Analysis of The Neo Classical Theory of Economics - Research Paper Example

Analysis of The Neo Classical Theory of Economics Introduction The classic theory of economics, propounded and supported by Adam Smith and others (Adam Smith 1776), laid down the foundations for value and monetary theory. The theory held that there were two prices, the natural and the market. While the natural price is based on the cost of production of the product, the market price is more theoretical and tends to move towards the natural price thought it might not reach it. The rational theory of economics, says that the economic decisions of the people depend on the rational choice that people tend to make over a period of time (John Scott 2000). This also introduced the concept that the price of a product is not decided by the cost of production of the product but on the perceived value of the product. The Neo classical theory of economics, introduced the concept of maximising profits or utility as the base cause for the rational decisions made by man. The economic man acts rationally so as to maximise the gains out of the action. In case of individuals, the utility of the product decides on the price and the market value of the product. In the case of the companies, it is the profitability of the company that would be deciding factor. Another leading concept behind the neo-classical theory is that it also accepted the fact that the individuals will act independently and their perception on what is profitable to them might vary. William Stanley Jevons (1871) in his seminal work, The Theory of Political Economy says, ‘Given, a certain population, with certain needs and powers of production, in possession of certain lands and other sources of material: required, the mode of employing their labour which will maximize the utility of their produce.’ The neo-classical was influenced by the thoughts of a number of economists of the twentieth century and the behavioural economics was adopted by the majority in lieu of the neo-classical. A modified version of this is termed the new classical economic theory and most of the current day work on economics is based on these principles. The new classical theory takes into consideration various factors that make up the economic decision making of the individuals (Emma Dawnay & Hetan Shah Jul 2005). It takes into account the behaviour and choice of people based on various reasons not necessarily controlled by the sense of maximising their utility or their value or their returns. Statement and its implications The statement brings to the forefront the seven basic principles that differentiate the new classic economic theory from the neo-classical one. However, this theory accepts the fact that the economics is one of choice and preference. The logic of preference or economic decisions is controlled by the market prices, the return to the person or the company is going to get out of it and finally the allocation of resources. Apart from these, the decisions are made based on a number of factors that are more behaviour oriented rather than economics directed. Information flow in the market place affects the market price and creates a trend in the market. Information in today’s world also has an impact on the economic behaviour of nations. Behaviour and psychology of a person has an effect on the decisions that are made by him. Some of the factors known to change the decision making of individuals include the following (Emma Dawnay & Hetan Shah Jul 2005): 1. Pressure from peers or peer-pressure. This would make the person to take a decision more out of a need than out of a well calculated and methodological reason. 2. Most people have habits that seldom die. Habits are more often decisions that are made without much thought as a routine. 3. People tend to do the right thing rather than the one that gives them more money. 4. Self expectations of individuals decide on how they behave in a decision making situation. This need not necessarily be a profitable one or the one that provides maximum benefit to them. 5. People are generally loss-averse. If there is a risk factor and if they perceive the risk to be of higher nature, then they might differ the decision and might as well live with something that provides lower returns. 6. In most of the cases, the decisions are made by thumb rules rather than after clearly calculated projections for the next ten years or twenty years into the future. In many cases, such projections are also not realisable and they could be very fuzzy. 7. Changing from one decision to another would require more than just financial gain and information. All these factors affect the decision of an individual which in turn will also affect the economic condition. The new classical theory of economics therefore, states that the economics would depend on numerous factors like the once above which are part of the behavioural nature of the man. This implies that most of the decisions that are made by man is not purely commercial and very well calculated to perfection. Instead most of the decisions are thumb rule based and personally motivated. Therefore, it is true and fact that man has no intention to maximise his returns or the value of the product or the utility. However, he does by nature what ever is right according to him. There is no hard and fast rule that would hold him to any other theory of economic decision making. Pros and Cons On analysis of this statement, a number of points in favour of this statement as well as anti to it are found. S No For Against 1 Decisions made by men are certainly clouded with other preferences which are physiological and psychological and very specific to the person concerned. Though decisions are made on the basis of the physical and mental requirements of the person, it still aims at maximising his own personal utility of that situation and does not construe to be a loss making venture for him. 2 Pressures from the society to perform and to produce more would be a great motivator for most of the decisions made. Social pressures move towards the Maslow’s need hierarchical pyramid. This again increases the utility factor of the product or service rather than provide any other kind of satisfaction to him or her. 3 Habitual decision making is pretty common in the day to day behaviour of people. In these situations, it is very common that the people do not really make well thought out decisions based on any scientific principles. Habits are implanted in the minds of the animals at birth (Williams James 1890). So are habits done in men! Habits are on many occasions a perfected method of natural selection. Bad habits die away slowly and the good ones are the ones that survive and thrive. Habits are a choice made by natural selection and this cannot be too away from the real good choice. Therefore, any choice made out of habit need not be away from the target of maximising the utilisation for the person concerned. What makes them difficult to understand and comprehend is that the reasons behind the habits are not fully ascertained and understood. 4 People always tend to do the right thing, though not for money. Money times the right things provide much lesser returns rather than the more off beat ones. Most common example would be if people were to pay for their dinner whenever someone invites them home, then sooner or later people will stop inviting them for dinner. Because taking payment for the dinner served is not in line with the right behaviour. It is very right that the right behaviour influences most of the decisions. Otherwise in many cases, right decisions are the legal ones. It is not right to take decisions that might give larger monetary return but not on the right side of the social behaviour. Obviously, a decision to rob the bank might give better returns but certainly not the right decision. 5 People tend to make decisions that are not loss making and their decisions are in line with the self expectations that the person might have. For the sake of self expectations, the person might be willing to make a loss as well. Averse to loss making is in line with maximising the utilisation of a product. People tend to maximise utilisation and the utility factor itself might be very varied for every individual. For one, spending the night at the disco might be best way to make full utilisation of the night, for the other it might be good night’s sleep and for the third may be spending the time in front of the computer. Night has different utility factors and gains for different people. Even making loss could be one of them. 6 Calculated projections are hardly ever made and therefore, the decisions are not based scientific reasoning but by taking a decision more out of the given situation and may be by thumb rule and instinct. The thumb rules and instincts are all based on the gains for the person as he perceives it to be. The rules and the instincts are basis of this feature. It is possible that the gains can be happening from on any of the reasons. The gain that the person is able to perceive decides on the person’s utility for the product or service. Once the person identifies this utility factor and is able to appreciate the value that the product or service adds to him, then he might make a decision to purchase the same. This perception of the value or utility for him might happen either because of scientific calculation or because of habits or thumb rules formed etc., But the perception of the value is essential. The perception of the value on many occasions is done by thumb rules passed down through generations. A similar value is perceived using technological capability in some cases. All of these are methods to perceive the value or utility of a product or service. Only when this perception is felt by man he makes the economic decision to buy the product or service. Therefore, this statement has to be seen in the light of this understanding to be appreciated fully. In this case, we could see that man always looks at himself in his own selfish environment. All systems that do not take into consideration the selfishness of the individual are destined to be a failure. Implications of this statement Other People’s behaviour: Invariably we tend to look at others to see how the others behave before deciding on how we behave. Tim Jackson’s Motivating Sustainable Behaviour indicates the effect of the influence wielded by the society on individuals. People learn from what others do (Albert Bandura 1977) and people tend to look for ‘proof’ for their actions from whom they perceive as experts (Cialdini 1993). This decides on the behavioural patterns of the people and the decisions that they make. Social identify and the key preferences are all decided based on the social factors. Habits: Anything that is done frequently is much more a habit than the one that is done less frequently. Smoking done every two hours is worse habit than drinking done every night. Something that is done every day is worse compared to the one that is done every year. Habits bring about decision making processes. It is not true that all habits are for the good the man. Most of the habits tend to be bad. Specific habits that produce immediate results are very difficult to get out of. The right thing: People tend to do the right thing, irrespective of the gains that they might have personally. There are rewards of different kinds. Intrinsic rewards are the ones that will help the people at the end of a job to realise the positive effects or give them a satisfaction of having done some good. Extrinsic effects are similar positive effects but are external to the human being. This could also be money. These are the motivations for doing some thing good and not necessarily gains in terms of money always. Self-Expectations and Loss aversion People are generally loss averse and do nothing to produce a possible loss probability. Any thing that has a higher probability of hitting at a loss does not attract the same reaction as something that has profitability factor. However, the self-expectations of the person also plays an important role. If the person has an expectation that is in line with a specific activity, even if he is going to sustain a loss, he might still execute the job. Conclusion It is true that many of these expectations are satisfied by today’s corporate when they try to sell products over the counter. Even if the buyer knows that there is no such thing as a free lunch, it is true that a buyer would always buy a pack of Nescafe with a free football than the other brand which does not have one. It is most common to see the basic ethics behind most of the decisions to provide blood or donate organs rather than any commercial significance. It is true to a great extent that the purchasing and economic decisions of individuals are controlled more by the personal behavioural traits rather than the economic compulsions. However, it may be noted that many of these behavioural traits are based on economic principles. References 1. Adam Smith (1776) An inquiry into the Nature and Causes of the Wealth of Nations, available at: http://geolib.com/smith.adam/woncont.html 2. Albert Bandura (1977) Social Learning Theory, Prentice Hall, Englewood Cliffs, NJ. 3. Cialdini R (1993) Influence: Science and Practice, 3rd Edition, Harper Collins, New York. 4. Emma Dawnay & Hetan Shah (Jul 2005) Behavioural economics: Seven principles for policy makers, New Economics Foundation, ISBN 1 904882 03 X. 5. John Scott (2000) Rational Choice theory. Understanding contemporary society: Theories of the present, ed. G Browning et al., Sage Publications. 6. William James (1890) The Principles of Psychology. Classics in the History of Psychology available at: http://psychclassics.yorku.ca/James/Principles/prin4.htm 7. William Stanley Jevons, 1871, The Theory of Political Economy, MacMillan & Co., London. Read More