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Economics has been defined as the study of the allocation of scarce means among alternative ends. In other words, it is concerned with how human needs and wants are satisfied in a world of limited resources, where everyone cannot have as much as he or she wants of everything. Neoclassical economics forms the basis of the view of how economic activity functions, as conventionally adopted in capitalist society. It represents the refinement and extension of ideas from the formative or classical phase of economics as an academic discipline. The classical period of economics is usually defined by the publication of Adam Smith\'s Wealth of nations in 1776 and John Stuart Mill\'s Principles of political economy in 1848. It was dominated by the work of David Ricardo (see neo-Ricardian economics), who developed a theory of relative prices based on costs of production in which labour cost played the dominant role. The labour theory of value was taken up by Karl Marx, to become a central feature of Marxian economics. The classical economists placed great emphasis on the ability of laissez faire to resolve conflicting self-interest in a manner that would benefit the community as a whole, via the \'invisible hand\' of market competition recognized by Adam Smith. It was the liberalism of the classical economists rather than the labour theory of value that characterized the neo-classical perspective. A view of human affairs that stressed individualism, laissez faire and reverence for market mechanisms (see market exchange) was more in accordance with the prevailing ethics of capitalism than one which attributed all value produced to the expenditure of labour.
The classical conception of an economy was one composed of many small enterprises, none of which could exercise a significant influence on market prices or on the total quantity of goods sold. The actions of any firm were dictated by consumer tastes as expressed in the marketplace and by the competition of innumerable other small firms seeking consumer expenditure. The utilitarianism of Jeremy Bentham provided a concept whereby consumer satisfaction could be represented. As this framework became formalized in mathematics, the new school of neo-classical economists emerged from the tradition of classical liberalism.
The rise of neo-classical economics is closely associated with three well-known texts published in the early 1870s: William Stanley Jevons\'s The theory of political economy, Karl Menger\'s Grundsatze der Volkswirtschaftslehre and Leon Walras\'s Eléments d\'économie politique. Although there were differences between their analyses, the basic approach and content of these works was similar: the framework set down is still highly influential in economics and economic geography.
Neoclassical theory portrays an economy comprising a large number of small producers and consumers without the power to influence the operation of the market significantly. Firms purchase or hire factors of production (land, labour and capital) which they utilize in the production process in such a way as to maximize their profits. The prices of factors and of finished goods sold are taken as given, and beyond the control of the firm. The decisions facing the firm are the productive process to be adopted (combination of factors) and the volume of output (or scale); plant location is disregarded. Households sell the factors of production that they possess: their land and capital if they have some, otherwise just their labour. They accept the given market price and use the resulting income to purchase goods and services in quantities selected so as to maximize individual satisfaction or utility. The entire system is regulated by the interaction of supply and demand in the marketplace, which serves both to allocate resources and to distribute income through the determination of prices for goods and factors of production.
This is essentially how conventional economics textbooks see the operation of a capitalist free-enterprise system. For example, Paul Samuelson\'s Economics (1998) portrays the competitive price system solving the basic economic problem of what to produce, how and for whom, in a manner summarized in the figure. Two groups of participants in the economy are recognized — \'the public\' and \'business\'. The markets for goods and for factors of production set the prices at which things are exchanged. The public offer their labour, land and capital goods for sale to business, and the interaction of supply and demand in the factor markets determines the prices paid as wages, rent and interest, i.e. it determines the distribution of income. The public takes its income onto the markets for consumer goods, expressing its preferences in the form of what Samuelson refers to as \'dollar votes\'. (The implicit analogy with the electoral process evokes the principles of democracy in support of free-market mechanisms: see pluralism.) Consumer demand interacts with the costs at which business is able to supply goods, to determine their prices.
All the elements of the economy represented in the figure are related to one another, so that a change in one will have repercussions for others. Thus a change in the willingness of either capital owners or labour to offer their services will affect prices on the factor markets, which will affect the cost of production, the price of goods, and the willingness of the public to consume them. Markets are supposed to adjust automatically to these changes, tending towards the restoration of a state of equilibrium at a price that brings supply and demand into balance. It is this self-regulating property that gives free-market mechanisms much of their attraction as means of allocating factors among alternative uses and of distributing returns among the various participants in the productive process.
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neo-classical economics
The consumption and production sides of the economy are themselves the subject of elaborate and sophisticated theory, formalized by the use of algebra and simple geometrical models. The concept of utility is crucial to the theory of consumer behaviour. Consumers are held to possess a utility function incorporating their tastes and preferences. They alone know what suits them best: this is the principle of \'consumer sovereignty\'. Consumers allocate their expenditure among alternative \'bundles of goods\' so as to maximize utility, subject to the \'budget constraint\' represented by income and to the prevailing set of prices. For a long time utility was assumed to be measurable, at least on an ordinal scale, but even this was found unnecessary as the level of abstraction from reality became such that consumer behaviour could be analysed without any empirical frame of reference. Economists of the neo-classical school went to great lengths to minimize the ethical content of their theories, which meant avoiding any reference to the actual specification of the utility function. The objective was to identify the general necessary and sufficient conditions for the maximization of utility, irrespective of the actual goods involved and the magnitude of the utility to be derived from their consumption in specific combinations. Consumers maximize utility when the utility derived from the last (or marginal) unit consumed, expressed as a ratio over the price of that commodity, is an equal proportion for all commodities. In other words, marginal utility per unit of expenditure should be the same for all goods or services consumed, otherwise there is additional utility still to be gained by the reallocation of expenditure from things offering low marginal utility to things offering more (cf. utility theory).
This analysis is then extended into the collective consumption of an entire community. Individual utility functions are aggregated into a social welfare function expressing community preferences for various goods and services. Resources and technology available create certain production possibilities (the community equivalent of the budget constraint), which place limits on what can actually be made available for consumption. community welfare is maximized through the maximization of the individual utility functions. This simple exposition of welfare theory in neo-classical economics (welfare economics) has been the subject of much development and debate, including some geographical extensions (see Pareto optimality; welfare geography).
The neo-classical analysis of the operation of the firm on the business side of the figure is analogous to that of consumer behaviour. To maximize profits, the firm operates at the highest level of efficiency in its use of resources and hence produces at the lowest possible cost. It purchases factors of production up to the point where the contribution to production of the last (marginal) unit of each factor, expressed as a ratio over the price of the factor, is an equal proportion for all factors. Thus the last unit of expenditure on each factor should yield the same increase in production, otherwise additional output could be achieved by reallocating outlays among factors or inputs (just as in the consumer\'s attempt to maximize utility). When production and consumption are brought together, resources are allocated among alternative goods and services in such a way that no reallocation is possible without diminishing the total value of production of the entire economy and the overall utility or welfare derived from it. Income is distributed according to the prevailing marginalist principles, each factor being paid according to its marginal productivity.
Although neo-classical economics traditionally ignores geographical space, attempts have been made to overcome this obvious defect through regional economics (see regional science). For the most part, this is a repetition of the conventional neo-classical formulations. For example, a strict interpretation of the notion of factors of production being allocated according to marginalist principles requires labour to move to places of shortage from places of surplus, and for capital to do the same, until no further addition to output can be achieved by spatial reallocation. This leads to a prediction that market forces will tend to equalize factor returns, and hence incomes, in geographical space. The Swedish economist Bertil Ohlin published a book Interregional and international trade in 1933, which showed how specialization and trade would lead to regional equality, given certain assumptions which he acknowledged would not necessarily be fulfilled in reality. The truth is that imperfect mobility of factors prevents the instantaneous adjustment that the market is supposed to achieve. The fact that the friction of distance is an important impediment to factor mobility makes the neo-classical perspective especially inappropriate as a general theory of how the space-economy actually functions. However, the rise of regional economics had some benefit for both geography and conventional economics, with the recognition that space is neither non-existent nor neutral in economic processes.
Regional growth theory in the neo-classical tradition has had an important influence on spatial economic planning. Albert Hirschman in The strategy of economic development (1958) argued that the selective development of particular sectors of the economy is the most effective way of promoting the interregional transmission of growth. This was similar to François Perroux\'s argument (1950) for the stimulation of propulsive industry as a growth pole, a concept which was translated geographically into that of the growth point or location selected for investment. Selective spatial development strategies depend on how effectively growth is transmitted from one place to another, or what Hirschman termed the \'trickle down\' effect.
Brian Berry (1970) and others have elaborated a view of \'growth impulses\' spreading down the urban hierarchy, rather like the diffusion of an innovation. The tendency towards equalization may be frustrated by \'polarization\' effects arising from efficiency advantages maintained where growth was initiated. Gunnar Myrdal\'s (1957) concept of circular and cumulative causation suggests that the \'spread\' effects would be counteracted by \'backwash\' effects, thus perpetuating uneven development or regional inequality. Particularly important is the process of concentration and centralization, which implies continuing growth in the core region of a metropolis at the expense of the periphery, as external economies are built up and capital generated in the periphery is transferred back as returns to investors in the core.
Neo-classical economic theory has some obvious attractions. It provides an elegant general theory, in the sense that all aspects of economic activity can be brought together in a set of statements that define the necessary and sufficient conditions for social welfare to be maximized. The association of all this with a market-regulated, free-enterprise system provides what can appear to be objective scientific support for the capitalist system. What is produced, how and for whom, can be conveyed as something ultimately depending on the \'democratic\' sanction of the people as they spend their money votes in the marketplace. Thus, however perverse the structure of consumption may appear to be, and however unequal the distribution of rewards, these can be traced logically to the free expression of popular preference and to the response of business under the discipline of the marketplace. Government intervention will merely impede the operation of processes which, if left to themselves, will adjust to change and resolve all conflict in the general interest.
Neo-classical theory is obviously at variance with reality in some important respects. Some of the defects have been addressed in subsequent modifications. For example, it is recognized that buyers and sellers may be large enough to affect prices, so competition is not perfect. In fact, there is a tendency in the competitive process for inefficient firms to be eliminated to the extent that monopoly, or something close to it, can develop. This in its turn distorts or constrains the very competition on which efficient reproduction is supposed to depend. Thus anti-monopoly laws usually form part of the attempt by the state to regulate a capitalist economy.
In addition to the monopolistic tendencies conventionally considered, spatial monopoly is a source of market imperfection. Another refinement includes the introduction of the category of public goods which do not lend themselves to supply under market conditions and for which society usually accepts collective responsibility even under capitalism, e.g. defence, certain social services and aspects of infrastructure. Social costs and externalities (unpriced benefits and burdens) are also seen as major distortions of the free-market model.
More fundamental defects of neo-classical theory have also been recognized. The existing pattern of factor ownership and income distribution is taken as given and its legitimacy is unquestioned. Social institutions characteristic of capitalism, such as the private ownership of land and capital, are portrayed as the natural order of things. The analysis of consumer behaviour is highly individualistic, emphasizing freedom of choice at the expense of examining the origins of personal preference and of the budget constraint. For all their formal elegance (or because of it) the analytical devices of neoclassical theory are confined to technical matters and ignore social relationships, such as those among classes under capitalism.
Much of the criticism of neo-classical theory has come from within mainstream economics itself. J. de V. Graaff\'s Theoretical welfare economics (1957) originally laid bare the long and restrictive list of assumptions necessary for a competitive, free-market capitalist economy to realize the optimally efficient and welfare-maximizing outcomes with which it is credited. J.K. Galbraith (1975) was responsible for a sustained critique on the grounds of the changed nature of business organization and control, while E.J. Mishan (1969) pointed to problems in welfare economics arising from such considerations as the negative externalities of economic growth.
Different lines of critique have been followed by radical and Marxist economists. The ideological content of neo-classical theory has been exposed by M. Dobb (1973) and others, who see the perpetuation of the self-regulating, free-market model with its welfare-maximizing properties, in the face of such evident logical flaws and discordance with reality, as attributable in part to its role in supporting the capitalist system. As seen from the Marxist perspective, the focus on purely technical relationships diverts attention from the exploitive nature of capitalism. Furthermore, capitalism is inherently cyclical (see Kondratieff cycles), leading to considerable fluctuations in prosperity over time and with great hardship generated by periods of \'downturn\'. The repeated crises of recession/depression, inflation, industrial unrest, business scandals, etc., do little to improve confidence either in the capitalist system as a benign, self-regulating mechanism or in the control capacity of those professional economists who claim to understand it (and whose training tends to be in the neo-classical tradition).
The critique of neo-classical theory can be overdone, however. As a theory of how capitalism (or indeed any economic system) actually operates, it is clearly defective. But the analytical devices used to demonstrate optimality in resource allocation in pursuit of efficiency and even the maximization of social welfare do have some practical applicability if adopted with sensitivity to their limitations. Central planning of the kind at one time followed in eastern Europe and the former Soviet Union used some neo-classical devices in the pursuit of allocational optimality, though the actual operation of these societies frustrated its achievement.
The 1980s and 1990s have seen a resurgence of interest in \'free market\' processes. This came first in the West, in Reagan\'s United States and Thatcher\'s Britain, for example, and then in eastern Europe with the collapse of socialism and central planning. While market mechanisms do have the capacity to improve economic efficiency in certain circumstances, their adoption in both West and East is often a matter of political ideology and faith rather then an outcome of careful understanding. The very specific conditions required for markets to work in reality as they are supposed to in theory are frequently overlooked in the enthusiasm of free-market fanatics to implement their favoured panacea. (DMS)
References and Suggested Reading Berry, B.J.L. 1970: City size and economic development. In L. Jacobson and V. Prakash, eds, Urbanization and national development. Beverly Hills: Sage Publications, 111-56. Dobb, M. 1973: Theories of value and distribution since Adam Smith: ideology and economic theory. Cambridge: Cambridge University Press. Galbraith, J.K. 1975: Economics and the public purpose. London: Penguin; New York: New American Library. Graaff, J. de V. 1957: Theoretical welfare economics. Cambridge: Cambridge University Press. Hirschman, A.O. 1958: The strategy of economic development. New Haven: Yale University Press. Mishan, E.J. 1969: The cost of economic growth. London: Penguin; New York: Praeger. Myrdal, G. 1957: Economic theory and underdeveloped regions. London: Duckworth. Ohlin, B. 1933: Interregional and international trade. Cambridge, MA: Harvard University Press. Perroux, F. 1950: Economic space, theory and applications. Quarterly Journal of Economics 64: 89-104. Samuelson, P.A. 1998: Economics: an introductory analysis, 18th edn. New York: McGraw-Hill. Smith, D.M. 1977: Human geography: a welfare approach. London: Edward Arnold; New York: St. Martin\'s Press. |
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