Question

Explain why the Neoclassical school of thought is considered the birth of a new school of economic thought and what is new compared to the classical school?

Answer 1

The Neoclassical school of thought although based on the classical school of thought has a more wider range of ideas as far as the modern world is concerned. Classical ecoonomics was founded by Adam Smith, where he invented the concept of 'Invisible Hand' which is basically the free movement of prices and trade. However, with the Great Depression (1929) which started in the United States showed its effects worlwide and then there was a need for an external force to help the economies revive. During that time, Keyenesian economics (proposed by John Maynard Keynes) started to become popular which introduced the concepts of sticky wages and prices. This means that unlike the classical assumption that wages and prices automatically move to the equilibrium, Keynes suggested that government intervention was necessary inorder to introduce public policies and achieve stability in the economy. During this period, Classical Economists failed to explain the causes and reasons of Great Depression and as to why prices and wages did not adjust immediately during this time.  Therefore, the new generation Classical Economists such as  William Stanley Jevons, Carl Menger, and Leon Walras who were the followers of Adam Smith came up with neo classical economics. Neoclassical economics is an extensive theory focusing on the forces of supply and demand and their effects on production, pricing, and consumption of goods and services. The term neoclassical economics was coined in 1900's. Neoclassical economist's most importantly focused on maximizing a consumer's personal satisfaction and the concept of utility comes into play.

The neo classical school is different from the classical school in a few aspects and that is what makes it new and modern. Some of the core aspects of NeoClassical Economics are:

1. Methodological individualism

Behavior of individuals explain everything that happens in the society as a whole. Any theory that states how an economy should run can be built from what individuals as single entities behave. This is the concept of individual economics agent. Neol classical economists study how a single individual takes decisions based on his/her tastes and preferences. Such characteristics are either fixed or unchanging and anything that deviates from this can be termed as an exogenous factor.

2. Rationality

The concept of rationality states that Neoclassical theory assumes that all individual behaviour is ‘rational’ which means that indivuals have well identified goals and they try to maximize their own utility given their budget constraint (i.e what is affordable to them) and firms try to maximize their profits. This works as a means for maximization of total gain.  

3. Equilibrium

Neo classical economics focus on understanding the concept of equilibrium in models which is a situation where no economic entity has any incentive to change or move from their current position. Equilibrium can be defined as a position of rest for the producer, consumer and all other economic entities of the real world. This essentially means that there is a price level in the market in which the consumer is maximizing his/her utility and the producer is maximizing his/her profits and nobody has any incentive to change their position unless any external factor puts force.

4. Price Mechanism

Price mechanism gets a central place in the NeoClassical economics as it is the main component connecting the economic agents of the market. The interaction between consumers and producers takes place through the price mechanism because that is the connecting dot between the two. All decisions in the market are based on the price i.e the consumer decides what good to buy and what quantity on the basis of prices and the producer decides how mych to sell on the basis of prices. Individuals in the market are therefore influenced by the price mechanism.

Therefore, this is how the Neo Classical Economics came into existence and although it has its roots in the pure classical theory, it can be considered as the emergence of a new school of thought inorder to explain the forces of the modern market.

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