Classical Theory of Income and Employment

1. Classical Theory of Income and Employment

2. Introduction The Theory of Income and employment was propounded by such economists as DavidRicardo, J.B. Say etc. J.B.Says was a classical french economist, Who was a follower of Adam smith, he was of the view that, when a product is created in economy, it creates an immediate demand in the economy equal to its own value. As a result of that demand equals to supply

3. Assumption of the theory- • There is the free market price system. • There is a closed laissez faire capitalist economy. • Wages and prices are flexible. • 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. • Capital stock and technological knowledge are given in the short-run.

4. Classical Model of Employment Production function Y=F(N) Labour supply=real wage rate NS=F(W/P) Labour demand=real wage rate Nd=f(w/p) NS=ND S=F(r) I=F(1/r) S=I

5. Statement of the theory- • The classical theory states that full employment is a normal feature of a capitalist economy. Full employment is defined as a situation in which all those who want to work at the existing rate of wages get work without any undue difficulty. The classical theory rules out the possibility of unemployment in a free market economy. The economy would always be in a full employment equilibrium. According to classical economists there is always full employment in the economy.The classical believed in laissez faire economy.

6. Classical model is explained with the help of four markets of economy.Money marketGood MarketLabour MarketCredit Market

7. J.B Says Law of Good Markets • In barter economy goods produced either for their own use or to exchange for other goods. 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.

8. Money Market • Says law of market is equally valid in a money economy. • In money economy goods and services are produced through out the year by the combination of four factors of production. • They are given rewards in form of rent , interest, wages and profits. These rewards are simply used for purchasing the goods and services. So consumer pay these rewards in the form of prices to the firms for the goods and services purchased. hence AS=AD

9. Labour Market • In this markets we will discuss supply of labour and demand for labour. • Further more demand for labour will be discussed from the from the point of view of single firm as well from economy point of view.

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

11. So the demand for labour is the demand which depend on MPL. • Inverse relationship exist between demand for labour and MPL . • It means that at the higher real wage rate the demand for labour will be low while at lower real wage rate the demand for labour will be high.

12. The relationship show in the diagram MPL MPL>W w1 E w MPL=W w2 MPL<W L2 l1 L labour

13. Aggregate demand for labour • Aggregate demand means demand for labour for all firms. • Negative slope, aggregate demand for labour shows different amount of labour at different demand for labour.

14. W/P Y W W0 DL o DL DL0 X

15. Supply of labour • The individual supply of labour how much works an individuals is willing to offer at different wage rate. • Wage rate is possitive related with supply of labour. • Market supply or aggregate supply means all individuals works willing and able to work.

16. Y ASL ASL=(W/P) W3 W2 Wage rate w1 L1 L2 O L3 X Labour supply

17. Equilibrium in labour market • Equilibrium in labour 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 is cut down the extra cost. So according to classic economist there is self adjustment process in economy so again wage rate tends to decrease an economy come back towards equilibrium.

18. Credit market • According to classical economist at the level of full employment saving is equal to investment. • It is the rate of interest which equalizer the saving and investment is decreasing function of rate of interest.

19. Y I S S>I r1 b a r E Interest rate c r2 d I>S I S o X Saving=Investment

20. If rate of interest increases from equilibrium rate of interest, saving become greater then investment it shows surplus saving. • Credit market is in equilibrium at point E & rate of interest is I. • Similarly if the rated of interest decreases then equilibrium rate of interest then investment become greater then saving.

21. This equality between saving and investment is automatic adjustment process and there is no need of govt. intervention. • Market forces clear the market and there is a full employment prevail in the economy.

22. Why is equilibrium possible at full employment P output S Real wage rate W/P N Labour S D E D S Employment

24. Criticism of classical theory • Possibility of deficiency in effected demanded. • Saving and investment are not interest elastic. • Criticism of flexibility of wages arguments. • Employment can not be increased by gernal money wage cut. • Possibility of under employment equilibrium.