Today, nearly all English-speaking countries rely on neoclassical economics to explain modern market economies, making it the world’s leading economic theory. Neoclassical economics grew out of the Classical School of economic thought proposed by economist Adam Smith in the 18th century. It sought to become a more encompassing economic theory by introducing two new concepts to Classical economics: perceived value (utility) and marginalism.
Classical theory states that a product’s value consists of the cost of materials plus the cost of labor, which factor into price. Neoclassical theory, however, suggests that consumers often perceive a good as having a greater value beyond its production cost, which would affect both price and demand. The theory also states that economic decisions are sometimes made based on margins, or the perceived likelihood that an economic choice will turn out to be profitable or beneficial in the future.
Though the term “neoclassical economics” was coined in 1900, historians trace the theory’s origins back to the 1870s through the works of economists William Stanley Jevons, Carl Menger and Leon Walras. These economists focused on how the perceived usefulness, or utility, of goods affected market forces. Since utility is determined at the consumer level, neoclassical economics largely became a study in microeconomics.
Neoclassical theory operates on a few basic assumptions–mainly that economic decisions are always made rationally based on fully informed evaluations of utility. In other words, consumers compare goods and purchase the ones having the greatest utility, or highest personal value. The consumer’s main goal, the theory states, is to maximize personal satisfaction. Likewise, the goal of companies is to maximize profits. When consumers and companies both achieve their goals, markets experience economic equilibrium. In 1933, economists Joan Robinson and Edward H. Chamberlin expanded the theory to include the idea of “imperfect competition” to explain how consumers and businesses continue to compete when some have an unfair advantage over others, such as in a monopoly. Later, other economists incorporated the principles of Keynesian macroeconomics into the theory. Thus, neoclassical economics gradually came to encompass a wide array of ideas from various schools of economic thought.
Some economists, however, reject the core assumptions of neoclassical economics as unrealistic. They argue that people and even businesses do not always behave rationally or make fully informed decisions. They criticize neoclassical economists for relying too heavily on mathematical models to describe markets, claiming such formulas are based on achieving economic utopia, not explaining how real markets operate. Mathematical formulas, they say, are too inflexible to accurately describe or predict human behavior, and too restrictive to apply to developing economies. Nevertheless, neoclassical economics remains the leading economic theory of the 20th and 21st centuries.