Neoclassical political economy

Neoclassical political economy

The time since the publication of Adam Smith's Inquiry into the Nature and Causes of the Wealth of Nations in seventeen seventy-six to the present day spans over two hundred years. Although there are important elements of continuity from Smith to the present world, neoclassical economics is not just a modern, updated version of classical political economy. The beginnings of the neoclassical system are placed in the eighteen seventies with the rise of marginalist economics. Before the eighteen seventies economics as a system of thought was dominated by the classical agenda: growth, distribution, and the labor theory of value. After the eighteen seventies, this agenda changed in important ways, although it did not change overnight.

To simplify a complex chapter in this history of economic thought, the marginalist revolution succeeded in doing two things. First, it advanced a theory of value grounded in the intensity of subjective feelings (subjective utility theory). And second, it developed the marginal calculus as a powerful conceptual and methodological tool. The upshot of these two developments was that, over the span of the next three to four decades, the emerging neoclassical consensus succeeded in replacing the labor theory of value with one grounded in subjective utility and placed the ideas of "marginal product" and "final demand" at the center while elbowing into the wings the concepts of total product and total demand. With these new ideas gathering momentum as they spread during the last quarter of the nineteenth century, the economy came to be thought of less in terms of material production and reproduction and more as a logic of human action.

The structure of the neoclassical theory

Central to neoclassical thinking is the notion of "constrained choice." In this perspective, the individual is understood as a choosing agent, someone who decides among alternative courses of action according to how he imagines those actions will affect him. Economists educated in the neoclassical tradition assume that we are all motivated to seek the highest level of satisfaction of our wants, thus the highest degree of happiness we can achieve given the resources available to us.

The idea of human motivation translates into a definite theory of human action. Individuals judge what to do according to how it will affect their levels of satisfaction. How to spend one's time, what to buy in the store, whom to marry, and so on, all depend on a judgment regarding the likely impact of choices on levels of satisfaction.

In order to choose we must compare the satisfaction of various alternatives. This comparison results in a ranking of the options according to the level of satisfaction or happiness each might provide. This ranking is termed a "preference ordering." We place each option in rank order according to our preferences and attempt to attain that option highest in the ranking of our preferences or desires.

The term "rational choice" refers to decision making based on an internally consistent ordering. A preference ordering is consistent if a preference for any item A over another item B joined to preference for B over C implies preference for A over C. Rational choice seeks the highest feasible level of subjective satisfaction for the individual. By making rational choices that follow our preferences, we ipso facto maximize our welfare. Rational choice means maximizing behavior.

A complication arises when we look more closely at the underlying necessity of choice. What about their circumstances requires agents to choose? Choice between options may mean deciding which among a set of mutually exclusive options we want and which we do not. Such a choice faces an individual when he or she decides, for example, which school to attend or which candidate to vote for. Alternatively, choice between options may mean deciding which among a set of desired options we want more (or most) when we would like to consume the entire set but, for some reason, cannot. Such a choice faces us, for example, when we would like to have a video recorder and a microwave oven but have money enough for only one. In the latter case, our welfare would be maximized if we make the "right" choice. The difference between the two cases has to do first with the presence (in the second case) and absence (in the first case) of mutually exclusive alternatives, and second with the presence and relevance of an additional condition: scarcity.

The significance of the concept of rational choice depends on the ability of competing goods to satisfy (if to different degrees) the same desire. In order to assure that this condition holds, the neoclassical theories assume that acts of consumption of different goods all provide a common result: the satisfaction or utility of the consumer. Rational choice, interpreted in this way, requires a foundation in the utilitarian image of persons as agents seeking a single end - subjective satisfaction, utility, or happiness - through alternative means. While the measure of this satisfaction remains unique to each individual, so that we cannot compare or sum satisfactions experienced by different people, within each person the consumption of different goods yields a single result measured by a common unit (usually termed "utility").

Given the possibility of comparing the degree of satisfaction (for a particular agent) from different goods, choice also presupposes scarcity. When the naturally available means are inadequate to satisfy desires fully, they are considered scarce. Scarcity depends both on subjective conditions (desire) and natural (or objective) conditions (availability of resources).

Although scarcity is a necessary condition for choice, it is not sufficient. It may simply mean that even in consuming his entire endowment, the individual will remain unsatisfied. Scarcity forces the individual to choose when his endowment includes items with alternative uses. If, for example, the individual's labor can be used to acquire different means of consumption but is not sufficient to acquire all that the agent desires, the agent must allocate labor among tasks according to a decision-making principle. Within this context, scarcity requires choice among competing ends.

Thus far, we have treated choice on the basis of competing goods. But the ideas of choice and maximization can apply more broadly. Whenever we act in ways that affect our level of subjective satisfaction, we are choosing on the basis of maximization in the face of scarcity. In this sense we can interpret nearly all of life as the application of economic calculation, as economizing behavior. This result works against any effort, based on the neoclassical approach, to identify a distinctively economic subset of our lives and our social relations. It erases the distinction between the economy and the other spheres of social interaction.

The neoclassical approach begins with the idea of the maximization of individual satisfaction. The next step is to use this idea to define conditions for maximization of the welfare of an interconnected system of individuals. Welfare for the group must be defined differently from (although on the basis of) the welfare of the individual alone. Maximum group welfare results from maximization of welfare on the part of each member separately only when the welfare of each is entirely independent. Group welfare takes on meaning when either of two conditions is met. First, acts of consumption affect individuals other than those who have chosen to engage in them. Second, other persons provide opportunities for mutual enhancement of welfare through exchange.

The first condition requires that the activity by which an individual experiences utility (consumption) affects other individuals either positively (that is, when my act of consumption yields an unintended benefit to someone else) or negatively (when my well-being is enhanced by an experience that harms others). Neoclassical theory terms these effects on others "externalities." When such externalities (or social consequences of private want satisfaction) exist, the welfare of the group cannot equal the sum of the welfare achieved by each individual on the assumption that satisfaction-yielding experiences are separable.

Even where externalities do not exist, the problem of defining group welfare arises when each member can (potentially) improve his or her level of satisfaction by acquiring goods owned by others. In this case, we need a definition of group welfare that takes into account the possibility that voluntary transactions between members can enhance their well-being. What constitutes the maximum welfare of the group subject to the condition that each pursues his private ends and that interaction takes the form of voluntary transactions?

Consider the case of a group composed of two individuals. Each has his own preference ordering and endowment of goods for satisfying his desires. Consumption of his endowment will yield a given level of satisfaction. Assume, however, that if we treat the endowments as a single pool of goods, there exists a distribution of those goods different from the one represented by the initial allocation that would improve the well-being of each and can be thought to maximize the joint or group welfare of the two taken together.

The implied notion of group welfare carries the same meaning as the notion of voluntary transaction based on individual rational choice. Such transactions must be welfare-improving or they would not take place. Given appropriate information, the desire to maximize their individual satisfaction will drive the parties to exchange elements of their endowments. In this sense, and under these conditions, the institution of voluntary transaction based on respect for property right (exchange) leads to an improvement in the welfare of the contractors taken as a group.

Since the conditions specified determine an appropriate exchange of goods between property owners, they must fix the prices at which goods exchange. If a redistribution of x units of good A held by the first individual for y units of good B held by the second improves the welfare of both, a price of good B equal to x divided by y of good A allows for a welfare-improving transaction.

In a "perfect" market characterized by a very large number of participants there will, under appropriate conditions, be a unique price for each good