Principles of Behavioral Economics
Lecture 4
The Neoclassical Tradition: An Introduction
Prof. Sujata Kar
Associate Professor
DEPARTMENT OF MANAGEMENT STUDIES IIT ROORKEE
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The Neoclassical Tradition: An Introduction
Module 4
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Introduction
• Before we can appreciate what behavioral
economics is about and is trying to achieve,
we need to know enough about the
assumptions and principles of neoclassical
economics–the theoretical tradition from
which it developed.
• The mainstream, neoclassical economics
approach has a very definite view of the
‘economic agent’: homo economicus or
ECON.
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Introduction
• In contrast, behavioral economics adopts a
different view, one based on flesh-and-blood
HUMAN.
• Important to know is what behavioral
economics is not, and this can only be
understood by knowing what neoclassical
economics is.
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Fundamentals of Neoclassical Economics
• Neoclassical economics owes much to the highly
influential 1890 book, Principles of Economics, by
Alfred Marshall. This book came to represent
what is meant by academically rigorous and
acceptable economics – then and now.
• Not only did Marshall distill the major
assumptions and principles of economics at that
time, but he also illustrated them with captivating
graphs which allowed visualization of complex
mathematical relationships.
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Fundamentals of Neoclassical Economics
• This set the tone and provided the analytical
template for the years to follow.
• Marshall’s work centered economics around
several major concepts, comprising
rationality, preferences, and utility
maximization.
• Efficiency has always been at the heart of
these processes, i.e. getting the most (utility)
out of the allocation of scarce resources.
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Fundamentals of Neoclassical Economics
• At its conceptual core, neoclassical economics
assumes individuals act on consistent
preferences, and it takes the maximization of
personal (self-interested) satisfaction (utility) of
these preferences as its normative criterion ( i.e.,
the way things should work).
• It is the combination of these notions that
comprise what is meant when we talk about
neoclassical economics
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Fundamentals of Neoclassical Economics
• Alfred Marshall may, indeed, be credited with instilling
the desire to base economic theorizing on sound
mathematical foundations, but he was sensitive to its
limitations as well as its allure. As he stated in a letter
to A. L. Bowley in 1906:
– (1) Use mathematics as shorthand language,
rather than as an engine of inquiry. (2) Keep to
them till you have done. (3) translate into English.
(4) then illustrate by examples that are important
in real life. (5) Burn the mathematics. (6) If you
can’t succeed in 4, burn 3. This I do often (Sills &
Merton, 2000).
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Fundamentals of Neoclassical Economics
• Marshall’s view was later reiterated by none other
than John Maynard Keynes, who was not himself
averse to complex equations. He said:
“Too large a proportion of recent ‘mathematical’
economics are mere concoctions, as imprecise as the
initial assumptions they rest on, which allow the
author to lose sight of the complexities and
interdependencies of the real world in a maze of
pretentious and unhelpful symbols”. - Keynes, 1936
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Fundamentals of Neoclassical Economics
• Even more recently, the limitations of a too narrowly
defined mathematical economics were highlighted by
Mervyn King in his 2016 critique of the financial crisis
of 2007– 2008, since as the then Governor of the Bank
of England he was in an excellent position to know.
• Yet, despite Marshall’s warning, neoclassical
economics developed along very specific
mathematical lines, combining algebraic rigor with
economic ‘laws’ to establish a powerful social science
with considerable practical implications and
applications.
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Fundamentals of Neoclassical Economics
• As the financial crash revealed that
sometimes crucial factors like different types
of debt and their levels, are left out of
economic models to render them
mathematically tenable.
• The predictive failures of these models even
surprised those who held them most dearly.
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Economic Entities
• When thinking about preferences and utility
maximization, neoclassical economics assumes two
entities: (1) the individual, also referred to as the
consumer – the idea is that we are always consuming
something, and ( 2) the firm.
• Both the individual and the firm are said to seek to
allocate their scarce resources in the most efficient
manner in order to maximize their payoff.
• Payoffs are in case of individuals, some form of
happiness or utility; and in case of firms, profit or
some other value measure; e.g., market share.
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Economic Entities
• It is, indeed, interesting to note that the same
analytical machinery of neoclassical economics is
applied to these, seemingly, very different
economic entities.
• It may be for this reason that neoclassical
economics appears to contain such a
circumscribed vision of the individual human
agent.
• In any event, to understand properly the
neoclassical economic view of ‘the consumer’, we
need to know something about ‘the firm’.
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The Firm
• Central to Alfred Marshall’s neoclassical economics
work was the characterization of what is known as
‘the firm’ – this is the focus of the subfield of
microeconomics.
• In its pure form, the theory of the firm contains
several defining features. First, for certain types of
markets, firms are assumed to sell homogenous
products so that the product from one firm is a
perfect substitute of the products sold by another
firm.
• In the modern world, though, brand marketing is all
about differentiating products.
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The Firm
• Second, firms are said to be price takers, not makers,
which means they treat the ‘market price’ as given.
• Third, it is assumed there is free entry and exit in the
market with perfectly mobile factors of production
e.g., labor, capital, land, as well as intellectual talent,
at least in the long run.
• In many sectors of our modern-day economies, this is
far from being the reality.
• Finally, both firms and consumers are assumed to
have perfect information so that no seller can buy at a
higher or a lower price compared to its competitors.
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The Firm
• These assumptions allow the construction of
elegant mathematical models that can be used to
describe, understand, and predict the future.
• For example, what would be the consequence on
consumer ‘demand’ of raising the price of petrol
by 10%.
• The manner in which consumers react to a
change in unit price is known as the ‘price
elasticity of demand.’
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The Firm
• Marshall’s work has been influential. For example, he
is famous for introducing into economics the standard
supply and demand graph, which is now contained in
every economics textbook.
• The graph relates: (a) supply and demand curves, (b)
market equilibrium, (c) how the quantity supplied/
demanded is related to price, (d) the law of marginal
utility, and (e) the law of diminishing returns.
• This has become the principal – and the principled –
way economists communicate their ideas.
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The Firm
• All of the above assumptions, introduced by
Marshall and elaborated by others, have been
scrutinized and challenged, but before we dismiss
the characterization of the firm as unrealistic,
even silly, and out-of-step with the modern
world, there remains an open question: do these
assumptions contain a good enough
representation of economic reality to make them
viable and useful for practical purposes?
• Few people would say they are a perfect
representation, not even neoclassical economists.
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The Firm
• This is what Milton Friedman had to say about
Marshall’s conception of the firm:
– Marshall’s apparatus turned out to be most
useful for problems in which a group of firms
is affected by common stimuli, and in which
the firms can be treated as if they were
perfect competitors. This is the source of the
misconception that Marshall ‘assumed’
perfect competition in some descriptive sense.
(Reprinted in Friedman, 1953)
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The Consumer
• The neoclassical conception of the individual
consumer, homo economicus (ECON), has a
set of definite characteristics that resemble
those of the firm.
• However, instead of seeking to maximize
profit, the individual consumer is said to seek
to maximize their satisfaction, happiness, and
welfare i.e., utility.
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The Consumer
• The individual consumer is assumed to have
a set of complete and transitive preferences,
which means they have complete ordering of
their preferences for various goods and
services.
• For example, do you prefer cream cakes over
apples or apples over cream cakes?
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The Consumer
• These strict assumptions are often ‘relaxed’ to
deal with reality, but for neoclassical economics
to work, it must assume that, to a sufficient
extent, people conform to these
characterizations, especially when they behave in
the market context with ‘real money on the table’
– this could be actual money or something else of
importance to the individual consumer (e.g.,
romantic attachment).
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The Consumer
• In this context, it may be said that when people
are properly incentivized to optimize choices and
maximize their utility, their latent preferences will
be ‘revealed’ in their choice behavior.
• While there will be a gross failure by some
individuals, the aggregate behavior of market
participants is assumed to conform well to these
characteristics.
• Otherwise, neoclassical economic models would
be descriptively flawed and predictively hopeless,
perhaps to a damaging degree.
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The Consumer
• The fact that these assumptions are not really a
reflection of reality does not trouble much the
neoclassical economist.
• They say that less-than-perfect models are better
than no models at all.
• However, such rigorous mathematical models
allow deviations from neoclassical predictions to
be quickly spotted: behavioral economists have
found this possibility positively inspiring.
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Marshall and Marginalism
• As we dive deeper into what is meant when we talk
about neoclassical assumptions and principles, and
especially when we consider the notion of ‘rational’
behavior, we will quickly grasp the importance of
marginalism, which applies equally to firms and
individuals.
• Marginalism is especially important in economics
because it shows that efficiency (an important part of
rational decision-making) is always obtained at the
margins of activity.
• This is said to apply to all decision- making situations
(e.g., relationships), and not just ones of an explicitly
economic nature.
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Marshall and Marginalism
• To illustrate the principle of marginalism, a firm
producing a widget should increase production to
the point where the marginal cost of production
i.e., the cost of making one extra widget, say ₹ 10
is equal to the marginal return from selling the
additional widget (i.e., ₹ 10).
• When the marginal return is ₹9, extra production
should cease as a marginal unit loss of ₹1 is
incurred.
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Marshall and Marginalism
• This reasoning provides a useful way to think
about how many widgets a firm should produce,
and it is a useful way to think of the decision
making of the individual consumer; we should
stop consuming when the costs outweigh the
benefits.
• We can even turn this around and say we should
stop producing (e.g., investing in a relationship)
when the marginal return has turned negative,
where marginal cost is now greater than marginal
benefit.
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Marshall and Marginalism
• In this way, it would be a mistake to average costs and
benefits over a longer time frame, which we most
certainly do in personal relationships – we forgive, but
less often forget, marginal transgressions!
• Obviously, there is a time frame over which marginal
costs/ benefits are considered, and this may well differ
from person to person, and domain to domain.
• Marginal utility is a fundamental concept in
neoclassical economics, and it is a useful way of
thinking about all economic activity – that is, the most
efficient allocation of scarce resources
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Marshall and Marginalism
• The law of diminishing marginal utility says something
especially important: the more we consume of
something, for example, food or talking to friends, the
less utility we are likely to derive from each extra
(marginal) unit of consumption.
• There often comes a point where we have ‘had
enough’ and each additional unit no longer brings
pleasure (utility).
• Therefore, we would be better off by stopping or
reducing one behavior and switching to another that
has a higher level of marginal utility.
• This makes good sense and we can easily relate it to
everyday life.
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Marshall and Marginalism
• To put things slightly differently, the doctrine of
diminishing marginal utility states that we should
continue eating cream cakes until the additional
bite does not produce marginal (i.e., extra) utility
(pleasure) – a point might even be reached when
the marginal utility is negative (i.e., disutility: “no
more, please!”).
• More formally, we should continue to consume
until marginal utility equals marginal cost.
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Marshall and Marginalism
• So compelling is the idea of diminishing marginal
utility, that when an individual violates it, we are
inclined to say, “ they have a problem”. For example,
excessive game playing, Twitter use, or pathological
behavior like an addiction to gambling.
• However, things are not quite straightforward. We
may have a very strong preference for something say,
cream cakes, and by consuming it, we are maximizing
utility.
• A problem would be identified if we were neglecting
other aspects of our life (e.g., job, family, etc.) in the
exclusive pursuit of this one guilty pleasure.
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Axioms of Consumer Behavior
• Neoclassical rationality requires preferences to
satisfy five axioms.
1. Completeness:
• Consumers can rank all possible choice bundles.
For any two options, A and B, they prefer A to B,
B to A, or are indifferent.
• Example: A consumer can definitively state they
prefer oranges (O) ≻ apples (A) ≻ lemons (L).
2. Transitivity:
• If O ≻ A and A ≻ L, then O ≻ L. Violations imply
irrationality.
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Axioms of Consumer Behavior
3. More-Is-Better:
• Ceteris paribus, more of a good is preferred to
less. Exceptions include "bads" e.g., pollution.
4. Continuity:
• Small changes in quantity should not cause
abrupt preference shifts.
5. Convexity:
• Consumers prefer diversified bundles to extremes
(e.g., a mix of apples and oranges over only
apples or only oranges).
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Neoclassical Rationality
• Behavior fulfilling all five axioms can be considered as
consistent.
• Consistent behavior based on consistent preferences is a
key aspect of neoclassical economists’ definition of
rational behavior.
Key Principles:
1. Marginal Analysis:
• Decisions are made incrementally. For example, a firm
produces until marginal cost = marginal revenue.
2. Sunk Cost Fallacy:
• Rational agents ignore irrecoverable costs (e.g., a non-
refundable concert ticket). However, humans often honor
sunk costs due to loss aversion.
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Neoclassical Rationality
3. Opportunity Costs:
• Cost benefit analysis must consider opportunity cost,
the cost associated with the next best forgone
alternative.
4. Incentive Response:
• ECONs respond to incentives.
• It aligns with the matching law of behavioral
psychology which shows that even simple animals
allocate their behavior over different choice options in
a way that maximizes their total reward, and thus
their utility.
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The Point of it All: Utility Maximization
• All rational behavior aims to maximize utility
(satisfaction, happiness, or welfare).
• Individuals act as homo economicus: self-
interested, consistent, and forward-looking.
• Example: If you are allocating $100 for a Night
Out, your aim is to maximize your total utility,
and the way to do this is to apply the principles
and procedures of Expected Utility Theory, which
is another major workhorse of neoclassical
economics.
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Expected Utility Theory (EUT)
Von Neumann-Morgenstern Theorem:
• It shows that, given a number of axioms, a
rational decision maker faced with risky or
uncertain outcomes of different choices should
behave in a manner to maximize ‘expected value’,
or utility.
Example: A gamble with a 1.25% chance to win 100
and a 98.75% chance of 0 has an expected value of
1.25. A rational agent should prefer this over a
guaranteed $1.
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Criticism of EUT
• Empirical Violations:
– Risk Aversion: People prefer certain
outcomes over higher-EV gambles (e.g.,
taking $1 instead of $1.25 gamble).
– Prospect Theory (Kahneman & Tversky):
People evaluate losses differently from
gains (loss aversion).
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References
• Corr, P., & Plagnol, A. (2023). Behavioral Economics: The Basics
(2nd ed.). Routledge
• Cartwright, E. (2018). Behavioral economics. Routledge.
• Wilkinson, N., & Klaes, M. (2017). An introduction to
behavioral economics. Bloomsbury Publishing.
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Thank You
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