Neoclassical Economics: What It Is

and Why It's Important

What Is Neoclassical Economics?
Neoclassical economics is a broad theory that focuses on supply
and demand as the driving forces behind the production, pricing, and
consumption of goods and services. It emerged in around 1900 to
compete with the earlier theories of classical economics.

KEY TAKEAWAYS

 Classical economists assume that the most important factor in

a product's price is its cost of production.
 Neoclassical economists argue that the consumer's perception
of a product's value is the driving factor in its price.
 The difference between actual production costs and retail price
is the economic surplus.
 Neoclassical economic theory can impact how businesses
operate gov and financial institutions operate, as well as how
governments regulate markets.
 Critics argue the theory doesn't account for other factors that
impact consumer decisions, such as limited information,
resource inequality, or emotional thinking.
One of the key early assumptions of neoclassical economics is that
utility to consumers, not the cost of production, is the most important
factor in determining the value of a product or service. This approach
was developed in the late 19th century based on books by William
Stanley Jevons, Carl Menger, and Léon Walras.

Neoclassical economics theories underlie modern-day economics,

along with the tenets of Keynesian economics. Although the
neoclassical approach is the most widely taught theory of
economics, it has its detractors.

Understanding Neoclassical Economics

Neoclassical economics emerged as a theory in the
1900s.1 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 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.2

Finally, this economic theory 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:

. Rational thinking: People make rational choices between

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

Criticisms of Neoclassical Economics

Critics of neoclassical economics believe that the neoclassical
approach cannot accurately describe actual economies. They
maintain that the assumption that consumers behave rationally in
making choices ignores the vulnerability of human nature to
emotional responses.

Neoclassical economists maintain that the forces of supply and

demand lead to an efficient allocation of 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.
Markets or businesses structured around solving a problem,
such as non-profit organizations or single-payer healthcare
systems, can often function with equal levels of efficiency and
effectiveness.
 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.3

Some critics also blame neoclassical economics for inequalities in

global debt and trade relations because the theory holds that labor
rights and living conditions will inevitably improve as a result of
economic growth.

Neoclassical Economics In the Real World

Neoclassical economic theory is important because of how it affects
both markets and economic policy.

Business

The principles of neoclassical economics can be used by companies

to set prices and grow their business.

A business that understands neoclassical economics, for example,

won't just look at the cost of making a product when setting a price. 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.

Governments and Banks

Governments and banks can also follow neoclassical principles,

which will impact economic policy and market regulation. Followers
of neoclassical economics believe that there is no upper limit to the
profits that can be made by smart capitalists 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.

This type of thinking was evident in the lead-up to the 2008 financial
crisis. Modern economists believed that synthetic financial
instruments had no price ceiling because investors in them
perceived the housing market as limitless in its potential for growth.
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.4 These financial instruments
were mostly unregulated by the federal government, allowing lenders
and investors to drive growth in the subprime mortgage market.5

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. They began to default in large numbers.6 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.7 The entire global economy suffered and required
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.8

Illinois State University Department of Economics. "Alfred Marshall

and Neoclassical Economics ."

New Keynesian Economics:

Definition and Vs. Keynesian
ROBERT C. KELLY

What Is New Keynesian Economics?

New Keynesian economics is a modern macroeconomic school of
thought that evolved from classical Keynesian economics. This
revised theory differs from classical Keynesian thinking in terms of
how quickly prices and wages adjust.

New Keynesian advocates maintain that prices and wages are

"sticky," meaning they adjust more slowly to short-term economic
fluctuations. This, in turn, explains such economic factors as
involuntary unemployment and the impact of federal monetary
policies.

KEY TAKEAWAYS

 New Keynesian economics is a modern twist on the

macroeconomic doctrine that evolved from classical Keynesian
economics principles.
 Economists argued that prices and wages are “sticky," causing
involuntary unemployment and monetary policy to have a big
impact on the economy.
 This way of thinking became the dominant force in academic
macroeconomics from the 1990s through to the financial crisis
of 2008.

Understanding New Keynesian Economics

British economist John Maynard Keynes' idea in the aftermath of
the Great Depression that increased government expenditures and
lower taxes can stimulate demand and pull the global economy out
of a downturn became the dominant way of thinking for much of the
20th century. That slowly began to change in 1978 when After
Keynesian Economics was published.

In the paper, new classical economists Robert Lucas and Thomas

Sargent pointed out that the stagflation experienced during the
1970s was incompatible with traditional Keynesian models.

Lucas, Sargent, and others sought to build on Keynes’ original

theory by adding microeconomic foundations to it. The two major
areas of microeconomics that may significantly impact the
macroeconomy, they said, are price and wage rigidity. These
concepts intertwine with social theory, negating the pure theoretical
models of classical Keynesianism.

New Keynesian economics became the dominant force in academic

macroeconomics from the 1990s through to the financial crisis of
2008.

The new Keynesian theory attempted to address, among other

things, the sluggish behavior of prices and its cause, and
how market failures could be triggered by inefficiencies and might
justify government intervention. The benefits of government
 intervention remain a flashpoint for debate. New Keynesian
economists made a case for expansionary monetary policy, arguing
that deficit spending encourages saving, rather than increasing
demand or economic growth.

Criticism of New Keynesian Economics

New Keynesian economics was criticized in some quarters for failing
to see the Great Recession coming and for not accurately
accounting for the period of secular stagnation that followed it.

The main issue of this economic doctrine is explaining why changes

in aggregate price levels are “sticky.” Under new classical
macroeconomics, competitive price-taking companies make choices
on how much output to produce, and not at what price, while in New
Keynesian economics, monopolistically competitive companies set
their prices and accept the level of sales as a constraint.

From a New Keynesian economics point of view, two main

arguments try to answer why aggregate prices fail to imitate the
nominal gross national product (GNP) evolution. Principally, under
both approaches to macroeconomics, it is assumed economic
agents, households, and companies have rational expectations.

However, New Keynesian economics maintains that rational

expectations become distorted as market failure arises
from asymmetric information and imperfect competition. As
economic agents can’t have a full scope of the economic reality,
their information will be limited. There will be little reason to believe
that other agents will change their prices, and, as a result, they will
keep their expectations unchanged. As such, expectations are a
crucial element of price determination; as they remain unaltered, so
will price, which leads to price rigidity.

Table of Contents

Understanding Malthus' Ideas




Early Life and Education




Published Works




Malthus and Population Growth




Criticism




Thomas Malthus FAQs




The Bottom Line

 ECONOMY
 ECONOMICS

Who Is Thomas Malthus?

By
JULIA KAGAN

Full Bio


Julia Kagan is a financial/consumer journalist and former senior editor, personal

finance, of Investopedia.
Learn about our editorial policies

Updated February 05, 2023

Reviewed by
MICHAEL J BOYLE
Fact checked by
HANS DANIEL JASPERSON
Thomas Robert Malthus was an influential British economist who is best known for
his theory on population growth, outlined in his 1798 book An Essay on the Principle
of Population.

In it, Malthus argued that populations inevitably expand until they outgrow their
available food supply, causing the population growth to be reversed by disease,
famine, war, or calamity.

He is also known for developing an exponential formula used to forecast population

growth, which is currently known as the Malthusian growth model.

KEY TAKEAWAYS
 Thomas Malthus was an 18th-century British philosopher and economist noted for the
Malthusian growth model, an exponential formula used to project population growth.
 The theory states that the supply of food cannot keep up with the growth of the human
population, inevitably resulting in disease, famine, war, and calamity.
 A noted statistician and proponent of political economy, Malthus founded the Statistical
Society of London.
 Malthus' theories were later used to justify British colonial policies that worsened the human
toll of the Irish Potato Famine.
 His theory is now largely dismissed, as modern farming techniques have allowed food
production to scale much faster than Malthus could have anticipated.
Understanding the Ideas of Thomas Malthus
In the 18th and early 19th centuries, some philosophers believed firmly that human
society would continue to improve and tilt toward a utopian ideal. Malthus countered
this belief, arguing that segments of the general population have invariably been poor
and miserable, effectively slowing population growth.

Based on his observation of conditions in England in the early 1800s, Malthus argued
that the available farmland was insufficient to feed the increasing population. More
specifically, he stated that the human population increases geometrically, while food
production increases arithmetically.

Under this paradigm, humans would reproduce until their numbers surpassed their
production capacity, at which point the population would be forcibly reduced by
famine or some other catastrophe and return to a manageable level.

The Dismal Science

These conclusions inspired the description of economics as the "dismal science."

Originally coined by the philosopher Thomas Carlyle, the term was used to describe
Malthus' conclusions regarding the inevitability of overpopulation and famine.

The naturalist Charles Darwin based his theory of natural selection in part on Malthus'
analysis of population growth. Malthus' views also enjoyed a resurgence in the 20th
century with the advent of Keynesian economics.

Malthus' Early Life and Education

Thomas Malthus was born on Feb. 13, 1766, to a prominent family near Guildford,
Surrey. Malthus was home-schooled before being accepted to Cambridge University's
Jesus College in 1784. He earned a master's degree in 1791 and became a fellow two
years later. In 1805, Malthus became a professor of history and political economy at
the East India Company's college at Haileybury.1

Malthus became a fellow of the Royal Society in 1819. Two years later, he joined the
Political Economy Club along with economist David Ricardo and Scottish
philosopher James Mill. Malthus was elected to be one of 10 royal associates of the
Royal Society of Literature in 1824.

In 1833, he was elected to both the Académie des Sciences Morales et Politiques in
France as well as Berlin's Royal Academy. Malthus co-founded the Statistical Society
of London in 1834.

He died in St. Catherine, near Bath, Somerset in 1834.1

Published Works of Thomas Malthus

Malthus' most famous work was his Essay on the Principle of Population, first
published in 1798 and enlarged in later editions. This work contained his famous
argument that human populations tend to grow faster than agricultural output,
resulting in famines or crises.

Later editions proposed that "moral restraint" could slow population growth.

Malthus was a prolific essayist and exchanged many letters with contemporary
economists. His other publications included:

 The Present High Price of Provisions (1800), in which Malthus criticized England's Poor
Laws and argued that aid to the poor would encourage them to have more children than
they would otherwise.
 Observations on the Effect of the Corn Laws (1814), in which Malthus argued in favor of
importing corn from abroad rather than supporting the protectionist Corn Laws.
 Principles of Political Economy (1820), a major work in which Malthus outlined his views
on free trade in response to the economist David Ricardo, who had written a book with the
same title.

The term "political economy" was first used in academic circles when Malthus joined
the faculty of the East India Company's college at Haileybury as a professor of history
and political economy.1

Malthus and Population Growth

Malthus' severe theory on population growth was shaped by his status as an 18th-
century Anglican cleric. He believed that poor people would work hard enough to
produce an abundant food supply in favorable times. However, he thought that they
would then abuse their newfound abundance, particularly by producing larger
families. At some point, their numbers would exceed their ability to provide the
necessities of life. Starvation or some other disaster would inevitably follow until the
population was reduced to manageable levels.

In short, Malthus was something of a misanthrope, although he denied it. In

his Principle of Population, he wrote that humans are by nature "inert, sluggish, and
averse from labour, unless compelled by necessity."2

He argued against England's Poor Laws on the grounds that "the aggregate mass of
happiness" would be increased if the very poor were denied lifesaving relief.3

Criticism of Thomas Malthus

The population theory espoused by Malthus has been largely discredited over time.
Technological advances invalidated his main conclusion. His theory was made
repugnant by some of the political decisions that it influenced.

However, his theory of the effects of "gluts" or overproduction continued to influence

economists, including John Maynard Keynes, who further developed the analysis of
the cycle of boom and bust that defines an economy.4
An Outdated Conclusion

Malthus' theory that population growth would inevitably exceed its means of
production was based largely on his observation of English life in the late 18th
century and his later travels in Europe.

The advances of the Industrial Revolution allowed agricultural production to be

ramped up to far greater levels than the subsistence farming of his day could sustain.
Later advances in farming techniques, chemical fertilizers, and genetic modifications
have allowed food production to continue to scale upwards.

For example, the Green Revolution of the 1960s in India, which boasts the world's
second-biggest population, helped feed a growing population in the state of
Punjab.5 In Europe after World War II, populations increased steadily without
widespread starvation.

An Excuse for Political Malpractice

If simplified enough, Malthus' theory sounds a lot like Ebenezer Scrooge's declaration
that the poor might as well just die and "decrease the surplus population."

Malthus' theory of population was used to support genocidal policies in colonial India.
Malthus was not even alive at the time of the Irish Potato Famine of the mid-19th
century, but contemporary politicians leaned on his theory to blame Irish
overpopulation rather than British government policies for the massive death toll.6

What Did Malthus Predict About Population

Growth?
Malthus predicted that natural population growth would inevitably outpace
agricultural output, ultimately resulting in famine and other catastrophes until the
population was reduced below a sustainable level.

The cycle is endless, he believed: Relative abundance causes an increase in fertility

until the population again grows to an unsustainable level and collapses.

How Did Thomas Malthus Influence Charles

Darwin?
Darwin's theory of natural selection was influenced by Malthus' population theories.
Darwin found that limited resources place competitive pressures on every species.
Darwin's revelation was that a species adapted over time to improve its rate of
survival.

What Is the Malthusian Growth Model?

The Malthusian growth model is a mathematical equation for population growth. It
holds that the rate of growth is proportionate to the current population. This is
functionally equivalent to exponential growth, where the size of the population
doubles at predictable intervals.

The Bottom Line

Thomas Malthus was an 18th-century British economist best known for his theory
that human populations tend to outgrow their agricultural production capabilities,
resulting in famines and other disasters.

These theories have largely been discredited by innovations in agricultural

technology, but they remain influential in the field of evolutionary biology.