Neoclassical economics in the context of "Marginalism"

In economics, a production function gives the technological relation between quantities of physical inputs and quantities of output of goods. The production function is one of the key concepts of mainstream neoclassical theories, used to define marginal product and to distinguish allocative efficiency, a key focus of economics. One important purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those factors, while abstracting away from the technological problems of achieving technical efficiency, as an engineer or professional manager might understand it.

For modelling the case of many outputs and many inputs, researchers often use the so-called Shephard's distance functions or, alternatively, directional distance functions, which are generalizations of the simple production function in economics.

John Maynard Keynes, 1st Baron Keynes CB, FBA (/keɪnz/ KAYNZ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in mathematics, he built on and greatly refined earlier work on the causes of business cycles. One of the most influential economists of the 20th century, he produced writings that are the basis for the school of thought known as Keynesian economics, and its various offshoots. His ideas, reformulated as New Keynesianism, are fundamental to mainstream macroeconomics. He is known as the "father of macroeconomics".

Keynes was educated at King's College at the University of Cambridge, where he graduated in 1904 with a B.A. in mathematics. During the Great Depression of the 1930s, Keynes spearheaded a revolution in economic thinking, challenging the ideas of neoclassical economics that held that free markets would, in the short to medium term, automatically provide full employment, as long as workers were flexible in their wage demands. He argued that aggregate demand (total spending in the economy) determined the overall level of economic activity, and that inadequate aggregate demand could lead to prolonged periods of high unemployment, and since wages and labour costs are rigid downwards the economy will not automatically rebound to full employment. Keynes advocated the use of fiscal and monetary policies to mitigate the adverse effects of economic recessions and depressions. After the 1929 crisis, Keynes also turned away from a fundamental pillar of neoclassical economics: free trade. He criticized Ricardian comparative advantage theory (the foundation of free trade), considering the theory's initial assumptions unrealistic, and became definitively protectionist. He detailed these ideas in his magnum opus, The General Theory of Employment, Interest and Money, published in early 1936. By the late 1930s, leading Western economies had begun adopting Keynes's policy recommendations. Almost all capitalist governments had done so by the end of the two decades following Keynes's death in 1946. As a leader of the British delegation, Keynes participated in the design of the international economic institutions established after the end of World War II but was overruled by the American delegation on several aspects.

Socialist economics comprises the economic theories, practices and norms of hypothetical and existing socialist economic systems. A socialist economic system is characterized by social ownership and operation of the means of production that may take the form of autonomous cooperatives or direct public ownership wherein production is carried out directly for use rather than for profit. Socialist systems that utilize markets for allocating capital goods and factors of production among economic units are designated market socialism. When planning is utilized, the economic system is designated as a socialist planned economy. Non-market forms of socialism usually include a system of accounting based on calculation-in-kind to value resources and goods.

Socialist economics has been associated with different schools of economic thought. Marxian economics provided a foundation for socialism based on analysis of capitalism while neoclassical economics and evolutionary economics provided comprehensive models of socialism. During the 20th century, proposals and models for both socialist planned and market economies were based heavily on neoclassical economics or a synthesis of neoclassical economics with Marxian or institutional economics.

Milton Friedman (/ˈfriːdmən/ ; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the complexity of stabilization policy. With George Stigler, Friedman was among the intellectual leaders of the Chicago school of economics, a neoclassical school of economic thought associated with the faculty at the University of Chicago that rejected Keynesianism in favor of monetarism before shifting their focus to new classical macroeconomics in the mid-1970s. Several students, young professors and academics who were recruited or mentored by Friedman at Chicago went on to become leading economists, including Gary Becker (Nobel Prize 1992), Robert Fogel (Nobel Prize 1993), and Robert Lucas Jr. (Nobel Prize 1995).

Friedman's challenges to what he called "naive Keynesian theory" began with his interpretation of consumption, which tracks how consumers spend. He introduced a theory which would later become part of mainstream economics and he was among the first to propagate the theory of consumption smoothing. During the 1960s, he became the main advocate opposing both Marxist and Keynesian government and economic policies, and described his approach (along with mainstream economics) as using "Keynesian language and apparatus" yet rejecting its initial conclusions. He theorized that there existed a natural rate of unemployment and argued that unemployment below this rate would cause inflation to accelerate. He argued that the Phillips curve was in the long run vertical at the "natural rate" and predicted what would come to be known as stagflation. Friedman promoted a macroeconomic viewpoint known as monetarism and argued that a steady, small expansion of the money supply was the preferred policy, as compared to rapid and unexpected changes. His ideas concerning monetary policy, taxation, privatization, and deregulation influenced government policies, especially during the 1980s. His monetary theory influenced the Federal Reserve's monetary policy in response to the 2008 financial crisis.

In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. The first known use of the term by economists was in 1958, but the concept has been traced back to the Victorian writers John Stuart Mill and Henry Sidgwick.Market failures are often associated with public goods, time-inconsistent preferences, information asymmetries, failures of competition, principal–agent problems, externalities, unequal bargaining power, behavioral irrationality (in behavioral economics), and macro-economic failures (such as unemployment and inflation).

The neoclassical school attributes market failures to the interference of self-regulatory organizations, governments or supra-national institutions in a particular market, although this view is criticized by heterodox economists. Economists, especially microeconomists, are often concerned with the causes of market failure and possible means of correction. Such analysis plays an important role in many types of public policy decisions and studies.

A price signal is information conveyed to consumers and producers, via the prices offered or requested for, and the amount requested or offered of a product or service, which provides a signal to increase or decrease quantity supplied or quantity demanded. It also provides potential business opportunities. When a certain kind of product is in shortage supply and the price rises, people will pay more attention to and produce this kind of product. The information carried by prices is an essential function in the fundamental coordination of an economic system, coordinating things such as what has to be produced, how to produce it and what resources to use in its production.

In mainstream (neoclassical) economics, under perfect competition relative prices signal to producers and consumers what production or consumption decisions will contribute to allocative efficiency. According to Friedrich Hayek, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people in the same way as subjective values help the individual to coordinate the parts of his plan.

Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Also known as orthodox economics, it can be contrasted to heterodox economics, which encompasses various schools or approaches that are only accepted by a minority of economists.

The economics profession has traditionally been associated with neoclassical economics. However, this association has been challenged by prominent historians of economic thought including David Colander. They argue the current economic mainstream theories, such as game theory, behavioral economics, industrial organization, information economics, and the like, share very little common ground with the initial axioms of neoclassical economics.

In economics and in particular neoclassical economics, the marginal product or marginal physical productivity of an input (factor of production) is the change in output resulting from employing one more unit of a particular input (for instance, the change in output when a firm's labor is increased from five to six units), assuming that the quantities of other inputs are kept constant.

The marginal product of a given input can be expressed as:

The invisible hand is a metaphor inspired by the Scottish economist and moral philosopher Adam Smith that describes the incentives which free markets sometimes create for self-interested people to accidentally act in the public interest, even when this is not something they intended. Smith originally mentioned the term in two specific, but different, economic examples. It is used once in his Theory of Moral Sentiments when discussing a hypothetical example of wealth being concentrated in the hands of one person, who wastes his wealth, but thereby employs others. More famously, it is also used once in his Wealth of Nations, when arguing that governments do not normally need to force international traders to invest in their own home country. In both cases, Adam Smith speaks of an invisible hand, never of the invisible hand.

Going far beyond the original intent of Smith's metaphor, twentieth-century economists, especially Paul Samuelson, popularized the use of the term to refer to a more general and abstract conclusion that truly free markets are self-regulating systems that always tend to create economically optimal outcomes, which in turn cannot be improved upon by government intervention. The idea of trade and market exchange perfectly channelling self-interest toward socially desirable ends is a central justification for newer versions of the laissez-faire economic philosophy which lie behind neoclassical economics.