Neoclassical Economics

Conceptual Overview

Like the classical economists before them, neoclassical economists sought answers to the burning political questions of their time. In the case of the classical [Page 954]economists, the issue was the distribution of power between landlords and industrialists; the issue that neoclassical economists dealt with was the distribution of power between industrialists and workers. The end of the 19th century saw a marked increase in the strength of workers' organizations in Europe. In 1871, England passed a law that legalized unions.

Classical economics was squarely on the side of workers. David Ricardo explained that the profit that a capitalist receives is the “residual” that remains after the capitalist pays the cost of replacing the capital that has been used in production and the cost of labor. In other words, workers produce value and this valueadded is the source of both the workers' wages and the profit of the capitalist. Ricardo assumed that workers are paid a subsistence wage, and that the rest of the value-added is the capitalist's profit. But if the profit is just a residual, there is no reason why it cannot be lowered in order to raise the standard of subsistence. Furthermore, if unions were successful at raising workers' wages, society as a whole would benefit because according to the theory of utilitarianism that was developed by another classical economist, Jeremy Bentham, economic efficiency means income equality. Karl Marx pointed out that what is considered subsistence is not determined by biology alone, and that it has changed throughout history according to the relative strength of employers and workers.

Neoclassical economics is the theory that argues that Ricardo is wrong. Profit is not a residual. Profit is determined by the level of the marginal productivity of capital, and the wage of workers is determined in a similar way by the marginal productivity of labor. Therefore, according to neoclassical economics, if a union succeeds in raising the workers' wage, the inevitable result will be unemployment. In tandem with this new theory of wages and profits, Pareto first dismissed the theory of utilitarianism, which called for redistributing income, and then developed a new definition of economic efficiency to replace it. According to Pareto's definition, the higher union wage results in economic inefficiency.

Although entirely different from Ricardo's theory of profits and wages, the neoclassical theory of profits and wages is an application of another of Ricardo's theories, that of land rent, and this is how neoclassical economics got its name. According to Ricardo, parcels of land differ in their fertility. The most fertile land is put into production first, and as agricultural production expands, less and less fertile parcels are added; the rent for less fertile parcels is lower than the rent for more fertile land. Neoclassical economists argue that the process of adding labor and capital when industrial production is expanded is similar. As industrial production expands, additional workers are hired (while the quantity of capital is held constant) and, exactly as the fertility of additional units of land in agriculture falls, neoclassical economics assumes that the productivity of each additional worker diminishes.

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