Economics Basics: Alternatives to Neoclassical Economics

While mainstream neoclassical economic theory has been dominant over the past century, some criticisms have been leveled at this school of thought. Some argue that the strong assumptions made that people are all hyper-rational, all-knowing, utility-maximizing beings is simply wrong. Critics have referred to these hypothetical rational individuals as a different species altogether, homo economicus. Other critics claim that the assumptions about efficient markets and equilibrium given supply and demand do not reflect reality either. Here we briefly give an overview of some alternative or supplementary ways that people theorize about the economy and economic activity.

Imperfect markets

An imperfect market refers to any economic market that does not meet the rigorous standards of a hypothetical perfectly (or "purely") competitive market, as established by equilibrium models. An imperfect market arises whenever individual buyers and sellers can influence prices and production, or otherwise when perfect information is not known to all market actors. Situations can arise in which too few sellers control too much of a single market, or when prices fail to adequately adjust to material changes in market conditions. It is from these instances that the majority of economic debate originates. For example, when there is too much stuff for sale and not enough demand, we experience a recession as price levels must decline.
Imperfect markets also exist when there are information assymetries. Neoclassical economics assumes that all buyers and sellers have perfect information – that they know everything that there is to know about the items in the market and about the intentions of all other market participants. In reality, however, producers of goods or other sellers tend to have much more information than buyers. For example, a company selling shoes might cut costs and use cheap materials that cause them to be of inferior quality. Unless they inform consumers, buyers probably do not know about these potential defects. Similarly, the seller of a used car will know that it is likely to be a pile of junk sooner than later, while a buyer must trust the word of the seller.
One proposed solution to imperfect markets has been government intervention to prop up prices and stimulate demand. Free market economists believe there is no role for governments in the market, but some schools of thought such as the Keynesians believe that government spending is not only important but necessary during economic crises.

Behavioral Economics

Behavioral economics was developed in the late 1970’s by psychologists who understood that people often fail to behave rationally in financial situations, although in predictable ways. They found that people were not always utility maximizing and that their economic behavior could be manipulated. One key finding by the social psychologists Amos Tversky and Daniel Kahneman (who later won the Nobel prize in economics), for example, showed that rather than being risk averse as neoclassical assumptions would predict, people are instead loss averse. In other words, people are more hurt by a loss than the utility they receive from an equivalent gain – losing $100 hurts more than the pleasure of finding $100. They recognized that human emotions play a role in economic behavior.
Behavioral economics has been a hot area of research over the past few decades by psychologists and economists alike, and has established a set of dozens of cognitive and emotional biases and heuristics that are surprisingly common and predictable.

Economic Sociology

While behavioral economics seeks to explain deviations from rational behavior by studying the phenomena that occurs within individual human minds, economic sociology seeks to explain this by shifting the level of analysis up to the role that social norms, expectations, values and beliefs play on economic action. For example, neoclassical economics states that as utility maximizers, if we know that we could get away with stealing something and would never get caught that we will. However, we are socialized to recognize that theft is immoral, and therefore the majority of people will never steal even if they know they won’t ever get caught.
Another key theory to emerge from economic sociology is the concept of embeddedness, which suggests that economic activity is embedded in a network of social relationships, both weak and strong. For example, you might do business with somebody because you like them as a person instead of searching for the best possible service at the best possible price. Or, people may prefer to do business with people of similar ethnic, racial, religious, or cultural backgrounds. Embeddedness also tells us that depending on the composition of a social network, the social norms and rules of behavior can change with regard to economic transactions. For example, it may be considered taboo to haggle on a price with a close friend, but perfectly acceptable with a stranger. Tastes and preferences can be influenced by friends as well as acquaintances and are not entirely developed on one’s own.

Heterodox Economics

In addition to the above theories, there are strands of economic thought that are considered heterodox, or that challenge mainstream beliefs within the discipline of economics. While this tutorial is not the place to elaborate on these, it is worth noting some of the dominant schools of heterodoxy.
  • Marxism Adherents of this theory argue that the ideas developed by Karl Marx about capitalism as a system are correct – that capitalism is doomed to fail due to a number of structural contradictions and that socialism is one solution to these problems.
  • Institutional economics asserts that people and organizations are not rational, but subject to bounded rationality, whereby people simply do not have the time or brain power to find out all the information they need to make economic decisions. Therefore, they accumulate the best information at hand and make a best effort to achieve a satisfactory outcome.
  • Austrian economics believes in completely free markets without any government intervention. Individuals each function according to their own self-interest, but that these individuals need not be utility maximizers and each have their own tastes and preferences. Importantly, macroeconomic phenomena cannot be explained by aggregating these individual actions.
  • Post-Keynesian economics developed from the work of the economist John Maynard Keynes believe in the importance of aggregate demand and effective demand. These economists also believe that money is endogenous, meaning that it is created from within the commercial banking system and is not simply created by central banks externally.