investopedia.com/terms/c/credit-crisis.asp). Economists thought [synthetic financial instruments](https://www.investopedia.com/terms/s/synthetic.asp) had no price ceiling since investors saw the housing market as having limitless growth potential. As a result, many investment banks and lenders continued to grow the market for subprime mortgages, assuming that continued growth in the market would prevent investment instruments that included these mortgages from losing value. These instruments were largely unregulated, enabling growth in the subprime mortgage market.

Both the economists and the investors were wrong, and the market for those financial instruments crashed. The housing market did eventually stop growing and begin to decline. Subprime lenders found themselves underwater on mortgages that they could not afford. Many began to default. This not only left huge numbers of borrowers unable to afford their homes, but it also undermined the stability of the banks and lenders who had backed their mortgages. The global economy suffered, needing government intervention to stabilize.

## What Are the Main Elements of Neoclassical Economics?

The main assumptions of neoclassical economics are that consumers make rational decisions to maximize utility, that businesses aim to maximize profits, that people act independently based on having all the relevant information related to a choice or action, and that markets will self-regulate in response to supply and demand.

  

## Who Was the Founder of Neoclassical Economics?

The movement from classical to neoclassical economic theory grew from the work of William Stanley Jevons, Carl Menger, and Léon Walras in the late 1800s. The dominant text of neoclassical economics, "Principles of Economics", was written by Alfred Marshall and used in the early 1900s.

## What Is the Difference Between Neoclassical and Keynesian Economics?

Neoclassical economic theory believes that markets will naturally restore themselves. Prices, and therefore wages, will adjust on their own in response to changes in consumer demand. [Keynesian economic theory](https://www.investopedia.com/ask/answers/012615/what-difference-between-keynesian-and-neokeynesian-economics.asp) does not believe markets can adjust naturally to these changes. It encourages using fiscal and monetary policy to impact the economy, specifically by slowing the economy during booms and stimulating it during recessions.

## The Bottom Line

Neoclassical economics posits that consumer perception drives product pricing, while rational choices aim to maximize utility. It emphasizes self-regulating markets where competition efficiently allocates resources, allowing supply and demand to achieve equilibrium without government intervention.

However, critics highlight its shortcomings, such as ignoring irrational consumer behavior, unequal resource distribution, and the complexity of real-world decision-making. Moreover, focusing solely on profit maximization and GDP growth may not account for broader measures of living standards and economic health.  

> **Article Sources**
>
> 1.  Veblen, Thorstein. "The Preconceptions of Economic Science." _T__he_ Quarterly Journal of Economics, vol. 14, no. 2, 1900, pp. 240-269.
>     
> 2.  Corporate Finance Institute. "[Neoclassical Economics](https://corporatefinanceinstitute.com/resources/economics/neoclassical-economics/)."
>     
> 3.  American Review of Political Economy. "[The Unreal Basis of Neoclassical Economics](https://arpejournal.com/article/id/180/)."
>     
> 4.  Government Printing Office. "[Financial Crisis Inquiry Commission: The Financial Crisis Inquiry Report, 2011](https://www.govinfo.gov/content/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf)," Page 200.
>     
> 5.  Government Printing Office. "[Financial Crisis Inquiry Commission: The Financial Crisis Inquiry Report, 2011](https://www.govinfo.gov/content/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf)," Pages 148-149.
>     
> 6.  Government Printing Office. "[Financial Crisis Inquiry Commission: The Financial Crisis Inquiry Report, 2011](https://www.govinfo.gov/content/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf)," Page 123.
>     
> 7.  Government Printing Office. "[Financial Crisis Inquiry Commission: The Financial Crisis Inquiry Report, 2011](https://www.govinfo.gov/content/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf)," Pages 226-227.
>     
> 8.  Encyclopedia Britannica. "[Alfred Marshall](https://www.britannica.com/money/Alfred-Marshall)."