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Importance of Political Economy than NeoClassical Economics

By Edited Jun 20, 2015 0 0

Logical flaws in NeoClassical Economics

Issues of general equilibrium and disequilibrium

The neoclassical economics is basically based on methodological individualism. This school of thought of Economics has assumption that consumers are utility maximise under perfect information. In addition, they derive individual demand curves and add individual demand curves to get market demand curves. The same applies to the supply curves of firms in a competitive market. Then the demand and supply find prices and they allocate resources between different markets and arrive at equilibrium in goods, labor and money market simultaneously. In this school of economic thought,  if markets  to work without any hinderance they produce greatest efficiency and equity based on the assumptions of consumer behaviour and behaviour of firms at micro level achieves Pareto optimality in welfare and greatest efficiency at macro level.

That is  the marginalist and Neoclassical economics apparently give a coherent picture of the market economy which is the best of all worlds. However, they ignore many complex issues and aggregation issues at macro level to do get the outcome as explained above in theory. This neoclassical economics has many logical flaws and they ignore many factors which are important practical consideration in a real world economy which have diverse tastes, commodities,  social interaction, conflict, institutional issues,  gender issues as well class formatiion,

 

Classical Economics

Foundations of Economics or more appropriately the foundation of political economy were laid by "classical economists" in the wake of Industrial capitalism in Britain in the period of 17th and 18 century.  Adam Smith's " Enquiry into Wealth of Nations" in 1776, si the first most comprehensive treatise on this subject. He considered that the key to wealth of nations is the broadening of market. He identified the basic force of the market economy is the self-interest of producers and consumers which also in the same time with the "invisible hand" increased public good.  He also emphasized  division of labour and specialization to increase the efficiency of the market system.  He identified demand and supply as the basic market forces. He also developed to some extent the labor theory of value which is further developed by has successor Ricardo, in his book  Principles of Political Economy and Taxation, 1817. Ricardo also formulated the law of comparative advantage and the market forces to international trade, which holds ground even today. He also formulated law of diminishing returns especially in relation to land.  J.S. Mill formulated, who is the last among the last in classical economists,  between production and distribution, where production must be guided by free market forces and distribution can have scope  for intervention by non-market forces, in his " Principles of Political Economy, 1848".

As well, Thomas Malthus in his "Principles of Populations, 1798" identified the long-term race between agriculture and population growth. He observed, that the former grows by arithmetic proportion the latter grows by geometric proportions, which leads to an imbalance, which can only be resolved by pestilence, disease and famine. This theory is till relevent to some countries even today.

As well, they all believed that the economy will be always at equilibrium at very close to full-employment if government intervention is small but necessary for the efficient functioning of markets by laws and some essential services such as postal and security services and protection of basic freedoms. In addition, they developed the quantity theory of Money.They also identified classes and class formation.

However, Karl Marx in "Das Capital" was not confident of the free market system and he has predicted the collapse of the system. He identified, contradiction inherent to the free market system when it develops  due to of exploitation and wages less than the value created by social labor and under consumption and the rate of profit falling down, creating crisis of the system . In his view, the labor theory of value is the regulator of the system and its dynamics and the demand and supply is the executor of the system.

Marginalism and Neo-Classical Economics

In 1870, and in later years the Neo-Classical economics emerged and neo-Classical economists developed precise economic laws of optimizing consumer at the margin given their preferences by maximizing the utility or calculating the cost and benefit of consumption at he margin of consuming goods and services spend by the last unit of money. In the same time, the firms produce, where small productivity is equal to wages, rate of interest is equal to the small efficiency of capital and rent is equal to small efficiency of land except for more productive land where there may  super profit as identified by Ricardo.  This law, optimizes the use of the factors of production. The level of production, is determined where marginal cost equals marginal revenue where profit is maximized. As well, demand and supply is always equal as there is tendency of equilibrium through the price mechanism. In addition, Pareto equilibrium states, that the free market produce best results. In effect, according to Neo-Classical economic point of view, competitive market equilibrium theory implies,  that the role of government must be as small as possible.  These  laws, were further developed and refined by Alfred  Marshall, of england, J.B. Say of France, Kunt Wicksell of  Sweden, Irving Fisher and J.B Clark of USA.

As, well, in neoclassical economics, Mathematics is important to neo-classical Economists. For example, the economist  William Stanley Jevons and Leon walrus used mathematical analysis as economics used quantitative measurements. In this way, Walrus pioneered " General Equilibrium Theory" using equations of all transactions in an economy.  Mathematical approach to economics was given shape by P.A. Samuelson in his book of " Foundation of Economics, (1947). In addition, recently mathematic approach to economics in neo-Classical economics came into being by " Game Theory". It was first pioneered by John Van Newman, Oskar Margenstern and by John Nash in " The Theory of Games and economic behavior" in 1944. In 2005, it was further popularized, by a Nobel prize-winning  economist Thomas Shelling. In the same time, technique of complex theory had an impact on economics using mathematical techniques.

However, one of the founder of Neo-Classical economics Alfred Marshall has been critical about mathematical techniques as a major way to ask the economic phenomenon. For example, he has observed in his principles, that 'Use of Mathematics as a short-term language and not an engine of inquiry". As well, John Maynard Keynes, trained as a Mathematician, has commented that purely mathematical approach to economic study is not right or not fruitful.

 

The flaws in the Foundation of Neo-Classical Economics

In Neo-Classical economics, is based on a concept called 'homo-economics'. That is, the person as an economic agent, whether the person is a consumer or a producer making choices is a faulty one.  That is, people do not make choices independently  their own choices, and their choices are influences by interpersonal relations, community values, media impacts as well by community and group values. In reality, people act in a social context,  be seen in that way and not isolated people abstracted from the social world .   Nobel prize economist Trygve Haavelelmo in his lecture " economics and Welfare 1989" has observed an individual embedded in a social world.

Another serious flaw in Neo-classical economics 'rational' choices made by a person in a self-interested way to maximize utility is extremely illogical. This is because, in reality people make spontaneous decisions, like impulse buying, thrill seeking, want to know the unknown, making decisions according to some religious or moral values especially in food consumptions and other consumptions, even though they need not be rational. In other words, in reality people make decisions, which are not motivated by self-interest alone and other influences which motivate them in consumption behaviour. They can also be motivated by ethical and moral values. In this sense, rational consumer behaviour as assumed by the Neo-Classical economics is extremely dubious and not based on empirical evidence or observation in day-to-day economic activity of any person.

In neo-classical economics, they base their ideal model to judge other market models. However, they rarely exist in any market economy. Most markets are far removed from the perfectly competitive markets. Some modern corporations are very huge and they exert power due to their money power as well their ability to manipulate consumers by the aid of advertisement, particularly in a reality where the information is asymmetrical and uncertainty is the norm and not exception. Corporations manipulate demand and not supply.  A renowned economist J.K. Galbraith has observed this fact. In other words, even if consumers maximize utility, the utility is not controlled by the person but manipulated by the modern  corporations in reality, perfect market conditions is a mere abstraction than concrete assumption based on empirical facts. 

In marginalist economic analysis firms take decisions where marginal cost equals marginal revenue to optimize profit . However, in actual practice, the firms do not make decisions as marginalist suggest. They often make these decisions not based on marginalist economic analysis, but in response to technological breakthroughs as well as by compulsions of machinery. and capital equipment. As well, , there exist no constant coefficient of production and there is no perfect divisibility of goods or factors of production. If this  is the case, even if markets are perfect, the economic efficiency and profit maximization is not the main goal of firms, or they cannot practice profit maximization based on marginalist analysis, they need not optimise the efficiency of the use of scarce resources.

In the text books, the market characterization is simple and they do not adequately cover brand and goodwill. They are important for any marketing people and marketing departments of any modern-day corporations. brands and goodwill are important considerations for modern business organizations than competitive markets alone as they do not compete with other firms solely o the basis of price alone. That is, some markets are not perfect markets and they are monopolistic markets and brand and goodwill are crucial factors competition than price.

In Neo-Classical general equilibrium model is static . They do not adequately consider uncertainty and dynamic processes in an economy.   Input-output relationships is linear in their model. However, in reality they are normally non linear and they are chaotic . As well, they tend are a rule and not an exception.

In addition, the neo-Classical economic models overlook institutional set-up like legal system, educational set-up and cultural institutions, which are very difficult  included due to the fact that these models are mathematically oriented and these are very difficult  concepts to be incorporated.

In the neo-classical model, economic activity in non-market sectors like family, educational area, health area and government are heavily overlooked, even they are crucial in a given market economy or even any modern market economy. For example it has been estimated that the family economic activity accounts for at least 40% of GNP in Western economics.

Micro economics of the Neo-classical model to predict macro level economic forecasting is not impressive.

Conclusions

As discussed above, even neo-classical economics is the dominant school of thought in economics, by many economists for their narrow definition and there claim that their economics is scientific. it is obvious from the above discussion, it is clear it has many logical flaws as well it overlooks many issues of the real market system and how it works and its role in the issues of efficiency and fairness as well how it develops over time. If these issue are not addressed and broader definition of economics like political economy with other social sciences is not undertaken in future.  Economics will be a dismal science and its usefulness to solve real world economic problems is questionable.

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