What’s Wrong with Neoclassical Economics?

A new Occasional Paper on the Business Roundtable website should be a useful resource for teachers of economics and participants in economic policy debates.

Written by Wolfgang Kasper, emeritus professor of economics at the University of New South Wales, Australia, an earlier version was delivered to the joint conference of the New Zealand Association of Economists and the Law and Economics Association of New Zealand in June this year.

For years I had urged Wolfgang to write a paper spelling out the limitations of neoclassical economics in understanding how the world works.

He resisted the idea (“nobody believes in neoclassical ideas any more”).  I told him he was wrong: various economics educators in New Zealand continue to teach on the basis of defunct human capital, and politicians attack free-market policies on the false assumption that they are grounded in neoclassical economics.

Finally Wolfgang relented and wrote the paper.

Neoclassical economics can be traced back to the work of British economist Alfred Marshall and to some extent even further back to ‘classical’ economists such as Adam Smith.  It is characterised by a focus on static equilibrium conditions in markets and the economy – like how supply and demand are matched and at what prices.  It does not explore the dynamics of the economic system, and in particular has little to say about entrepreneurship and economic growth.

As Wolfgang says in his paper:

The poverty of neoclassical economics becomes evident when one realises that key concepts – such as competition, enterprise, profit, the costs of transacting business, the need for law and other rules of coordination (institutions) – have simply been ‘assumed away for simplicity’s sake’. It is also imbued with a wrong-headed pessimism, derived from nineteenth-century agricultural reality (law of diminishing returns).

Almost as though on cue, a classic example of the persistence of neoclassical misunderstandings came to light just as Professor Kasper’s paper was being printed.  The New Zealand Herald, which features a constant diet of op eds by anti-market critics such as Jane Kelsey and Bryan Gould, printed this article by Auckland secondary school economics teacher Peter Lyons, whose articles also appear frequently in Herald columns.

It was entitled ‘Mantra of free market ideology wearing thin’ and contained a familiar theme: “In the past 25 years New Zealand has embraced the free market ideology of of neoclassical economics.”

As someone involved in some of the reforms, I can certify that none of the economic advisers of the governments concerned were slaves of neoclassical economics.  While recognising its insights they were well aware of its limitations as identified by Wolfgang Kasper, and drew on a far wider and richer body of economic literature.  A reading of relevant official documents would make this immediately apparent.

Similarly, governments in the United States, Britain, Australia and many other countries that embarked on liberal economic reforms around the same time as New Zealand were not driven by narrow neoclassical economics.  Again a reading of official documents would quickly confirm this.

Professor Kasper responded to Peter Lyons in this article.  Regrettably, the Herald declined to publish it.

I worry about bad economics teaching in our classrooms and lecture rooms.  I worry too about the effect of bad economics on public understanding when newspapers do not publish critical responses.

Professor Kasper’s paper should demonstrate that those who attack liberal economic policies on the grounds that they are based on neoclassical economics are attacking a straw man.