What is Neoclassical Economics?

Definition: Neoclassical Economics is a school of economics that focuses on rationality and mathematics to explain the behavior of a given economic system. In other words, it bases its theories on rationalism to predict how the economy will behave.

What does NeoClassical Economics Mean?

Neoclassical economics bases its theories in classical economics but departs from it by stating that individuals make their economic decisions based on rationality and utility. This means that everyone within an economic system acts and decides by analyzing all elements thoroughly before entering a given transaction. This criterion of usefulness establishes that a given good or service can be priced at a much higher amount than the sum of its per-unit costs if consumers perceive that the level of utility is higher than the cost of producing the good. This school of economics, although it is currently the predominant one, has some detractors.

This detractors state that the presumptions on which these theories are founded are fantasies and don’t reflect real world situations accurately. For example, individual don’t always make their purchases based on rationality, many times there is a lot of subjectivity attached to the transaction. Nonetheless, these neoclassical theories have helped develop modern economies up to the current point and have deeply shaped the way in which we understand the economic systems.

Here’s an illustration of how these theories work in a practical situation.

Example

Futura Devices LLC is a company that designs and manufactures electronic devices. One of their recent devices is a holographic cell phone. The cell phone doesn’t have a physical screen; instead it reflects a holographic touch screen that the user can manipulate easily. This phone is the ultimate piece of technology and is very much desired by the consumers. The cost of producing this phone is $300 but consumers are paying more than $1,500 to get it. How neoclassical economics will explain this phenomenon?

As we previously explained, neoclassical economics state that the price of a good or service can be higher than the cost of production if consumers perceive that the intrinsic utility of the good is higher than that. They will pay as much as the level of utility they perceive. This means that, in this case, the perceived utility value of this phone is $1,500 or higher.