Neoclassical theory

What we find nowadays in modern textbooks about microeconomics is the neoclassic theory. More precise: We find a somehow eclectic and arbitrary collection of neoclassical concepts.

We have already talked very often throughout the different chapters of this website that it is unclear why certain concepts have been canonised and others have fallen into oblivion. A possible explanation could be the methodological approach. If a concept can be mathematically or graphically modeled, it has a good chance to get through and to belong to the academic canon. If this is not the case, it risks to be forgotten.

The basic methodological approach decides over the content. It is even possible that the original theory is not canonised, but the mathematical / graphical model of this theory, even if this model is wrong. This happened for instance, to mention the most important case, with keynesian theory. What is taught at universities is the IS-LM model, which is logically incoherent, see Keynes, and has little to do with the original version, which is logically very coherent, see the little book downloadable from the startsite of this website.

The same is true for any more "political" approach, for instance for the Neoliberalism of Milton Friedman or the Austrian School in the Friedrich Hayek version. We don't say that their theories are convincing, but they address relevant questions and both are Nobel prices of economics. The question is not whether we agree or not with their political statements, the question is that the methodological approach impedes a discussion about their concepts in the academic sphere.

The methodological approach has another side effect. Neoclassical theory, in other words what we find in modern textbooks, is all about equilibriums in different forms and shapes. The different authors, especially Vilfredo Pareto, Léon Walras and Carl Menger don't discuss how the equilibrium is reached or how we get from one equilibrium to an equilibrium at higher level, the actually more interesting questions. They analyse the equilibrium itself. An equilibrium by definition is a state where nothing changes. That obviously simplifies the task. There is no need to take into account variables and parameters that doesn't change. We get models where everything that could change are a priori, independently from any experience, are excluded from the model. Such simple systems can be mathematically or graphically modeled. We get "economic laws", something economists are fond of. If they have "economic laws" that looks at least from a formal point of view as laws in physics, they have the impression that economics is a science as scientific as physics, although these laws only express trivial relationships. In social science only trivialities are universally valid.

The methodological approach has another strange side effect. Actually there is no relationship between Alfred Marshall and Vilfredo Pareto. Alfred Marshall is an intellectual, Vilfredo Pareto is mad, actually a case for the psychiatry. Alfred Marshall in his Principle of Economics covers a very wide range of topics, the methodological approach is different, the philosophy is different, he has a very broad cultural background, he is very cautious in his statements. Vilfredo Pareto in his Manuale di Economia Politica has one topic: equilibrium under very strange conditions. His analysis is based on a market where products are only exchanged, but not produced. The "philosophical" background can be summarised easily. It a kind of social Darwinism.

The term neoclassical theory doesn't make any sense. Actually that doesn't exist and things become even worse, if neoclassical theory is confused with neoliberalism as it happens very often. Neoclassical theory is about efficiency. It is assumed that the market knows best how resources should be allocated. Neoliberalism is about freedom. Governmental intervention not only inefficient, but a menace to freedom. We can even say, that following the neoliberal logic governmental intervention would even be unacceptable if efficiency could be improved this way, because in any case liberty would be at stake. We will return on the topic in the chapter about Milton Friedman.

It is often said that the common characteristic of all neoclassical authors, Alfred Marshall, Léon Walras, Vilfredo Pareto and Carl Menger is the "marginal revolution".

Marginal revolution points to the fact that allocation of resources depends on the last unit and not on the average. Let's illustrate what that means by a simple example. Let's say that petrol can be used in different branches, to produce plastics, for fuel, as lubricants. And let's say that the marginal revenu of each liter, gallon, ton, barrel whatever is.

Branche A 4000 dollars, 3000 dollars, 2000 dollars, 1500 dollars (2625)
Branche B 5000 dollars, 2900 dollars, 1900 dollars, 1400 dollars (average 2800)
Branch C 4300 dollars, 3500 dollars, 1700 dollars, 1600 dollars (average 2775)

If someone has now 10 liter, gallons, ton, barrel whatever of petrol, what he is going to do with this 10 units. The first unit he will invest in Branche B, that's obvious. The next unit in Branche C and the next unit in branche A. Then he will invest in Branche C, Branche A and Branche B. Then in A, B, C. Until now he has invested nine of his ten units. The last unit he will invest in C and the story is finished. Similar logic if he has less than 10 units. He will obviously not invest all his units in Branche B, although Branche B has the highest average. For the optimal allocation of resources the last unit is relevant, not the average.

However the marginal revolution never happened. In the time of the neoclassical authors the concept of marginality was already elder than the green hills of Africa. Beside that it is trivial: 100 per cent of the people who look at the example above would get after 1 minute to the conclusion that the last unit is relevant for the maximization of the profit, not the average.

The idea of marginality is already present in the natural price of Adam Smith. The natural price for a productive factor, for instance wages, is reached, if this price is the same everywhere. Under ideal conditions this is actually achieve automatically or naturally. If, for instance, the workmen change their job if they can earn more in other branche, we will have two effects. In the branches the workmen go to the wages will decrease and in the branche they leave they will increase. At the end they wages will be the same everywhere and there will be no fluctuations any more.

The concept of marginality is as well inherently contained in the concept of the rent of David Ricardo. Given a certain demand for food, it is the last producer who can still produce under the given circunstances, that decides over the rent and the rent is what Alfred Marshall will call producer surplus. Due to the strange assumptions of David Ricardo, the rent exists only in the case of land, although in reality it exists for any productive factor and resources.

The clearest description of the concept of marginality we found in the Traité d'Économie Politique de Jean Baptiste Say where he explains the famous Say's Law. Say describes very clearly that the utilitiy diminishes with every unit consumed and therefore prices have to decrease in order to a greater amount be bought.

However the concept of marginality describes only a tendency. In the long run people, to stick with this example, will move to another branch, after having acquired the necessary skills, moved to another place, having found a new school for their children etc., but reallocation is nothing that is going to happen immediately. There is tendency to optimal allocation of resources, but it will never be achieved. If it were the case, the wages would be the same anywhere. We know, that this is not the case.

In the neoclassical theory however, most of all in the theory of Léon Walras, optimal allocation happens in lightning speed. Once the mathematical equations are resolved, hundred of millions of people have moved to another job, training is not required, universities are completely useless, equipment and machines for billons of dollars have been substituted by new ones, entire continents like Africa have reached in seconds the same technological standard as Europe. Neoclassical theory describes the paradise. Unfortunately we live on earth.

But even if a "marginal" revolution had ever happened, what is not the case, that would not allow to summarise different authors under the same label, because all the other characteristics that they don't have in common would be neglected. We can't say that kangaroos and frogs belong to the same group because both of them move forward jumping on two legs.

We cannot not even say, if we put aside Alfred Marshall, that neoclassical theory is an advance compared to classical theory, especially Adam Smith or Jean Baptiste Say. Actually some basic pillars of market economies are better described by Adam Smith and Jean Baptiste Say than by Léon Walras and Vilfredo Pareto. (Carl Menger can be silently ignored.)

Market economies are often perceived as somekind of "survival of the fittest". The original idea of Adam Smith is different. A market economy has inherent control mechanisms, that prevents the abuse of power. The selfish homo oeconomicus alone is not a useful concept, but together with a intensity of competition high enough to controll him, it is a useful concept. No doubt that even in market economies an abuse of power is possible and therefore the is a space for governmental intervention, but who complains about markets, have to explain how he will control the government.

Neoclassical theory is only about efficiency, especially Léon Walras and Vilfredo Pareto, is only about efficiency. The idea that power have to be controlled is missing.

The basic problem of market economies is EXPLICETLY ignored by Léon Walras and Vilfredo Pareto. In classic theory, especially in the theory of Jean Baptiste Say, the entrepreneur plays a crucial role. In the theory of Léon Walras and Vilfredo Pareto this figure not even exists. The resources allocates themselves alone, steered by the law of the market the same way the course of the planets are steered by physical laws. Actually market economies doesn't work with human decisions and without entrepreneurs. The market prices contains the needed information, but someone is needed who evaluates them in a decentral information processing and reacts on the incentives.

But if total information is assumed, as in the neoclassical theory, there is no information processing needed, because everybody is perfectly informed, without any cost and effort. If this is the case, the market economy is useless. The problem it resolves, would be already resolved.

The somehow "astronomic" thinking of the neoclassical theory has the effect that a lot of students can perfectly describe mathematically the cross-price elasticity, the impact of the consumption of one product on another product, but has no clue what market economies are about.

On a daily basis we can read and hear through the mass media something about the "capitalism", although nobody actually knows what this term means. Most people refer with this term in vague way to market economies, although the term means something different. The meaning of the term is that the capital moves history and the capital is in private hands.

Actually this has nothing to do with market economies. It is perfectly imaginable that all the "capital", machines, buildings, raw materials etc. belong to stock corporations and the stocks are widely distributed among millions of shareholders, but the essential decentral information processing is done by managers who have no "capital" at all. That they earn a lot of money and have private "capital", a nice car, a house etc. is another story.

Given to the fact that the central economic problems are not discussed in the neoclassical theory and the this theory is dominant in academic teaching the terms neoliberalism, machester capitalism, neoclassic theory, capitalism have become the same thing. Not because they are actually the same, but because in public debate they means actually nothing.

If someone wants an illustration of all the problems, he can read the wikipedia article neoclassical economics. This article is false from the beginning to the end and the relevant issues are not addressed. It is true that microeconomics as taught at universities is a eclectical selection of some neoclassical concepts, but that is not the point. At a university level, when it comes to publicly financed studies, the question is whether neoclassical theory discusses the relevant issues and the problem is, if we put aside Alfred Marshall, the neoclassical concepts are irrelevant when iti comes to understand the real live.

If we use the term neoclassical theory we refer to the eclectic collection of some concepts of Alfred Marshall and Vilfredo Pareto we find in modern textbooks about microeconomics. However it is absolutely necessary to understand that there is no relationship between Alfred Marshall, the intellectual between the authors nowadays assigned to the neoclassical theory, and Vilfredo Pareto, that would be better eliminated completely from textbooks for a lot of reasons.

Modern textbooks about microeconomics as well as macroeconomics are indeed very similar. In Peru as well as in Germany, in the USA as well as in India, in France and in Algeria the most important thing is the equilibrium. All problems are resolved if we only have a nice equilibrium on a piece of paper.

There is no doubt that it would be a good idea to go back to the original version of microeconomics, to the Principles of Economics by Alfred Marshall. There is broader range of topics, the problems are discussed more in depth and from different perspectives. This book has been used for decades in academic teaching before world war I and it is hard to see the advance of modern textbooks, beside the fact that they are in interesting business.

Another possible reason, beside the reason already mentioned for the canonisation of certain concepts is the fact that teaching and taking exams is simpler if there is a clear standard. An academic teacher can work just anywhere. He can teach everywhere the same thing and the exams are everywhere the same.

Some microeconomics concepts play a role in costing and commercial accounting, but they are irrelevant in public debate. Perhaps it would be better to integrate microeconomics in courses about costing and commercial accounting and forget what it is irrelevant everywhere.

People are never interested in economic equilibriums, because this is trivial. Actually the price of butter, milk, bread and honey can be lower without taxes, obviously, perhaps someone would eat more cheese it this where the case, but from a practical point of view things are very simple. For consumers the prices are always too high and for the producers prices are always too low. That's all.

Equally trivial is the equilibrium on the labour market. Neoclassical theory assumes that unemployment is given to the fact that some people prefere doing nothing if the wages are too low. Therefore there are not actually unemployed in the sense that they would like to work for a given wage, but didn't find a job. They don't want to work. This is one possibility. In this case we have a equilibrium wage.

In the case that people really don't find a job, the neoclassical theory assumes that wages are too high, if wages were lower, everybody willing to work would find a job. That is trivial. It is crystal clear that the unemploymente rate in a country like the USA or Germany would be zero if people would would be disposed to work for one dollar a day. Households would hire people instead of buying a washing machine. From one dollar a day nobody can make a living and therefore they would die and dead people are not unemployed and that way we reach an equilibrium on the labour market. That sound a little bit crude, but this is actually the theory of David Ricardo.

The theory makes a little bit of sense if we assume that lower wages means lower production costs and lower production costs means lower prices, therefore amounts increase and more people can be employed. However it is doubtful that this is going to happen. If the wages decreases faster than the prices, it is even possible that the situation gets worse. Less demand, less amounts produced, less people employed.

Most students as well as their teachers who study and teach microeconomics, in other words equilibriums, are not even aware that they study static states. An equilibrium is by definition a state where nothing changes. An equilibrium can exist at any level. However we are not interested in the equilibrium, but on the level of the equilibrium. Public discussion is never, absolutely never, about equilibriums. Public discussion is about the dynamic processes that determines the level of the equilibrium, but the equilibrium itself is irrelevant.

Furthermore it is no requirement for a market economy to be in a however defined equilibrium. Actually the opposite is true. In the case that a market economy reaches equilibrium, we don't need it any more. In an equilibrium every entrepreneur knows what he produces, how he produces it and for whom he produces it. There is no need for decentral information processing and no incentive for market researches. There is no need for entrepreneurs. The government can take over the economy and get it planned by a central planning commision. An equilibrium state is nothing typical for a market economy, it is the END of the market economy.

Focusing on equilibriums in the context of a market economy is as studying a dead body in medicine.

In order for a market economy to work it is enough that there is a tendency towards an equilibrium, a tendency for the optimal allocation of resources. This dynamic is best explained by the concept of natural price / market price of Adam Smith.

It is argued that the analysis of equilibriums is helpful to understand certain issues. That may be true, but the insight obtained are rather trivial. Two or three hours we can dedicate to equilibriums, but than we have to talk about the relevant aspects of a market economy.

The Edgeworth boy is highly irrelevant when it comes to analyse real world phenomen. We have a contract curve, the line that connects all the points where the pareto criterion is valid, at all times and everywhere. In the antiquity, in the middle ages, today and in China, Mozambique, the USA and in France. The statement of the contract curve is as true as the statement "the darker it is, the less we see". That's true, no doubt. But that is not an advantage, it is a problem, because in social science only trivialities are always true.

The fact that the academic teachers actually don't know what they are teaching is the ceteris paribus clause. Almost any textbook about microeconomics and any lecture starts explaining the ceteris paribus clause. If somenone needs an example, there he can find one: Lecture Clip: Ceteris Paribus. We here the old story that economics can't be studied without isolating certain facts, because it is so complicated and so on.

[Well, we admit. The course if funny. In general there is little doubt that academic teaching in the USA is much more professional than for instance in Germany. But the basic problems remains the same.]

The problem is this: IN EQUILIBRIUMS, THAT'S WHAT IS STUDIED IN MICROECONOMICS, NOTHING CHANGES. If nothing changes in any case, we don't need the ceteris paribus clause. What the guy in the video will finally analyse is the relationship between amount and price in equilibrium. To be more precise: He will not analyse a causal relationship, but the relationship of two effects.

The argument, that economy is to complicated and therefore at the beginning we have to simplify it, is not very strong, if the alternative is telling trivialities with a lot of mathematical and graphical abracadabra. It is to assume that the next three year he will tell his students the same thing and student will leave university without having learned something relevant. The argument with the assume complexity is always put forward to justify trivialities.

His illustration of the problem with the airplanes is entertaining for the students, at least if they don't pay for the classes, in this case it is a lot of money for little fun, but not convincing. Aircraft engineers at the end of their studies has at least an idea how to construct an airplane, although some working experience is already needed, but economists have no clue how the economy works at the end of their studies. They will have lost a lot of time and money. Money they paid themselves or the tax payer.

The same argument, to complex therefore we have to simplify it, could be put forward in any science. However if someone said that in medecine, he would be fired. The argument that the human body is to complicated and therefore we have to assume that he is in equilibrium and not ill, would sound funny in this case.

Other sciences don't simplify, but in the first semester some basics are taught needed to understand other things. Very often for instance it is necessary to understand the role of receptors in cells to understand how certain drugs work.

However microeconomics is not the basis to understand economic processes, because very little can be learned from analysing equilibriums. We can't analyse a phenomenon if we exclude the relevant factors from our analsis. If in medecine all kind of illnesses were excluded from the analysis, people would never become physicians.

We can sometimes simplify, but we can never simplify to an extent that the problems we want to analyse doesn't exist anymore.

What applies for the ceteris paribus clause applies as well for the second assumption of neoclassical theory, transparency. Transparency is the assumption that all market players are perfectly informed, that means, that all of them has the same information and that all of them has all the information needed. In the equilibrium this is true. If people do the same thing for years they are perfectly informed of what they should do.

However the biggest economic problem is INTRANSPARENCY. Market economies are about finding out how things work. Market economies are about trial and error. No entrepreneur has never ever all information he needs. He is never, never, never in equilibrium. In the equilibrium, we don't need entrepreneurs. In equilibrium we need a central planning commission.

Market economies are about failure. Very often the only way to find out if something works, if it can be produced from a technical point of view, if it can be produced at costs accepted by the (different) markets, if there is a demand for this product, etc. etc., is to do it and very often companies will fail in this process of trial and error. Suppose transparency is absurd in this context. We won't get any results if we abstract from the crucial problem.

The difference between an economic order where everything is planned by a central planning commission and a market economy is that in the first case the whole society pays for the errors and in the second case a private company. The problem is the same, but the private company is more efficient. It is better informed about their alternatives, about its capacities and weaknesses, it can react quicker to changes in the environment and, perhaps the most important thing, it works harder, because in case of failure it pay the price.

A public employee, although they don't see it like that, is always a communist. He uses the money of other people, he has no risks and is personally responsible for nothing, has a livetime job and has no incentive to do more than what is absolutely necessary.

It is very often said that neoclassical theory is the mainstream in teaching and politics, but what people actually wants to say is that NEOLIBERALISM is the mainstream in politics. Neoclassical theory is actually what we find in textbooks about microeconomics, but neoliberalism is completely different beast. There are thousands of websites on the net who confuse that, here is an expample: Neoliberalism.

This is completely wrong. Neoliberalism focus on the dynamic of markets and decentral information processing through the price signals. Governmental intervention are not only considered as inefficient, but as a threat to freedom. Neoliberal position is quite well explained by the serie "free to choose" by Milton Friedman, here is an example: Milton Friedman on Why Free Market Capitalism is Best.

In neoclassical theory there is no information processing needed, because everybody is already perfectly informed. A coordination process is not needed, everything is already perfectly coordinated in the equilibrium. Only some equations are needed to describe the equilibrium.

Many people believe that neoclassical theory is the opponent of marxism. That is not the case, not at all. In both cases the economy is steered by universally valid laws. The only difference is that in the neoclassical theory the economy is maintained in equilibrium by economic forces the same way the universe is maintained in equilibrium by the laws of physics. In the case of marxism the universal valid economic laws pushes the economy towards a final end, but in both cases human beings can do nothing but sit, wait and watch. Terms like entrepreneur do not even appear in the writings of these authors.

[We repeat: Alfred Marshall is always excluded, if we use the term neoclassical theory.]

Neoliberalism has more similarity to classic theory, especially to Adam Smith and Jean Baptiste Say. The difference between classic theory and neoliberalism is that governmental intervention is considered in classic theory only under the aspect of efficiency. In neoliberal theory governmental interventions is a risk to freedom, see equality and freedom.

The problem with the neoliberalism is that its relationship to democracy is unclear. If everything that must be steered and controlled is steered and controlled by the market and anyting that cannot be steered and controlled by the market shouldn't be steered and controlled at all, there is no space for democratic decision making. The question therefore is, whether there are some issues that a central planning commission can be organise better than the market. We will return on the topic when talking about Milton Friedman.

However in mathematical and graphical modelling of the neoclassic theory there is no market in this sense. Equilibrium can be find in five minutes putting some lines on a piece of papper or with the help of some equations. The advantage of this system is that there is no risk, only profitable companies are funded, we get all rich. The disadvantage is, that it has nothing to do with reality.

Academic teachers argue in general that microeconomics is needed to analyse more complex problems. The argue that in medecine as well first some bases must be set in order to discuss more complex problems.

The problem is, that the concepts of microeconomics are irrelevant when it comes to discuss real world problems. The level of the equilibrium, that's what we are actually interested in, we are not interested in the equilibrium itself, depends for instance from the efficiency of the educational system, but in order to analyse this system, we may need to something about didactic and psychology, but microeconomics is of no help in this case and in general it is of little help. Outside the academic sphere is is completely irrelevant.

There is lot to say about Milton Friedman, as well concerning his affirmations about economic issues in a more narrow sense, but there is no question that he puts the right topics on the agenda. There is no microeconomic in his videos, but he addresses issues that at least could be discussed, see What's Wrong With Our Schools Featuring Milton Friedman. It is doubtful that the problems of schooling would be resolved by only privatising schools, we will return on the topic in the chapter about Milton Friedman, but it is obvious and can be illustrated with any amount of examples, that microeconomics and neoclassical theory is of little help when it comes to analysing real world problems.

Neoclassical theory does three things. It simplifies drastically the reality, eliminate man from its analysis and converts processes in automatisms. Every one of these errors is fatal.

Neoliberalism underlines the importance of human decision making and the decentral information processing through prices and puts an emphasis on incentives. It doesn't predict any result, not even that an equilibrium of whatever kind is reached, but affirms that information processing by individuals and the possibility to follow their own interests is the most efficient way to organise economic processes. For the same reason he is against governmental interventions. If a governmental institution intervenes it will believe to know more than the individual market player, what is never the case.

Neoliberalism contains actually some basic pillars that should be taken into account if we discuss about economic issues, although we do not agree with its positions. Neoclassical theory contains nothing relevant.

The error of neoliberalism is that it believes that the only way an economic system can be controlled and steered is by the market mechanisms. Actually transparency can have a similar impact, see preliminaries.

The third term used in public debate is capitalism. It is to assume that very few people who use this term would be able to explain the difference between neoliberalism and capitalism. It is curious that Milton Friedman, the most prominent representative of neoliberalism use the term as well. His most famous book is called "Capitalism and freedom". No doubt that from a purely marketing point of view that sounds much, much better than "Optimal allocation of resources through decentral information processing through prices in comparison to governmental central planning". Millions of copies were sold of "Capitalism and freedom". With the more correct title it is to assume that he would not had sold even one copy.

Milton Friedman could have named his book as well "Neoliberalism and freedom" but we admit that "Capitalism and freedom" sounds better. Better as well than "Free markets and freedom".

The term capitalism is actually reserved. Capitalism, as described in the work of Karl Marx The Capital, refers to an economic order where the principal agent is not the man, but the capital, that has a live on its own, that's why the book is not called The Capitalists, that would refer to human beings taking decisions, but The Capital. The Capital allocates itself alone in an optimal way. This excludes as well that it can be destroyed. The problem of this kind of capitalism is the same as the one we have with the neoclassical theory. Capital is something like an energy in physics, for instance the potential energy. Put in motion part of it becames labour with the same stability as potential energy becames kinetic energy if the ball rolls down the hill. If we put capital on the moon, the same thing would happen than on earth.

One could argue that Milton Friedman could choose any term he likes. That's true. But discussions becomes a little bit difficult if synomyms are used for things that actually, at least for some people, means the exact opposite. Neoliberalism underlines the importance of the coordination through markets. Marxism denies completely that this is necessary. In the three thick volumes of The Capital we find nothing about how economic activities should be coordinated. In socialist countries it happened through central planning and at least at the beginning it was believed that this is not very difficult.

Actually there was no need to give a new meaning to the word capitalism. Liberalism as conceived by John Stuart Mill includes already the idea of private property. (If Milton Friedman wanted to underline the importance of private property.)

However private property, at least as a productive means, is not at all a condition for a market economy. Allmost all big companies, Google, Microsoft, Chrysler, Monsanto etc. etc. are stock corporations. The productive capital is therefore somehow "socialised". What is needed for a market economy to work is a sufficient intensity of competition. The right time is therefore market economy and we assume that most people, although vaguely, mean that if they talk about capitalism.

The term neoliberalism means a little bit more than market economy and the term is more controversial than the term market economy. For some people, perhaps the majority, it is a synonym for predatory capitalism, kind of mercyles survival of the fittest. For others, perhaps a minority, it is the strongest opponent of governmental intervention associated with a restriction of freedom. These people use as well another term: market radicalism.

In practise things are a little bit more complicated. Things can be steered and controlled by the private sector or by the government. Indepedently from the question how this government is legitimized, it is to presume that governmental burocracies and its employees react on the same incentives as the private companies and the indivuals working there. In other words: It is to assume that they work for the public interest, if they are controlled and they work most of all in their own interest, if they are not controlled. The difference is, that markets, given a certain intensity of competition, are automatically controlled and bureaucracies not. They will try to get bigger and bigger and they will always find new tasks and therefore a good reason to employ more people. It is actually difficult to say that Milton Friedman is completly wrong: Milton Friedman: The Problem of Bureaucracy. It is even worse. If private companies get an influence on government, they get a lot of power, including policy and military power. A possible solution is therefore to reduce government activities by law.

Market radicals by the way are always in favour of funding new publicly financed "research" instituts. One can wonder why they don't enjoy free markets and fund companies. Funding a company is more useful than writing about companies.

It is not enough to be against "market radicalism". Those who are in favour of governmental intervention has to explain how governmental activities can be controlled, see preliminaries. We will return on the topic in the chapter about Milton Friedman.

A free market economy is compatible with a wide range of economic orders and it is not even necessary, that the productive capital, machines, buildings etc. belongs to the entrepreneur or the manager. Actually this is seldom the case. The biggest companies are amost always stock companies, but the single shareholder has normally no influence on the company.

There is only one kind of capital that always belongs to someone, the human capital. But this doesn't fit with the marxist idea of capital, because with this kind of capital the owner does whatever he likes.

Market economy doesn't mean either, as assumed in the classic theory or the neoclassical theory, that the distribution of income is the result of a market process. The social market economy for instance leaves the allocation of resources to the market mechanism, but the result is changed by social transfers, taxes etc..

A market economy is as well compatible with keynesian monetary or fiscal interventions. Increasing the amount of money and lowering the interest rate has, whatever the austrian school says, no impact on the allocation of resources, see interest rates.

The fact that Milton Friedman uses the term capitalism is strange for another reason. Milton Friedman is the founder of the monetarism. Monetarism works with the same monetary transaction mechanism than Keynes, but due to special assumptions he got to the same conclusions as the classic theory.

Milton Friedman was therefore well aware that "capital" is actually money and money can be printed. Savings ar not needed for investments and the interest rate is not a price in the sense of a market economy, see interests rates.

By using the term "capitalism" he suggests that the owners of "capital" can attract the resources they need as assumed in the classical theory and in marxism. However resources are attracted with money and money can be produced by the banking system.

We have therefore a lot of terms that in public debate means more or less the same thing or, more precisely, people have only a very vague idea about their meaning: classical theory, neoclassical theory, neoliberalism, capitalism, free market, austrian school. It is useful to have a clear idea about the possible meaning of these terms, before using them.

Furthermore it is crucial to understand the real difference between all these lines of thinking and keynesianism. All these lines of thinking assumes that "capital", by which they understand not consumed income of the past, is necessary for investments. In this logic, a sacrifice, less consumption in the present, is needed to invest. To induce someone to make a sacrifice, it is needed that he gets a reward for it, the interest rate. In other words, the interest rate is a price in the sense of the market economy and has an impact on the allocation of resources. They higher the interest rate, the more people will save, the less consumtion goods will be produced at the benefit of capital goods that improves the productive potential.

In a situation where part of the productive potential is unemployed in keynesian theory savings are not only not needed, but they are harmful. Savings are needed if there is no unemployed productive potential. In this case an increase of the production of capital goods is only possible at charge of the production of consumption goods. But why reduce the production of consumption goods if it is possible to produce more consumption goods AND more capital goods.

To put it simple. Someone who has to works 16 hours a day in order to satisfy his basic needs and a little bit more, has to make a big effort if he wants to build a house. He has to reduce even more his consumption, earn less in the present and build the house after having worked let's say 14 hours. With 14 hours he is at the physical subsistence level. He saved two hours and this two hours he can use to build his house. The production of capital goods, in this case a consumer durable good, is only possible at the expense of consumption. The situation is completely different if he only has to work two hours a day in order to make a living and is bored the rest of the day. There is no reduction of consumption needed to build his house. (We assume that he lives on an island and everything he needs to build his house, wood, bricks etc. he has to produce himself.)

Let's now assume that he let his house build by someone and this someone has nothing to do or has already an unemployed productive potential. All the lines of thinking besides Keynes assume that the future house owner can only built a house if he has saved the money before or if there are other people who borrow him the money they have saved before.

This is however a strange kind of perspective. The fact that some people have reduced their consumption in the past is no guarantee that there is a construction company with unemployed capacities and this is the crucial question. It is often argued that prices will increase, if demand exceeds supply, in other words, if all the capacities are fully employed. However this can happen in both cases. If the money needed to build the house is the result of former savings, freshly printed by the central bank or generated by the banking system.

In both cases we will have an increase in prices if demand exceeds supply. The construction company will construct the house that yields the greatest profit. The idea, that the construction companies will increase their capacities, because people didn't buy a new car and saved money is mad. It is even to assume that the interest rates are low, because only at the moment that people start actually buying something, the companies knows in what to invest. There will be little demand for the savings and therefore the interest rates will be low.

The same thing is true, with opposite signes, in case of unemployed capacities. The construction company doesn't care where the money comes from, if people didn't buy new cars in the past or if the money is freshly printed buy the central bank or generated by the banking system. (For more detail how the banking systems generates money see interest rates.)

In case of unemployed capacities the only difference between financing the house with savings, reduction of consumption in the past or with money produced by the central banks or generated buy the banking system is this. If the house is financed by savings, the national income was lower in the past than would it could had been. The car companies would had liked to build and sell more cars, but there was no demand. This money is used to finance the house. The amount of money remains the same, but the national income is lower.

In the case that the house is financed with freshly printed money or generated by the banking system, the national income was higher in the past, the amount of money will increase for a while, until the house owner will have paid back the credit and the money created before will be destroyed again. For a more detailed discussion see interest rates.

Neoclassical theory shares with the classic theory all the errors about capital, money, savings, interest rates. This is due to the fact that both, as well as neoliberalism, assume full employement.

If we stick with our example their logic is this. People will only relinquish to buy new cars and save money, if the interest rate is high enough to reward the sacrifice and this is the case, if there are lot of people who needs money to buy a house. They assume therefore, an adaptation of the productive structure is needed as well, that the workmen who produced cars before now produce houses.

However even if that were true, and there are reasons which suggests that it is not true, it is hard to see why this should be useful in a case of unemployment. In a case of unemployment the people in the car industry can continue to produce cars and new employed workmen can produce houses financed with an increase in the amount of money. If this increase in the amount of money is destroyed afterwards when the credit is paid back, we will get no inflation.

In the case of full employment it is actually true, that the production of capital goods is only possible at the expense of consumer goods. Saving, the reduction of consumption, makes sense in this case. The interest rate is a price, in this case, in the sense of a market economy. It signals scarcity and it is a reward for a sacrifice. Money and capital are really two different things in this situation. Capital is not consumed income of the past, money is just printed paper. In this situation, full employment, investments has to be financed with capital. Financing them with money would lead to inflation.

However all this is NOT true in a situation of unemployment. Classical and neoclassical theory take full employment for given. They not even discuss the possibility of unemployment and still less they distinguish between a situation of employment and a situation of unemployment.

Because classical theory and neoclassical theory shares the same error in thinking, Keynes doesn't distinguish between classical and neoclassical theory, see the little book downloadable from the start site of this website.

Concerning the fundamental concepts and if we put aside the irrelevant abracadabra there there is actually little difference between the classical and neoclassical theory. However there is a big difference in the methodological approach.

Classical authors, Adam Smith, Jean Baptiste Say, David Ricardo didn't reflect about the methodological approach and they didn't define their object of study. They analysed human behaviour as long as they believed intuitively that is has something to do with economics and they explained, illustrate and proved their statements by just any means they believed intuitively suitable. With ficticious numeric examples, example taken from history, psychological remarks based on introspection, excursions to philosophy and what we would call nowadays sociology. The first case of a more "systemic" thinking is David Ricardo, where the range of topics adressed is drasctically reduced, but David Ricardo didn't reflect either about the economic approach.

[To illustrate this point: If we introduce an entrepreneur in our economy, a human being, than we have to address psychological and sociological issues as well. We have to analyse how an entrepreneur makes decisions, what distinguish an entrepreneur from other people, how the society as a whole reacts on entrepreneurial personalities etc.. Automatically we have to address psychological and sociological phenomenon into account. If we simple say that the entrepreneur is actually capital, not even a capitalist, we have no human being in our economy and psychological or social issues are irrelevant. That's the reason why we find a lot of statements in the work of Jean Baptiste Say we would assign nowadays to psychology or sociology in the work of Jean Baptiste Say and nothing of this kind in the work of David Ricardo. We get a more "systemic" kind of thinking, with only few variables and parameters. However it is to presume that the absence of an entrepreneur in the work of David Ricardo is not due to a consciously taken decision, but to "intuition".]

All the neoclassical authors, see the respective chapters, reflect over the methodological approach to be used. That includes a reflection concerning the object of economics as well as the methods to be used to study this object. The definition of Alfred Marshall for instance of the object of study in the context of economics is for instance human behaviour that can be measured with money. Concerning the methods physics became the methodological paradigm. Another difference in comparison to the classics is that neoclassical authors tended to conceive economics as "pure" science. In classical authors, we find a lot of remarks what should be done and what not should be done. There is nothing like that in the neoclassical authors. This is in part due to the fact that they conceive economics as steered by universal valid laws and as much can be done to change the course of economics as can be done to change the course of the planets.

Whatever induced them to reflect about these issues, we can assume that nor the object nor the methods to be used seemed something obvious for them. They "felt" that nor the object nor the methods to be used are obvious and concerning these feelings they were right.

It is indeed true that the object is as undefined and the methods to be used to study the object unclear. However they draw the wrong conclusions of that by defining arbitrarly the object take the methodological approach of physics as the paradigma.

Nowadays the situation has changed. There is no discussion nor about the object nor about the methods to be used. The object of study has been canonized and reduced to some few variable that can be measured quantitavely with money, although theses variables are only effects, but not the causes.

The most exhaustive discussion of the topic we find in Principles of Economics by Alfred Marshall, see methodological approach. A lot of concepts of neoclassical thinking, for instance the whole Vilfredo Pareto abracadabra can be silently ignored, but it is usefull for economists to be aware of the problems related to the object and methodological approach. Therefore it would be useful to use in classes the original book version of microeconomics, Principles of Economics by Alfred Marshall, instead of the copies, the modern textbooks. If would even be cheaper.

Something like classical theory or neoclassical theory actually doesn't exist. There are huge differences between the authors today assigned to one group or another. However concerning the basic errors there are no differences.

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Neoclassical theory

The marginal revolution never happened