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.

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.

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.

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).

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.

In a “perfect” market characterized by a very large number of participants there will, under appropriate conditions, be a unique price for each good that allows all welfare-improving transactions to take place. Such a price arises out of independent and voluntary actions of the individuals pursuing maximization of private satisfaction. If prices are flexible in the sense that parties are free to pursue transactions at whatever rates they deem mutually beneficial, they will, under appropriate assumptions, tend to settle at levels that allow for all welfare-improving transactions. Under these assumptions, free market processes yield an optimum of social welfare.^{[12] [13] Economists term this type of group welfare the Pareto optimum after its discoverer, Vilfredo Pareto.}

Clearly, criteria other than Pareto optimality could be used in the effort to evaluate alternative allocations of the wealth held by the members of a group. The attractiveness of the Pareto criterion stems from its loyalty to the preferences of individuals taken by themselves. That is, it does not require us to impose any preferences on the group as a whole other than those already given in the orderings of its members, no one of which is given precedence over the others. Thus, the attractiveness of the Pareto condition depends on the attractiveness of the premise that social outcomes should derive from the subjective preferences of individuals.

Acceptance of the Pareto criterion has significant implications for the judgments we make concerning when to use markets to determine pat­terns of group consumption. Because of the link between free markets and optimization, acceptance of the Pareto criterion for determining the allocation of resources appropriate to a group of persons constitutes a powerful argument for the use of markets to determine production and distribution.

On a practical level, the neoclassical approach links welfare with choice. The greater the range of choice, the greater the feasible level of social welfare, all other things equal. Markets increase choice; nonmarket allocations inhibit choice. Consider a favorite example of the application of economic reasoning to economic policy:^[15] gasoline rationing. The example involves resource al­location in the face of a shortfall in supply of gasoline relative to existing and recent levels of consumption. In such cases, we can bring demand into line with supply simply by allowing price to rise until demand falls to the point at which it equals supply (assuming, of course, that demand and price are inversely related, which they may not be, especially in the short run). Al­ternatively, the government can bring demand into line with supply by fixing the price level and rationing consumption. The government can, for example, distribute rationing cards equal to supply and require that purchase of gas­oline at its regulated price be limited by available rationing cards. The ar­gument against rationing follows the contours of the argument linking choice to welfare, optimality to free markets.

Assume that the government fixes the price of gasoline at a level that stimulates more demand than can be met with the available supply. It does so, for example, in order to prevent hardship for low-income consumers resulting from a substantial increase in the price of a basic consumption good. In order to limit demand, the government distributes rationing cards ac­cording to some principle deemed equitable (that is, the same number of cards to all individuals owning cars, perhaps adjusted in various ways to particular circumstances).

Application of the kind of reasoning outlined immediately suggests that under these conditions welfare gains will result if individuals can buy and sell the rationing cards allocated to them. The existence of a market in rationing cards allows those who would prefer to consume less gasoline, if by so doing they will be able to consume more of other goods, to do so. Since each person remains free to hold his rationing cards and consume gasoline, the presence of a market brings together individuals in voluntary transactions aimed at improving the welfare of each without adversely affecting the well­being of others. The market provides a choice where none existed previously, without removing preexisting opportunities. Taken by itself, the result should be a higher level of satisfaction for those who exercise this choice without any necessary adverse effects on others.

The market for rationing cards sets a price for cards that in effect constitutes a part of the price of gasoline (equal to the sum of its regulated price and the market price of the rationing card). By allowing for a market in rationing cards, we have, in effect, facilitated establishment of a market price for gasoline. The sole remaining function for rationing cards is to redistribute income from the producers of gasoline (or alternatively from those who are taxed to subsidize gasoline producers).

Gasoline rationing combined with a market for rationing cards is now an indirect method of income redistribution. We can also apply the neoclassical method of reasoning to the determination of the price of labor (wage) so that a market determination of incomes also yields maximum choice and a welfare optimum.^[16] Even if we refrain from taking this step, and deny the optimality of market outcomes for income distribution, correcting inequities through distribution of rationing cards must seem inefficient and even inappropriate given the more direct methods of redistribution available, for example, through the tax system.

The conclusion, with regard to product markets (if not labor markets also) is that the connection between markets and choice argues against government intervention. The issue of the limits of the market becomes that of the limits within which choice enhances well-being. To specify such limits, we need to consider principles (such as individual rights)^[17] that take precedence over choice. We return to this issue in Chapter 9.

To sum up, neoclassical economics sees the market as the institution al­lowing maximum scope for free exchange and hence efficiency. The market allows one to reshuffle (use in alternative ways) resources and commodities so as to achieve their most desirable use. Viewed from the consumer’s stand­point, there is a large number of bundles of consumer goods from which to choose. From the producer’s position there is the possibility of combining productive factors in many different ways. Land, labor, and capital - all of which have important subcategories - can be mixed in different proportions to produce goods for sale on markets. This process of substitution will go on until societal resources have yielded maximum product for producers and maximum utility for consumers (Dasgupta, 1985:78-9).

Given the preceding description, it should be clear that, once the values of the exogenous variables (endowments, preferences, technology, and rules) are given, the results on the part of choosing agents can be known with precision. This prompts us to ask if neoclassical economics is an abstract logic of choice or a behavioral science that makes contingent (hence refutable) predictions about the activities of economic man in different situations. To the extent that rationality and maximizing behavior are axiomatic and pref­erences are derived ex post from the explained behavior, actions of economic agents are assumed to reflect just what these preferences are as well as the constraints that must have existed to prevent them from achieving more. To the extent that rationality is treated as a hypothesis about economic agents, an independent specification of preferences and a full account of constraints (the information available to agents, limits on calculating ability) is needed ex ante. If information on these factors is present, it is possible to treat outcomes as tests of refutable hypotheses about rationality, self-interest, and maximizing behavior.