What’s it: Neoclassical economics views supply and demand as the main factors that determine the economy, starting from goods, prices, to income in the economy. Neoclassical economists adopt the equilibrium method to explain how the economy should operate. This concept also describes how resources are distributed in society.
Economic agents are considered individualistic. Consumers and businesses pursue each other’s interests. Consumers will satisfy their needs and wants. Meanwhile, businesses will try to maximize profits.
Neoclassical economic ideas
Some of the concepts that neoclassical economists advocate are:
- They like the competitive market concept because it allows the most efficient allocation of resources
- Economic agents should be selfish.
- They also offer the idea of a decentralized economy.
- They believe that the market will move toward equilibrium itself when there is disequilibrium.
Father of neoclassical economics
Alfred Marshall (1842-1924) is considered to be the father of neoclassical thought. Some of the concepts he introduced include:
- Supply and demand
- Market equilibrium
- The law of diminishing marginal return
- Consumer surplus and producer surplus
- Price elasticity of demand
- Marginal utility
- Production cost
Several economists later adopted his thinking, including William Stanley Jevons, Karl Menger, and Léon Walras. They highlight the role of marginal utility as a significant determinant of exchange rates.
One of the essential models in neoclassical thinking is the Solow growth model. This model shows you that the increase in potential output (potential GDP) depends on input accumulation and technology.
The basis of neoclassical economics
Neoclassical economics emphasizes the individualistic attitude of economic agents. Economic agents act to maximize personal satisfaction, be it individual or business. They make decisions based on a fully informed evaluation of utility.
Consumers will maximize utility, while businesses maximize profits. Consumers will satisfy satisfaction by buying several items that can meet their needs and wants plus according to their budget. Meanwhile, businesses will produce goods that maximize their profits.
To maximize profits, companies must offer high prices. Or, they produce at the lowest cost, that is, by offering low-quality products. This, of course, is not what consumers want.
Likewise, maximizing individual utility often hurts business. Consumers want the product at the lowest price but get the best quality. For business, of course, this is impossible.
Then, conflict arises when each tries to be selfish. The conflict is then resolved in the market through supply and demand mechanisms. Consumers and businesses will use demand, supply, and price information to make the best decisions for them.
The critical thoughts of neoclassical economic: supply-demand
Supply and demand determine how the economy should work. Both determine goods, output, and distribution of income in the economy. To achieve efficient resource allocation, the marginal cost must equal marginal revenue.
In a disequilibrium condition, the market will return to its new equilibrium. The new equilibrium is achieved automatically due to the interaction of supply and demand between economic agents—no need for government intervention.
For example, during an oversupply, the market price is above the equilibrium price. Producers will cut prices to boost demand. Lower prices signal consumers to buy more, thus increasing demand.
Price cuts and increased demand will continue until the market reaches a new equilibrium. In the new equilibrium, the quantity demanded is the same as the quantity supplied.
The demand-supply concept is essential in explaining economic problems such as scarce resources, discrimination, patents, and the foreign exchange market.
A neoclassical economic view of the business cycle
In macroeconomics, the neoclassical offer no theory about business cycles. However, they believe that changes in technology over time cause shifts in aggregate demand and aggregate supply. This shift causes a temporary deviation from the long-run equilibrium.
Deviations in aggregate economic activity are short-lived as the economy readjusts. And, in this case, the invisible hand will work to rebalance the economy.
How will the economy return to equilibrium?
During a recession, for example, there is downward pressure on the nominal wage when real GDP falls below its potential. This pressure is due to the excess supply of labor.
During the period, the demand for labor contracted while the supply of labor remained relatively unchanged. It causes a high unemployment rate and sizeable idle production capacity.
Low wages reduce production costs. With lower production costs, businesses are eager to increase production. As a result, they will try to boost output and gradually recruit a workforce.
Higher demand slowly raises wages. Finally, when the production returns to normal, the short-term equilibrium will return to its potential level.
Likewise, when short-run aggregate supply is above its potential output, the nominal wage rate increases. Higher salaries increase production costs and hence lower profit margins.
Businesses will streamline their production. It encourages businesses to cut production, so that aggregate supply is reduced.
The role of government in the economy
Neoclassical economics argues that markets must be free in allocating economic resources. The government should not intervene because that will only make the market inefficient.
Without government intervention, individuals and businesses are free to create the best economic results for them. Such freedom would result in a more varied supply, increasing GDP, wages, and living standards.
Neoclassical economists do not believe in what Keynesians call “fine-tuning.” Thus, the government should not take action to influence economic growth. Neoclassical economists believe that the primary determinant of economic output is aggregate supply.
A stable economic environment and low inflation will promote economic growth. The tax rate must be low and unchanging. Under these conditions, private economic agents can make the best investment decisions.
Optimal investment in physical capital and human resources will encourage technological improvement. At the same time, it also boosts economic growth.
Comparing neoclassical economic thought with other schools of economics
In this section, I will present two alternative thoughts: classical and Keynesian and Classical economics.
Neoclassical economics Vs. Classical economics
Neoclassical economists introduced the concept of utility. This concept does not exist in classical economics.
In their analysis, classical economists emphasized the production of goods and services. It differs from neoclassical economics, which takes into account individual actions and decisions. Efforts to maximize utility determine actions and decisions.
Neoclassical Economics Vs. Keynesian
Neoclassical economics assumes flexible wages and prices. Neoclassical economics focuses on long-term economic activities.
Such flexibility implies that the aggregate supply has vertical lines. It indicates the price level has no effect on real GDP. An increase in aggregate demand will not result in higher real GDP.
Meanwhile, Keynesian economists focus on short-run economic phenomena and assume wages and prices are sticky. Wages are inflexible and cannot go up and down according to economic conditions.
One of the causes of wage stickiness is the contract system. Take a simplified example. When you work, you get a salary, and the company will adjust it once a year, depending on economic conditions. When the next quarter of economic growth picks up, you naturally cannot renegotiate higher wages. Conversely, when the next quarter of the economy crashes, the company will not necessarily lower your salary.
Aggregate demand is the determinant of aggregate output and economic growth in the short run. An increase in aggregate demand also plays a key role in eliminating cyclical unemployment.
Keynesian assumes that aggregate supply is upward sloping with a positive slope. When aggregate demand rises, it pushes up short-run output (real GDP) and aggregate prices (inflation).
As with behavioral economics, the government must intervene. During a recession, the government should lower the tax rate, increase its spending, or combine both. Conversely, to prevent an overheated economy, the government should reduce its spending and increase the tax rate.
Government intervention is an integral part of influencing economic activity. The economy will not return to a new equilibrium on its own.
Take, for example, during a recession. One solution to escape a recession is to stimulate aggregate demand. The options are by increasing household consumption, business investment, or government spending.
Another option is export. However, it is beyond domestic economic actors‘ control because it depends on partner countries’ demand and economic conditions.
During a recession, income falls. So, rationally households will not be willing to increase consumption.
Likewise business. During a recession, profits fall due to weak demand, resulting in downward pressure on selling prices and creating excess supply. Increasing business investment will only result in greater excess supply, lowering selling prices, and deeper pressure on profits. Therefore, on a rational basis (profit motive), they will not increase investment during a recession period.
Consequently, increasing government spending is the best way to increase aggregate demand. The government is not profit-oriented and can increase or decrease spending at its discretion.
During a recession, the government should increase spending, such as spending on infrastructure. It will have a ripple effect on aggregate demand and economic activity in the private sector.
The 1930s Great Depression did not support the beliefs of neoclassical economists. Neoclassical economists believe that the economy will operate at full employment over time or at its potential level.
Therefore, the depression refutes the argument that the economy is operating at full employment. The depression shows that the United States can operate below potential output for long periods and not recover. Also, the business cycle is generally more severe and more prolonged than the neoclassical model suggests.
To describe the cycle, his theory only mentions Schumpeter’s creative destruction theory. Such devastation stems primarily from technological advances, which cause the economy to fluctuate. In particular, neoclassical economics does not explain business cycles.