Editing Neoclassical economics (section)

== Theory ==

=== Assumptions and objectives ===
It was expressed by [[E. Roy Weintraub]] that neoclassical economics rests on three assumptions, although certain branches of neoclassical theory may have different approaches:<ref>{{Cite web |title=Neoclassical Economics, by E. Roy Weintraub: The Concise Encyclopedia of Economics {{!}} Library of Economics and Liberty |url=http://www.econlib.org/library/Enc1/NeoclassicalEconomics.html |access-date=2024-11-29 |website=www.econlib.org}}</ref>

* People have [[Rational choice theory|rational preferences]] between outcomes that can be identified and associated with values.
* Individuals [[utility maximization|maximize utility]] and firms [[profit maximization|maximize profits]].
* People act independently on the basis of [[Perfect information|full and relevant information]].

From these three assumptions, neoclassical economists have built a structure to understand the allocation of scarce resources among alternative ends—in fact, understanding such allocation is often considered the definition of economics to neoclassical theorists. Here is how [[William Stanley Jevons]] presented "the problem of Economics".

<blockquote>Given, a certain population, with various needs and powers of production, in possession of certain lands and other sources of material: required, the mode of employing their labor which will maximize the utility of their produce.<ref>[[William Stanley Jevons]] (1879, 2nd ed., p. 289), [https://books.google.com/books?id=aYcBAAAAQAAJ The Theory of Political Economy] {{Webarchive|url=https://web.archive.org/web/20231011193705/https://books.google.com/books?id=aYcBAAAAQAAJ |date=October 11, 2023 }} Theory of Political Economy''.] Italics in original.</ref></blockquote>

From the basic assumptions of neoclassical economics comes a wide range of theories about various areas of economic activity.  For example, profit maximization lies behind the neoclassical [[theory of the firm]], while the derivation of [[demand]] [[demand curve|curves]] leads to an understanding of [[consumer good]]s, and the [[Supply (economics)|supply]] curve allows an analysis of the [[factors of production]].  Utility maximization is the source for the neoclassical theory of consumption, the derivation of demand curves for consumer goods, and the derivation of labor supply curves and [[reservation price|reservation demand]].<ref>[[Philip H. Wicksteed]] ''The Common Sense of Political Economy''</ref>

=== Supply and demand model ===
[[Market analysis]] is typically the neoclassical answer to price questions, such as why does an apple cost less than an automobile, why does the performance of work command a wage, or how to account for interest as a reward for saving. An important device of neoclassical market analysis is the graph presenting supply and demand curves. The curves reflect the behavior of individual buyers and individual sellers. Buyers and sellers interact with each other in and through these markets, and their interactions determine the market prices of anything they buy and sell. In the following graph, the specific price of the commodity being bought/sold is represented by P*.<ref>Wolff, R. D. and Resnick, S. A. (2012) Contending Economic Theories. The MIT Press. pp. 56.</ref>

[[File:Supply-demand-equilibrium.svg|Supply-demand-equilibrium]]

In reaching agreed outcomes of their interactions, the market behaviors of buyers and sellers are driven by their preferences (= wants, utilities, tastes, choices) and productive abilities (= technologies, resources). This creates a complex relationship between buyers and sellers. Thus, the geometrical analytics of supply and demand is only a simplified way how to describe and explore their interaction.<ref>Wolff, R. D. and Resnick, S. A. (2012) Contending Economic Theories. The MIT Press. pp. 57–58. {{ISBN|978-0262517836}}</ref>
Market supply and demand are aggregated across firms and individuals. Their interactions determine equilibrium output and price. The market supply and demand for each factor of production is derived analogously to those for market final output<ref>{{Cite web
|url=http://bea.gov/bea/glossary/glossary.cfm?key_word=Final_use&letter=F#Final_use|archive-url=https://web.archive.org/web/20170203033739/https://bea.gov/bea/glossary/glossary.cfm?key_word=Final_use&letter=F#Final_use|url-status=dead|title=U.S. Bureau of Economic Analysis Glossary: Final use|archive-date=February 3, 2017}}</ref> to determine equilibrium income and the income distribution. Factor demand incorporates the [[marginal productivity]] relationship of that factor in the output market.<ref name="Stigler" /><ref>Christopher Bliss (1987),  "distribution theories, neoclassical", ''The New Palgrave: A Dictionary of Economics'', v. 1, pp. 883–86, [[doi:10.1057/978-1-349-95121-5 105-1]].</ref><ref>Robert F. Dorfman (1987), "marginal productivity theory",  ''The [[New Palgrave: A Dictionary of Economics]]'', v. 3, pp. 323–25, [[doi:10.1057/978-1-349-95121-5 988-2]].</ref><ref>C.E. Ferguson (1969). ''The Neoclassical Theory of Production and Distribution''. Cambridge. {{ISBN|9780521076296}}, ch. 1: pp. [http://assets.cambridge.org/97805210/76296/excerpt/9780521076296_excerpt.pdf 1–10] {{Webarchive|url=https://web.archive.org/web/20110510010218/http://assets.cambridge.org/97805210/76296/excerpt/9780521076296_excerpt.pdf |date=May 10, 2011 }} ([https://www.jstor.org/pss/2720638 excerpt]).</ref>

Neoclassical economics emphasizes equilibria, which are the solutions of [[agent (economics)|agent]] maximization problems. Regularities in economies are explained by [[methodological individualism]], the position that economic phenomena can be explained by aggregating over the behavior of agents. The emphasis is on [[microeconomics]]. Institutions, which might be considered as before and conditioning individual behavior, are de-emphasized. [[Economic subjectivism]] accompanies these emphases.  See also [[general equilibrium]].

=== Utility theory of value ===
Neoclassical economics uses the [[utility theory of value]], which states that the value of a good is determined by the [[marginal utility]] experienced by the user. This is one of the main distinguishing factors between neoclassical economics and other earlier economic theories, such as [[Classical economics|Classical]] and [[Marxian economics|Marxian]], which use the [[labor theory of value]] that value is determined by the labor required for production.<ref name=":0" />

The partial definition of the neoclassical theory of value states that the value of an object of market exchange is determined by human interaction between the preferences and productive abilities of individuals. This is one of the most important neoclassical hypotheses. However, the neoclassical theory also asks what exactly is causing the supply and demand behaviors of buyers and sellers, and how exactly the preferences and productive abilities of people determine the market prices. Therefore, the neoclassical theory of value is a theory of these forces: the preferences and productive abilities of humans. They are the final causal determinants of the behavior of supply and demand and therefore of value. According to neoclassical economics, individual preferences and productive abilities are the essential forces that generate all other economic events (demands, supplies, and prices).<ref>Wolff, R. D. and Resnick, S. A. (2012) Contending Economic Theories. The MIT Press. pp. 58–59. {{ISBN|978-0262517836}}</ref>

=== Market failure and externalities ===
Despite favoring markets to organize economic activity, neoclassical theory acknowledges that markets do not always produce the socially desirable outcome due to the presence of [[Externality|externalities]].<ref name=":0" /> Externalities are considered a form of [[market failure]]. Neoclassical economists vary in terms of the significance they ascribe to externalities in market outcomes.

=== Pareto criterion ===
In a market with a very large number of participants and under appropriate conditions, for each good, there will be a unique price that allows all welfare–improving transactions to take place. This price is determined by the actions of the individuals pursuing their preferences. If these prices are flexible, meaning that all parties are able to pursue transactions at any rates they find mutually beneficial, they will, under appropriate assumptions, tend to settle at price levels that allow for all welfare–improving transactions. Under these assumptions, free-market processes yield an optimum of social welfare. This type of group welfare is called the [[Pareto optimum]] (criterion) after its discoverer Vilfredo Pareto.<ref>CAPORASO, James A., and LEVINE, David P., 1992, Theories of Political Economy. Cambridge: Cambridge University Press. pp. 82–83. ISBN 978-0-521-41561-3</ref>
Wolff and Resnick (2012) describe the [[Pareto optimality]] in another way. According to them, the term "Pareto optimal point" signifies the equality of consumption and production, which indicates that the demand (as a ratio of marginal utilities) and supply (as a ratio of marginal costs) sides of an economy are in balance with each other. The Pareto optimum point also signifies that society has fully realized its potential output.<ref>Wolff, R. D., and Resnick, S. A. (2012) ''[[iarchive:contendingeconom0000wolf/page/101/mode/2up|Contending Economic Theories]]''. The MIT Press. pp. 101. {{ISBN|978-0262517836}}</ref>

[[Normative economics|Normative]] judgments in neoclassical economics are shaped by the [[Pareto criterion]]. As a result, many neoclassical economists favor a relatively [[laissez-faire]] approach to government intervention in markets, since it is very difficult to make a change where no one will be worse off. However, many less conservative neoclassical economists instead use the [[compensation principle]], which says that an intervention is good if the total gains are larger than the total losses, even if losers are not compensated in practice.<ref name=":0" />

=== International trade ===
Neoclassical economics favors [[free trade]] according to [[David Ricardo]]'s theory of [[comparative advantage]].<ref>{{Cite web|title=Chapter 3: Trade Agreements and Economic Theory {{!}} Wilson Center|url=https://www.wilsoncenter.org/chapter-3-trade-agreements-and-economic-theory|access-date=May 2, 2021|website=www.wilsoncenter.org|language=en|archive-date=May 2, 2021|archive-url=https://web.archive.org/web/20210502162246/https://www.wilsoncenter.org/chapter-3-trade-agreements-and-economic-theory|url-status=live}}</ref> This idea holds that free trade between two countries is mutually beneficial because it allows the greatest total consumption in both countries.