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ECONOMICS：New Classical Versus Neoclassical Framework
Xiaokai Yang
The first draft: 1997.
The final version: October 1999
at Harvard University
This textbook belongs to a new species of economics textbook. It differs from Marshall’s
first generation of economics textbook that separates the analysis of demand and supply
from the analysis of individuals’ decisions in choosing their levels of specialization. It
differs from his marginal analysis of demand and supply based on neoclassical
dichotomy between pure consumers and firms. This book begins from an analysis of
individual consumer-producers’ decisions in choosing levels of specialization, and then
applies inframarginal analysis (total benefit-cost analysis across corner solutions in
addition to marginal analysis of each corner solution) to investigate how the network size
of division of labor in society is determined in the market place. According to this
inframarginal analysis, demand and supply are two sides of the division of labor (Allyn
Young, 1928). Hence demand and supply are determined not only by resource allocation
for a given network pattern of division of labor, but also by the network pattern of
division of labor.
Also, this textbook differs from Samuelson’s prototype of the second generation of
economics textbook. It does not have a dichotomy between microeconomics and
macroeconomics. Since a particular level of division of labor is associated with a certain
size of market network, the extent of the market and aggregate demand are determined by
individuals’ decisions in choosing their levels of specialization that yield the network
size of division of labor for society as a whole. Hence many macroeconomic phenomena,
such as unemployment and business cycles are some special features of the complicated
network of division of labor.
In this text non-linear programming, dynamic programming, and other nonclassical
mathematical programming are employed to resurrect the spirit of classical mainstream
economics within a modern body of formalism. Since the spirit of the book is older than
neoclassical economics, while its body is younger than neoclassical economics, we
would like to address the new species New Classical Economics.
Despite the innovation in this text, it keeps the continuity of the mainstream of
economics through a synthesis of the existing and emerging branches of economics.
Neoclassical microeconomics based on the dichotomy between pure consumers and
exogenously given firms is covered in the text. But possible corner solutions and
inframarginal comparative statics of general equilibrium (discontinuous jumps of
endogenous variables across corner and interior solutions in response to changes in
parameters) in the neoclassical framework are emphasized. Neoclassical trade theory is
synthesized into the text by highlighting its features of inframarginal comparative statics
that generate jumps of equilibrium trade pattern across corner and interior solutions
(chapter 12). New trade theory developed by Dixit and Stiglitz (1977), Krugman (1979,
1980, 1981), Ethier (1982), and others is covered in chapter 11. New equilibrium game
models, such as the models of sequential equilibrium of Milgrom-Roberts and Kreps-
Wilson and the model of commitment game of Dewatripont-Maskin, are covered and
applied to analyze the relationship between endogenous transaction costs and network
size of division of labor in chapters 4, 9 and 12.
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New models that formalize the notion of endogenous transaction costs caused by
moral hazard and information asymmetry, the theory on structure of residual rights and
incomplete contract, and the new theory of the firm are covered in chapters 9 and 12.
These models are extended in this text to explore the relationship between endogenous
transaction costs, evolution of division of labor, structure of property rights, and
emergence of the institution of the firm. New endogenous growth models (AK models,
R&D based models, and models with endogenous evolution of division of labor) are
covered in chapters 21, 22, 23, and 24. The different endogenous growth models are
compared in the light of recent empirical work that tests them against observations.
Several new classical general equilibrium models are used to develop an overarching
framework for explaining all micro and macro phenomena. It is shown that when the
network size of division of labor is endogenized in a general equilibrium analysis,
marginal comparative statics for a given pattern of the network can address conventional
microeconomic resource allocation problem, while inframarginal comparative statics
explain discontinuous jumps of the equilibrium size of network of division of labor and
related aggregate variables across different structures. The inframarginal comparative
statics (or dynamics) can then explain emergence of money, business cycles, and
unemployment from division of labor. Hence, for our grand synthesis, macroeconomic
analysis and microeconomic analysis are just at two different levels within an integrated
framework.
Many insights of Buchanan, Cheung, Coase, and North into transaction costs,
property rights, institution of the firm, and contract are formalized in the text. Challenges
posed by nonlinear evolutionary economics (see Nelson, 1995, Conlisk, 1996, and
references there) and by the Austrian School (see Kirner, 1997, and references there)
against the mainstream are taken and absorbed into the text. For instance, the concept of
Walrasian sequential equilibrium is developed in chapter 24 to predict concurrent
evolution of economic organisms and evolution of information acquired by society
through social experiment with various organisms using price mechanism. The recursive
paradox, which means that a decision problem based on bounded rationality cannot be
well defined, raised by nonlinear evolutionary economists is solved in a well closed
dynamic general equilibrium model based on adaptive behaviors and bounded rationality.
The dynamic equilibrium model substantiates the proposition in nonlinear evolutionary
economics that concurrent evolution of organisms and information about organisms
acquired by society involves uncertainty of the direction of the evolution as well as a
certain tendency of the evolution (Nelson, 1995).
This text can be used at two different levels. Since each chapter includes a part of
descriptive intuition behind the formal models and mechanism at work, with aids of
graphical illustrations, the text can be used for third or fourth year (micro or macro)
economics courses and third or fourth year courses of development economics, trade
theory, industrial organization, economics of transaction costs and property rights,
economics of contract and institution. The focus for the undergraduate courses is on
training of economic thinking. If the text is used for the purpose, questions for
assignments and examinations can be chosen from the questions in the end of each
chapter and difficult algebra and exercises in the end of each chapter can then be skipped.
The text can be used for a microeconomics course at graduate level. It can be used as
a reference in graduate courses of macroeconomics, development economics, growth
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theory, economics of transaction costs and organization, economics of contract and
institution, industrial organization, trade theory as well. The focus for the graduate
courses is on formal basic training as well as on innovative, creative, and critical
economic thinking. For the part of basic training, students are asked to pay more attention
to duplication of major models in the text and to work out main exercises in the end of
each chapter. One hour spent on duplicating the models is as effective as 8 hours spent on
listening and reading. The formal training is characterized by strong accumulation effects.
If each model covered in the text is duplicated and well understood, the studies will
become increasingly easier. But if one of the major models cannot be duplicated or a
lecturer is missed out, the studies may become increasingly more difficult later on.
For the part of creative and critical thinking, students are asked to pay more attention
to the trial-error process in designing models and in choosing one from many possible
frameworks. Not only all original ideas must stand the test of rigorous deduction, of
logical consistence, and of empirical evidences, but also insights that might be too
sophisticated to be formalized by any available mathematical instruments are encouraged.
Questions and exercises in the end of each chapter include many good thesis topics for
master and Ph.D. programs. Free assistance can be obtained for such programs from the
author upon request.
The text can be used for a one-year course. For this case, the teacher may pay more
attention to basic training in the first semester which may cover parts I-V. Then more
attention may be paid to encouraging creative, independent, and critical economic
thinking in the second semester. If it were used for a semester course, the teacher might
choose major chapters in parts I-V, then quickly outline main results in other chapters
with the aids of graphical illustrations.
This text is a response to increasing demand for a text and a survey from which
technical substance of new classical economics and inframarginal analysis can be
systematically learnt. It covers many new research results of new classical economics and
inframarginal analysis and compares the new classical framework with the neoclassical
one. Some of the new research results are published for the first time. I hope that the
reader will experience exciting intellectual adventure and find inframarginal analysis of
network of division of labor as a bridge between the mainstream economics and this era
of networking.
Since new classical economics can be applied to many fields of economics, we are
developing a franchise network to promote teaching, research, and publications of new
classical economics and inframarginal analysis. One of many franchise units is
Development Economics, by Jeff Sachs and Xiaokai Yang, which applies new classical
economics to development economics, synthesizing it with other new research in this
field. This book will be published by Blackwell as well. Other possible franchise units
under consideration include Economics of Property Rights and Transaction Costs and
New Classical Trade Theory. If you are interested in involvement in this franchise
network, please contact us at xiaokai_yang@ksg.harvard.edu or xiaokai.yang
@buseco.monash.edu.au. We will provide training support and all necessary information
about technical substance for working out a book applying new classical economics to a
field of economics.
Too many individuals and institutions contribute to this project. I am first greatly
grateful to my teachers back to Princeton University, Hugo Sonneschein who taught me
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the theory of general equilibrium, Edwin Mills who taught me development economics
and urban economics, Gene Grossman and Avinish Dixit who taught me trade theory and
new general equilibrium models with increasing returns, Gregory Chow, Whitney Newey,
Anguish Deaton, and Richard Quandt who taught me econometrics, Joseph Stiglitz, Barry
Nalebuff, and Sanddy Grossman who taught me information economics and game theory,
Alan Blinder and John Taylor who taught me macroeconomics, and William Baumol,
Michael Katz, and Robert Willig who taught me Industrial Organization.
I am also greatly indebted to my coauthors of various research papers which are covered
in this text: Jeff Borland, Been-Lon Chen, Wen-Li Cheng, Ben Heijdra, Geoff Hogbin,
Chien-fu Lin, Monchi Lio, Mong-Chun Liu, Pak-Wai Liu, Siang Ng, Yew-Kwang Ng, Babu
Nahata, Bob Rice, Jeff Sachs, He-Ling Shi, Guangzhen Sun, Ian Wills, Jianguo Wang, Karyiu
Wong, Shuntian Yao, Dingsheng Zhang, Yiming Zhao, Lin Zhou. I have benefited
immensely from comments and criticisms on research papers and books that relate to this
text from Ken Arrow, Gary Becker, Avner Ben-Ner, Fischer Black, James Buchanan,
Steven Cheung, Cyrus Chu, Eric van Damme, Herbert Dawid, Jurgen Eichberger, Karl
Farmer, John Gallup, Robert Gilles, Oliver Hart, Heinz Kurz, Lachie McGregor, Douglas
North, Lloyd Reynolds, Peter Ruys, Andrei Shleifer, Hugo Sonnenschein, Sherwin Rosen,
Donald Smythe, Willy Spanjers, Guoqiang Tian, Andrew Warner, Chenggang Xu, Gang Yi,
Weiying Zhang, and participants of numerous seminars and conference sessions. Many
students at Harvard University, Monash University, Peking University, Chinese University
of Hong Kong, University of Hong Kong, National University of Taiwan, and University of
Louisville provide useful feedback to the teaching of the materials covered in this text.
Special thanks go to Jeff Borland, Sherwin Rosen, Monchi Lio, Mei Wen, and Julan Du for
drawing several references cited in the text to my attention. Mei Wen and Yiming Zhao have
done an excellent job to draw many graphs in this text. My gratitude also goes to six
anonymous referees of the draft of this text.
The financial support for this project and related research from the Center for
International Development at Harvard University, Australian Research Council, Chinese
University of Hong Kong, National Taiwan University, Institute of Economics of Academia
of Sinica, the National Sciences Council of the Republic of China, China Economic
Guanghua School of Management, Peking University, and Centre for Economic Research
at Tilburg University is gratefully acknowledged.
Last, but not least, without love, patience, and strong support of my family, this book
would never exist in this world. I hereby express my deepest love and thanks to my wife,
Xiaojuan Wu and kids, Xiaoxi, James, and Edward.
Of course, any remaining errors are solely my own responsibility.
Xiaokai Yang
August, 1999, at Harvard University
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