Neoclassical Economics
Introduction
Neoclassical economics can be described as a broad theory that mainly focuses on demand and supply as the driving forces that steer production, pricing as well as consumption of goods. Neoclassical economics emerged in the early 1900s to challenge the earlier classical economics theories. Some of the common tenets of neoclassical economics include; marginal utility, rational agents, market equilibrium, relevant information, and perceived value among others. The neoclassical economics theories have continued to dominate as well as draw immense criticism in the modern-day economics world (Lawson 2013). Scholars elucidate new evidence and gap each decade triggering substantial challenges towards the operationalization of neoclassical economics.
Different studies indicate that neoclassical approaches cannot accurately infer actual economics. Research indicates that the neoclassical assumption that buyers behave rationally when making purchasing decisions ignores the vulnerability nature of human beings to make emotionally driven choices. Majority of the neoclassical economists hold that forces of demand and supply always lead to an “efficient” allocation of the intended resources (Henry 2012). This paper seeks to discuss the challenge to neoclassical microeconomics arising from three main theories; asset specificity, information incompleteness, and asymmetry and contested exchange. These theories stem from the neoclassical rationality of consumer theory and producer theory.
The producer theory focuses on supply while the consumer theory focuses on demand. The producer theory assumes that a seller is motivated by profit. In this case, any cost that is linked to the profit arises from the physical characteristics of the entire production process. Also, the profit can be measured directly. On the other hand, the consumer theory considers what the buyers like, a tenet that cannot be measured directly but must be inferred (utility function). Therefore, the theory is built on the premise that the choices that people make can be used to infer what they like (Lenzen et al. 2007). Simply, the consumer theory seeks to maximize the utility function through choosing the best combination of goods that conform to the buyers’ tastes and preferences while the producer theory attempt to maximize profit through choosing the best combination of variable factors.
Asset specificity
There are different challenges concerning the asset specificity theory as represented by Williamson (1989). Different scholars have continued to explore the subject, given that there is no clear definition of asset specificity. Asset specificity revolves around the transaction of interparty relationships (Whyte 1994). It deals with the extent to which investment revolving around a particular transaction has increased value in comparison to any investment that would be have been made for any purpose whatsoever. This subject has been studied deeply in various aspects of economics and management. These areas include marketing and management information systems.
Williamson’s (1989) definition of asset specificity has evolved, given different interpretations by scholars over the years. Scholars have changed the interpretation to emphasize different aspects of asset specificity. Despite this being a good sign when it comes to the advancement of knowledge on the field, they add ambiguity to the already ambiguous definition of asset specificity (David and Han 2004) All these definitions can be summarized to six definitive themes which are a classification of varying definitions of different scholars on the subject. These include the following:
- The extent of customization necessary in maintaining a transactional relationship.
- How unique the assets delegated to the task are.
- How important the identities of both parties are to the transaction.
- How mobile or transferable the investments or assets required for the transaction are.
- The value bound on ensuring the relationship continues.
Since Williamson (1986) first came up with the theory of asset specificity, several scholars have attempted to rework as well as expand the operationalization of the theory. Understanding of the operationalization of asset specificity is a major issue. This is more than basic theoretical or definitional complexity. There have been concerns to develop a consistent measurement of asset specificity to grasp a better understanding of the complex nature of this subject. However, to date, there have been complexities in coming up with an agreed operationalization of the construct of asset specificity. Perturbing inconsistencies have been noted in the findings concerning the measurement of asset specificity. A vague definition of the nature of the construct is to blame for this (Barthelemy and Quelin, 2002). It is also true to consider that asset specificity cannot be observed directly but is rather noted by various indicators and the assimilation of multiple dimensions. There are four different kinds of asset specificity. They include:
- Physical asset specificity including physical assets such as land
- Human asset specificity including labor.
- Site specificity
- Dedicated asset specificity.
However, Zaheer and Venkatraman (1995) added a dimension of asset specificity to include procedural specificity to cater for empirical solutions in service industries. Also, temporal specificity by Malone et al, (1987) was later added creating more operationalization inconsistencies.
The other consideration is issues concerning inter-firm relations performance. Some studies suggest that asset specificity increases with satisfaction with the relationship. This enhances commitment to the relationship by both partners. This specifically enhances tie expectations in the continuity of the relationship. Switching costs of suppliers involved in the study displayed that they were high because of long and continued interaction. Transfer of transactional skills was facilitated by mutual adoption. Specific asset inv5estents add to the hugest addition to customer switching costs. This is with the exception of adoption from sellers, the incentive that the seller offers, and KAM objectiv5e and subjective performance (De Vita, Tekaya, and Wang 2011).
Once a party involved in the transaction makes a relationship-specific investment, the other party could threaten to ease the purchase of the products birthed from the relationship-specific investment (De Vita, Tekaya, and Wang 2011). Henceforth, they impose capital costs from the party that is investing. Costs are hence reduced because those involved in the transaction design contracts specifically to reduce or prevent the likelihood of holdups. Contracts can exceed this mandate of preventing holdup situations by anticipating ways to control long term prices regardless of or not regarding exclusive dealing (De Vita, Tekaya, and Wang 2011).
Information incompleteness and asymmetry
Buyers often find themselves in situations where a party has more information than the other during an economic transaction. In this case, the parties have an unequal amount of information. Joseph E. Stiglitz helped to foster the economics of information, a discipline that focuses on market equilibrium aspects such as asymmetries of information among others. Stiglitz’s work demonstrates the various ways in which all kinds of markets can fail to accomplish efficient outcomes. According to Stiglitz (1993), markets are said to reach equilibrium when the buyers and sellers have full information about the price as well as the quality of the product. Lack of enough information may lead to poor transaction poor decisions.
The economics of information involves two major aspects; incomplete information and asymmetric information. Incomplete information entails situations where either a buyer or a seller or both do have enough information to make the right choice about the quality and price of a product or service (Stiglitz 1993). The term incomplete signifies the lack of enough information required to make informed decisions. On the other hand, Asymmetric information refers to situations where either the seller or buyer has more information than the other party in regards to the price or quality of a product or service (Basu 2001). For instance, owners of used cars may have more information than they often reveal while marketing their used cars to buyers.
However, substantial gaps exist in the economics of information. Some economists hold that incompleteness and asymmetric information have drastically reduced due to the advancement of the internet and technology. For instance, before a guest visits a restaurant he/she can search for online reviews to get better insights on what to expect. Nonetheless, still inaccurate online information may be provided which can lead to poor decision making. Economists should focus on producing cheaper information. Firms must follow the required accounting principles, collateral standards, net worth requirements, disclosure of information, and presence of rating firms (Basu 2001). For instance, blogging has emerged as a new source of cheap information that has helped to reduce the implications of insider information by inhibiting people in position from concealing information from people.
Also, the theory does not address the fact that asymmetric information commonly manifests after a transaction has ended as represented by Stiglitz (1993). For instance, an individual that has covered his/her car with reputable insurance may be less cautious since any negative consequences are considered as the responsibility of the insurance company. More so, in the financial markets, the borrower always has more information about his/her financial strength than the lender. In this case, the lender has no guarantee the borrower wouldn’t default. Another good example is people with welfare benefits, who may cease to look for employment or entrepreneurial opportunities actions they would never take if they didn’t have the benefits.
Contested Exchange
Bowels and Gintis (1993) challenge the neoclassical microeconomics because it is based on assumptions and ideas that do not reflect in the real world of the economy. First, markets are not just allocating and promoting movement with a predetermined production limit; they also act as a disciplinary institution and provide mechanisms for changing market forces. Therefore, markets can influence inputs and production outcomes. For instance, workers get jobs through the labor market and also labor market sets a conducive environment for standardization of quality and limits of work.
Credit markets assist beyond borrowing capital by traders since they do not involve a third party to enforce repayments. Besides, credit markets offer non-contractual methods of enforcing prudent risks. A similar trend is observed in the goods market where consumers pay an excessive price for a good at marginal cost, and they possess the ability to change their suppliers when dissatisfied with the quality of the product. This prompts the supplier to improve the quality of their products. Bowels contests against the imperfection of the market forces since they bow to pressures arising from the competition which favors the emergence of better mechanisms. Bowel believes that markets are not justified to provide disciplinary and allocative actions since they are not perfect in providing sustainable solutions to ever-present problems in the contested marketing exchanges.
Secondly, repeated transactions among agents lead to price and terms of payment being done in excess for at least one best alternative to an agent. This is referred to as Enforcement rent. This type of rent arises since it is suboptimal for one of the agents experiencing enforcement challenges when making an exchange to make an equal offer to another partner’s best alternative. If such an offer is expected, partners will be indifferent in subsequent exchanges and there will be no means of applying threats to end the exchange relationship in enforcing the terms of transactions (Bowles and Gintis 1993). Using threats to terminate a relationship to ensure compliance and offering an enforcement rent to the exchange partner is referred to as a contingency renewal strategy. When this strategy is used, some partners receive competitively determined enforcement rents. In case the agents are indifferent between the current transaction and the next alternative, agents get constrained in terms of quantity; therefore they cannot make their preferred transactions.
Therefore the contingency renewal does not clear the equilibrium. Elements that are less competitive such as interactions among small teams that happen when there is a specific transaction or investment are essential in supporting exchanges produces related outcomes but the nature of contested trade exchange results from endogenous enforcement. In a labor market with a contested exchange, for instance, rent is at equilibrium. The cost associated with the loss of a job is an enforcement rent for workers. Having a fear to lose a job will make a worker perform with an extra effort as opposed to less effort put in the absence of fear.
Bowles and Gintis (1993) argue that credit markets operate on enforcement rents mechanism. Borrowing and rendering are based on the principle of enforcement rent which makes a relationship termination threat a workable tool for the lenders. Transacting parties are likely to comply with threats particularly when there are associated terminating costs, reputation issues, and specific investment losses.
Contested exchange market perform allocation functions as well as claim enforcement, they fail to apply socially effective resource utilization. In this regard, a superior transaction exists to the equilibrium. This is a very obvious case in the labor market which majorly depends on involuntary employments. In a comparative analysis, a competitive strain resulting from competitive aspects of lenders and borrowers is socially ineffective. Most projects are not funded at the equilibrium although the returns expected are greater than the interest rate accrued at equilibrium. Therefore neoclassical theories fail to provide sustainable means of running the economy.
Markets ensure discipline by exercising power. Bowel and Gintis (1993) believe in economizing and governance as the most important tools in the neoclassical economy. While the traditional economy is built on fiscal federalism and public finance which causes a tension between the economic benefits of centralism and the undesirability of putting up uniform policy on a population that is geographically diverse. Power limits borrowers’ and lenders’ interest in the market. A market sanction affects the contested exchanges. Many economic benefits can be accrued by having a broad scope of authority. Although authorities are seen as a form of infusing orders to people, they solve conflicts and realize mutual economic benefits. Governance leads to a rise in economies of scale by providing public goods. Additionally, governance is important in enlarging the marketing scope of goods and products by promoting international trades and lobbying against international trade restrictions. Contested exchanges are influenced politically and sanctions follow political structures and designs. Governing markets is thus regulated by political powers. However, when power is exercised in mutually agreed transaction parties feel compelled and lack the freedom to make choices.
Contested Exchange Vs, Governance,
While Bowles and Gintis place emphasis on contested exchange and power, Williamson (1993) believes in economizing and governance as the most important tools in the neoclassical economy. While the traditional economy is built on fiscal federalism and public finance which causes a tension between the economic benefits of centralism and undesirability of putting up uniform policy on a population that is geographically diverse, Williamson outlines that different levels of government are necessary for the allocation of expertise in response to tensions in trade between the scale benefits and heterogeneity costs. Many economic benefits can be accrued by having a broad scope of authority. Although authorities are seen as a form of infusing orders to people, they solve conflicts and realize mutual economic benefits (Alesina and Spolaore 1997).
Williamson (1993) challenges the paradigm of resource allocation by the authorities because it does not provide for the continuity of contractual ties and organization; the focus is on the output, prices, and market forces such as demand and supply mechanisms. This is contrary to the views of the Common who perceived the importance of organization and contractual relations continuousness. Also, neoclassical economic theories disregard economics by institutions since they failed to make a progressive research agenda that was in line with empirical testing and predictions. Therefore, neoclassical economics rejects the price theoretical method to economics which would have been the 20th-century dominant paradigm (Marks and Hooghe, 1999). Despite the view by neoclassical economics that institutional economics were less important, they had good transformative ideas for the economy.
The transaction costs in trade are largely ignored in the neoclassical economy. Theories around neoclassical economy assume the cost of running and reforming the government. Governments are run based on types of citizens. The neoclassical economy ignores the infrastructural, informational, and decisional costs the government incurs in running the economy. The government’s ability to take advantage of the economies of scale doesn’t lift off its burden in providing public goods such as trade and security for citizens. Neoclassical theories fail to consider that the cost of infrastructure on government is dependent on the economies of scale when coming up with, adjudging, and applying the law as opposed to its extensions in territories (Williamson 1993).
As the number of governments increases, its size and efficiency decrease significantly. Information costs to rules and citizens increase with an increase in the number of governments as well. For instance, the cost of gaining information from the citizens about a particular policy increases with an increase in the number of governments. To gain information, therefore, policymakers make policy constituencies similar to take advantage of economies of scale. Significant costs are incurred during the decision-making process since governments have different competencies. It is difficult to reduce overlap in competencies since decisions are tied to some extent. However, to increase the government’s responsibility to a particular policy, there is a need to compartmentalize policies.
Conclusions
Neoclassical theories describe imaginary worlds that do not represent the current problems in modern-day economics. These theories can be described as thin and are largely disconnected from the specific contexts of the targeted systems. This entails the rationality of producer and consumer theory and the imminent theories such as specific assets, incomplete and asymmetric information, and contested exchange. This is also palpable in the governance structures as path-dependent channels are easier to establish and fund as opposed to creating new levels of government, a narrative-driven by neoclassical economics. To reduce transaction costs and at the same time address to neoclassical economics idea of a different layer of government, powerful competencies can be derived from the established governments. The transaction cost of setting up a new government is greater than establishing competencies for the existing ones. Therefore, there is a need for path-dependent dynamics. Economies of scale prompt the governments to extend its authorities although a wide geographical scope causes heterogeneity which in turn limits the government jurisdictions. Both factors affect transaction cost which constrains an increase in the levels of government
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