What is the Fundamental Difference between Classical Economics and Neoclassical Economics?

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Note: This is the English translation using the deepL of my Chinese answer to the Zhihu’s question: What is the Fundamental Difference between Classical Economics and Neoclassical Economics?

Classical economics and neoclassical economics have similar approaches to analysing land because the classical concepts of extensive and intensive differential land rent are similar to the neoclassical marginal analysis of land rent. Thus, there is not much to discuss on this point, so we will skip it and just talk about the difference between the two.

The difference lies mainly in whether one considers that there is a clear quantitative relationship between the real wage rate and the level of employment (and thus the level of output). Neoclassical economics uses the labour demand curve as a tool to show that they themselves believe that there is a clear quantitative relationship between the real wage rate and the level of employment. In fact, the neoclassical view is that demand substitution effects among factors of production, triggered by changes in relative prices, cause each factor of production to have a downward-sloping demand curve.

However, in the classical view, we do not think that there must be substitution effects between factors of production due to changes in relative prices. (This is known as the non-substitution theorem, which holds in classical economics without assuming the Leontief production function!) Therefore, classical economists did not use the downward-sloping labour demand curve concept commonly used in neoclassical works.

Understanding this, it is clear why the classical view is that there is no clear quantitative relationship between the real wage rate and the level of employment: the neoclassical reason for the clear quantitative relationship is that neoclassical economics believes that there is a substitution effect between factors of production, while the classical cut off this step in the logical chain.

As an example, suppose that the real wage rate now rises. In neoclassical economics, labour becomes relatively more expensive. Due to substitution effects among production factors, manufacturers will choose more capital-intensive technologies, so labour demand and employment levels must fall. But in classical economics, since the substitution effect need not exist, manufacturers may not seek more capital-intensive technologies leading to a decline in employment levels. The only thing we know for sure in classical economics is that an increase in the wage rate leads to a decrease in the profit rate, yet on this basis, it is uncertain how the wage rate further affects the level of employment. A rise in the wage rate may trigger an increase in effective demand, causing the level of employment to rise; conversely, a rise in the wage rate may also lead to a fall in the level of employment if the rise in the wage rate inhibits the amount of investment by capitalists. Thus, in classical economics, a change in the wage rate is at best the first step in influencing the level of employment rather than a directly decisive one.

We have just mentioned that understanding that the substitution effect between factors of production has a different status in the two theories is an important step in understanding the differences between the two theories. In neoclassical economics, we emphasize substitution effects; in classical economics, we emphasize no substitution effects. But why does this difference arise? This is a deeper question. In fact, the most fundamental difference is the different understanding of production between the two. The neoclassical economics’ understanding of production is a linear flow: the amount of factors of production available to each period of production is given at the beginning of the period (that is, they are considered as endowments). Since they are given at the beginning of the period, these factors of production are necessarily scarce. Therefore, neoclassical economics must argue that substitution effects have important economic roles. In contrast, classical economics sees production as a circular flow: we produce goods by goods. Therefore, the classical view does not consider that the amount of factors of production available in each period of production is given at the beginning of the period; some of the amount of factors of production available in that period can be provided in the middle of the period by the inter-industry exchange of labour products (denoted in the inter-industry technology matrix A). Therefore, the classical view is that the substitution effect is not necessary and that an increase in the wage rate does not necessarily lead to a decrease in the level of employment — it is perfectly possible to change the level of employment (and thus the level of output) by exchanging products between industries, changing capacity utilization, or opening new plants (i.e., capital inflows) during the production period without changing technological conditions and without changes in the real wage rate.

The two understandings of the substitution effect, and ultimately of production, are different. This is why neoclassical and classical economics are not the same and require different data when calculating equilibrium prices.

For neoclassical economics, they need the following three sets of data:

  • Individual preferences.
  • Known production methods.
  • The endowment of factors and their distribution among consumers.

Classical economics, however, need the following three sets of data:

  • The normal level of production.
  • Known production methods.
  • The real wage rate.

We note that only the second point is the same for both. Given known production methods, output and real wages are determined simultaneously in neoclassical economics by individual preferences and endowment distribution data in the form of crossed supply and demand curves. However, in classical economics, the two are determined separately, and the fact that one is given does not mean that the level value of the other is given at the same time. The reason for this difference has been elucidated above.