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Classical theory

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Classical theory

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  1. Classical theory

  2. History / system before classical theory : mercantilism

  3. What are the measures taken : ROLE OF GOVERNMENT

  4. Main features of classical theory

  5. How output is determined

  6. Production function

  7. Marginal productivity It is the addition to total output by additional labor. MPn= change in output/ change in labor. slope of production function indicates marginal productivity of labor. As more and more labors are hired, MPn starts falling. Initially it falls but remain positive. But afterwards it become negative.

  8. How the level of employment is determined It is determined by labor demand and labor supply. LABOR DEMAND Labor is demanded by the firms which employ that level of labor that maximize their profit. In the perfect competition, profit is maximized at a level where the marginal cost is equal to the price. MC = P Mc is the cost of producing extra unit. Thus equal to money wage/ MPn

  9. It should equate to price. Thus P = W/ MPn w/p = MPn This equation gives the labor demand curve Real wage

  10. Labor supply REAL WAGE2> REAL WAGE1 24 * REAL WAGE2 24 * REAL WAGE1

  11. Intersection of both the curves determine the equilibrium real wage rate and employment level.

  12. Equilibrium level of output N*

  13. Aggregate supply curve This curve establish a relationship between price and quantity. In an economy if price rises, the firm will try to increase the output. But as we know the supply of labor is constant. Every firm will try to hire more worker , they will increase money wage so as to bid workers away from other firms. Firms which cannot increase the wages lose their workers. This process will continue till money rise in equal proportion to prices. Graphically, Increase in prices leads to rise in labor demand , shifting the Nd rightwards. Also, the real wages falls thus shifting the labor supply backwards.

  14. Real wage Labor supply Labor demand labor Money wage Ls (3 P1) Ls ( 2P1) Ls( P1) Nd* 3 P1 Nd* 2 P1 Nd *P1 labor

  15. Aggregate demand curve it has been derived from Fischer equation Money demand= k p.y where k= 1/v money demand= money supply Ms= k P.Y P= Ms/ kY

  16. Determination of output, labor and wages

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