The neoclassical approach is the prevailing paradigm in health economics (and all else). It aims to be both a scientific enquiry into the choices that individuals actually make (“positive economics”) and a way of advising policy-makers about the social choices that they should make (“welfare economics”). The key point is that neoclassical thinking assumes individuals know what they are doing, so it is best to leave them alone. They are predictably rational and narrowly self-interested and make decisions to benefit themselves. Consequently, free markets – in the view of neoclassical economists – are the most efficient way to distribute goods and services. Only in a few specific instances do markets malfunction and the state needs to intervene – with the proviso that government failure also occurs.

Neoclassical economics has several strengths, which partly explain its success. It starts from the individual and her rights and thus resonates with western ideas of freedom and individualistic, rights-based thinking. It is the only economic theory that is able to model whole economies (not just parts of them) with mathematical methods. It offers an intuitively appealing narrative and makes bold claims about individual and social behaviour. Its math-ematical approach appears prima facie to be a natural science and thus it is seen as a “hard” science with conclusions that are often treated like fact-based, logically derived results.

This chapter provides a first approach to some key elements of the discipline that are essential for understanding health economics.

Neoclassical theory is built on several key assumptions: first, people are rational individuals: the Homo economicus being the paradigm for the individual. Consumers are represented by their utility function, which, in turn, is based on von-Neumann–Morgenstern axioms (i.e. the utility functions meet mathematical requirements – they are complete, stable, transitive and independent from irrelevant alternatives – see below). Supply is modelled via production functions that represent producers. Second, markets work at infinite speed and are free of transaction costs, and all information about prices now and in the future is known to all. Third, and finally, institutions and laws do not matter much for economic analysis and are at best only providing the framework for individual interaction.