1. Classical Theory of Income and Employment

2. Introduction to classical theory
Classical economists : Adam smith, Ricardo, Edge Worth, Pareto, J.B Say and Marshal etc
According to these economists there is always full employment in the economy.
The classical believed in “Laissez-faire Economy”
means a free enterprise economy.

3. Introduction to classical theory
J.B Say ( ) was a classical French economist, who was a follower of Adam smith, he was of the view that, when a product is created in the economy, it creates an immediate demand in the economy equals to its own value. As a result of that demand equals to supply.
This conclusion came to be known as Say`s Law of Market.

4. The simple statement of the Say`s Law is “ supply creates its own demand”.
The very act of producing goods and services generates an amount of income equal to the value of the goods produced.
According to this, whatever is produced in a free enterprise economy is automatically demanded and over a long period of time when a supply of a good and services increases, the demand for them also increases and vice versa.

5. Say's Law of Markets
Say's law of markets is the core of the classical theory of employment. He enunciated the proposition that "Supply creates its own demand".
Production creates market (Demand) for goods
Barter system at its basis
General over-production impossible
Saving Investment Equality
Rate of interest as a determinant factor
Labour Market

6. Saving-Investment Equality
There is a serious omission in Say’s Law. If the recipients of income in this simple model save a portion of their income, consumption expenditure will fall short of total output and supply would no longer create its own demand.
Consequently there would be unsold goods, falling prices, reduction of production, unemployment and falling incomes.
However, the classical economists ruled out this possibility because they believed that whatever is saved by households will be invested by firms. That is, investment would occur to fill any consumption gap caused by savings leakage.
Thus, Say’s Law will hold and the level of national income and employment will remain unaffected.

7. Saving-Investment Equality in the Money Market
The classical economists also argued that capitalism contained a very special market – the money market – which would ensure saving investment equality and thus would guarantee full employment.
According to them the rate of interest was determined by the demand for and supply of capital.
The demand for capital is investment and its supply is saving. The equilibrium rate of interest is determined by the saving-investment equality. Any imbalance between saving and investment would be corrected by the rate of interest. If saving exceeds investment, the rate of interest will fall. This will stimulate investment and the process will continue until the equality is restored. The converse is also true.

8. Price Flexibility
The classical economists further believed that even if the rate of interest fails to equate saving and investment, any resulting decline in total spending would be neutralized by proportionate decline in the price level. That is, Rs 100 will buy two shirts at Rs 50, but Rs 50 will also buy two shirts if the price falls to Rs 25. Therefore, if households saves more than firms would invest, the resulting fall in spending would not lead to decline in real output, real income and the level of employment provided product prices also fall in the same proportion.

9. Wage Flexibility
The classical economists also believed that a decline in product demand would lead to a fall in the demand for labour resulting in unemployment. However, the wage rate would also fall and competition among unemployed workers would force them to accept lower wages rather than remain unemployed. The process will continue until the wage rate falls enough to clear the labour market. So a new lower equilibrium wage rate will be established. Thus, involuntary unemployment was logical impossibility in the classical model.

10. Classical Theory of Employment
Basic Assumptions
There is the free market price system.
There is a closed laissez faire capitalist economy.
Wages and prices are flexible.
A barter model of money – "products are paid for with products;"
Flexible prices – all prices can rapidly adjust upwards or downwards;
No government intervention.

11. Basic Assumptions
Capital stock and technological knowledge are given in the short-run.
There is close coordination between money wages and real wages. Since supply creates its own demand, there can never be any deficiency in demand.
Total output of the economy is divided between consumption and investment expenditures.

12. Propositions and its implications of the Say's law.
Full employment in the Economy
Proper Utilization of Resources
Perfect Competition
Laissez-faire Policy
Saving as a social virtue

13. Explanation of classical model in various markets
Classical model is explained with the help of four markets of economy.
Money market
Good market
Credit market
Labor market

14. 1 J.B say Law in Goods Market
J.B say Law of Market
1 J.B say Law in Goods Market
In barter economy goods produced either for their own use or to exchange for other good. So concept of aggregate demand and aggregate supply works and process of value equalization starts till the equilibrium is settled in market.
Supply creates its own demand, means whatever is produced in barter economy is sold out”
Hence no possibility of over production and no unemployment in economy.

15. J.B say Law of Markets (cont….)
For example one person produces wheat, while other produce cloth they will exchange the products with one another so nothing remain unsold and no producer will face losses, as a result there will be no unemployment.

16. Say’s law of market 2 money market
Say law of market is equally valid in a money economy
In money economy goods and services are produced throughout the year by the combination of four factors of production. They are given reward in form of rent, interest, wages and profit. These rewards are simply used for purchasing the goods and services . So consumer pay back these rewards in the form of prices to the firms for the goods and services purchased.

17. conclusion Hence aggregate supply= aggregate demand.
So no question for over and under production and similarly no unemployment.

18. Labor market in classical model
In this market we will discuss supply of labor and demand for labor.
Furthermore demand for labor will be discussed from the point of view of single firm as well from economy point of view.

19. Demand for labor by a single firm:
We know that a firm will hire labor unless and until the value of labor is equal to wage of labor.
The above condition for hiring labor is profit maximizing condition for the firm demanding labor.

20. So demand for labor is the demand which depends on MPL.
Inverse relationship exist between demand for labor and MPL.
It means that at higher real wage rate(w*) the demand for labor will be low, while at lower real wage rate the demand for labor will be high.

21. Labor market in classical model (cont….)
This relationship is shown in this graph.
MPL
MPL> W*2
W*3 E
MPL=W*2
W*2
MPL< W* 2
W*1
MPL o L L1 L2 L3

22. Explanation of graph
A firm will not employ OL1 units of labor as here MPL >W2, as a result it will increase the employment of labor.
Similarly a firm will not be interested to demand OL3 units of labor, as here MPL < W2.
Thus a firm will be in equilibrium at OL2 where MPL= W2

23. Labor market in classical model (cont….)
Aggregate demand for labor
Aggregate demand means demand for labor by all firms.
Negative slope, ADL shows different amounts of labor at different wage rates
W/P W*
ADL =f(W*) 1 W* DL DL
DL1
DL2

24. Supply of labor
The individual supply of labor shows how much work an individual is willing to offer at different wage rate.
Wage rate is positive related with supply of labor.
Market supply or aggregate supply means all individual workers willing and able to work.

25. GRAPHICAL PRESENTATIONW*
ASL= f(W/P)
W*3
W*2
W*1
SL1
SL2
SL3
ASL

26. Equilibrium in labor market
Equilibrium in labor market is attain at W/P, where DL=SL
If wage rate increase due to any reason, then this increase will cause unemployment for short period, because firms will lay off some employees to cut down the extra cost. So according to classical economist there is self adjustment process in economy so again wage rate tends to decrease and economy come back towards equilibrium.

27. Equilibrium in labor market cont`d
Similarly if wage rate decreases, it will create an an excess demand for labor, this will lead to increase in wages and economy once again come towards equilibrium.

28. Equilibrium - In the following figure the equilibrium wage rate (wo) is determined by the demand for and the supply of labour. The level of employment is OLo.

29. The lower panel of the diagram shows the relation between total output and the quantity of the variable factor (labour). It shows the short-run production function which is expressed as Q = f ( K, L ), where Q is output, K is the fixed quantity of capital and L is the variable factor labour. Total output Qo is produced with the employment of Lo units of labour. According to classical economists this equilibrium level of employment is the ‘full employment’ level. So the existence of unemployed workers was a logical impossibility. Any unemployment which existed at the equilibrium wage rate (Wo) was due to frictions or restrictive practices in the economy in nature

30. The classical economists believed that aggregate demand would always be sufficient to absorb the full capacity output Qo. In other words, they denied the possibility of underspending or overproduction. This belief has its root in Say’s Law.

31. 4 Credit market in classical model
According to classical economists at the level of full employment saving is equal to investment.
It is the rate of interest which equalizes the saving and investment.
Saving is increasing function of rate of interest while Investment is decreasing function of rate of interest.

32. Credit market in classical model (cont…)B i2 io E i1 P Q
I > S I
S=I

33. Credit market in classical model (cont…)
If rate of interest increases from equilibrium rate of interest ,saving become greater than investment it shows surplus saving.
Credit market is in equilibrium at point “E” and rate of interest is i0.

34. Credit market in classical model (cont…)
Similarly if rate of interest decreases than equilibrium rate of interest then investment become greater than saving.
This equality between saving and investment is automatic adjustment process and there is no need of Government intervention.
Market forces clears the market and there is full employment prevail in economy.

35. Criticisms of Say's Law
M. Keynes in his General Theory of Employment, Interest and Money published in 1936, made a frontal attack on the classical postulates and Say's law of markets.

36. Criticisms of Say's Law Supply does not create its Demand.
Equilibrium level not always the full employment level
Theory is applicable in long run
Money income also determines the saving and investment level apart from rate of interest.
Employment and output are not functions of wage rate . Employment is a function of effective demand.

37. Criticisms of Say's Law
Wages-cut no solution as it leads to falling aggregate demand .Self-adjustment not possible.
Over Production and under-production is Possible.
State Intervention.
Demand creates its own supply

38. Keynesian Theory of Employment
Keynes has strongly criticised the classical theory in his book ‘General Theory of Employment, Interest and Money’.
His theory of employment is widely accepted by modern economists.
Keynesian economics is also known as ‘new economics’ and ‘economic revolution’.
Keynes has invented new tools and techniques of economic analysis such as consumption function, multiplier, marginal efficiency of capital, liquidity preference, effective demand, etc.

39. Keynesian Theory of Employment
In the short run, it is assumed by Keynes that capital equipment, population, technical knowledge, and labour efficiency remain constant.
That is why, according to Keynesian theory, volume of employment depends on the level of national income and output. Increase in national income would mean increase in employment.
The larger the national income the larger the employment level and vice versa. That is why, the theory of Keynes is known as ‘theory of employment’ and ‘theory of income’

40. The Principle of Effective Demand (or) Keynes's Theory of Employment
In a capitalist economy the level of employment depends on effective demand.
Keynes used the term 'effective demand' to denote the total demand for goods and services at various levels of employment.
Effective demand manifests in the aggregate expenditure of the economy.
The aggregate expenditure comprises of :
Household expenditure
Investment expenditure of firms
Government e
The aggregate expenditure depends on level of national income.

41. Theory of Effective Demand
According to Keynes, the level of employment in the short run depends on aggregate effective demand for goods in the country.
Greater the aggregate effective demand, the greater will be the volume of employment and vice versa.
According to Keynes, the unemployment is the result of deficiency of effective demand.

42. Theory of Effective Demand
Effective demand represents the total money spent on consumption and investment. The equation is:
Effective demand = National Income (Y) = National Output (O)
The deficiency of effective demand is due to the gap between income and consumption.
The gap can be filled up by increasing investment and hence effective demand, in order to maintain employment at a high level.

43. Determinants of Effective Demand
According to Keynes, the level of employment in effective demand depends on two factors:
(a) Aggregate supply function, and
(b) Aggregate demand function

44. Aggregate demand function
Aggregate demand function refers to the total expenditure of an economy on goods and services at a given level of employment.
Aggregate demand = Aggregate Expenditure = Consumption Expenditure +
Investment Expenditure

45. Aggregate demand function
1.The essence of aggregate demand function is that the greater the number of workers employed, the larger the output. That is, the aggregate demand price increases as the amount of employment increases, and vice versa.
2. The aggregate demand is different from the demand for a product. The aggregate demand price represents the expected receipts when a given volume of employment is offered to workers.
3. The aggregate demand curve or aggregate demand function represents a schedule of the proceeds of the output produced by different methods of employment.

46. Aggregate Demand Aggregate demand or aggregate demand price
Aggregate demand drawn as a function of employment
Positive relation between level of employment and level of expenditure in the economy.

47. As level of employment increases aggregate demand curve rises but at a diminishing rate, hence the slope of curve diminishes.
AD = f(N)
AD=Sale proceeds expected by entrepreneurs
N = Number of workers employed

48. Aggregate supply function
Aggregate supply drawn as a function of employment.
Aggregate supply refers to the total volume of all goods and services available for consumption and investment.
Money value of all goods and services produced in an economy is known as national output/product.
National product is also the payment made to the four factors of production.

49. Aggregate supply function
The income of factors of production constitutes the expenses incurred by all the firm on various goods and services produced at a given level of employment.
The firm will maintain this level of employment if all of them taken together can earn sufficient income to meet the expenses incurred on the factors of production.

50. Aggregate supply function
The aggregate supply price is positively related to the level of employment.
AS= f(N)
AS = Agg supply price of output
N = Number of workers employed

51. Aggregate Supply Proceeds or income Z N
Z function rises at an increasing rate due to diminishing returns—increasing marginal supply price

52. Positive slope of aggregate supply curve
As marginal costs are positive, aggregate supply curve will slope upward as employment increases.
When employment and output increase less efficient factors of production are bound to be employed. Hence Aggregate supply curve rises steeply as diminishing returns set in.
At full employment level, any increase in costs does not result in extra employment, hence aggregate supply curve becomes vertical.

53. The equilibrium level of employment is where Agg D = Agg S and this may or may not be full employment

54. Equilibrium Employment Level
Income and expenditure Z y*
D = C + I n* N
To proceed Keynes examines the components
of D (C and I) more closely and as a function
of income rather than of employment

55. Comparison between Classical and Keynes’ Theories
Long run and short run
Emphasis on supply and demand
Flows and stocks
Different treatment to Investment and Saving functions
Full employment and Underemployment equilibrium

56. Comparison between Classical and Keynes’ Theories
a) Equilibrium at full employment:
(i) According to classical theory, the economy can only be in a state of equilibrium at full employment level. Any deviation from full employment would be of short period.
(ii) Keynes’ theory is of the viewpoint that an economy can be in equilibrium even at less than full employment level. There is a small possibility of full employment in a country.

57. (c) Aggregates vs. Innumerable decisions:
(b) Macro vs. Micro:
(i) The classical economic theory dealt with individual aspects of the economy, and relates to microeconomics.
(ii) Keynes’ theory relates to macroeconomics which studies the economy as a whole.
(c) Aggregates vs. Innumerable decisions:
(i) The classical economic theory studies the economic system in terms of innumerable decision making units, for example, producers’ equilibrium and consumers’ equilibrium.
(ii) Whereas, the Keynes’ theory deals with aggregates, for example, aggregate supply and aggregate demand.

58. (d) Wages and employment:
(i) Classical economists believed that a state of full employment could be brought about through cuts in money wages.
(ii) According Keynes, lowering wages will reduce the aggregate income and so effective demand which in turn reduce the level of employment in an economy.
(e) Interest:
(i) According to classical theorists, interest is the reward for ‘waiting’ or for time preference.
(ii) According to Keynes, interest is a reward for parting with liquidity.

59. (g) Statics vs. Dynamics:
(f) Rate of interest:
(i) According to classical theory, the rate of interest is determined by the interaction of savings and investment.
(ii) According to Keynesian theory, the rate of interest is determined at different levels of income.
(g) Statics vs. Dynamics:
(i) The classical theory is based on the conception of static economy.
(ii) The Keynesian theory is based on the conception of dynamic economy.

60. (h) Full employment theory vs. General theory:
(i) The classical theory relates only to full employment.
(ii) The Keynesian approach is a general theory which has a very wide application at all situations, i.e., unemployment, partial employment and near full-employment.

61. (i) Theory of money and prices:
(i) The classical economists had segregated the theory of money from the theory of value and output, and dealt with them as if they are unrelated to one another which is actually not the case.
(ii) Keynes’ theory is more realistic. He has integrated the theory of money and prices with the theory of income and employment in the country.

62. j) Budgeting:
(i) Classical economists believed in orthodox finance and balanced budgets.
(ii) According to Keynes’ a country’s budget should reflect the financial situation, and should vary in accordance with the requirements. Keynes has not emphasised on balanced budget, because there are several developing countries with deficit budgets dictated by their economic conditions and requirements.

63. (k) Supply of money:
(i) According to classical economists, increase in money supply would bring about inflation and should be controlled in order to avoid the employment less than full employment.
(ii) Whereas, the Keynes’ theory states that an appropriate increase in money supply would increase employment and output and does not necessarily bring inflation.