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The classical economists believed in the existence of full employment in the economy. To them, full employment was a normal situation and any deviation from this regarded as something abnormal. According to Pigou, the tendency of the economic system is to automatically provide full employment in the labour market when the demand and supply of labour are equal. Unemployment results from the rigidity in the wage structure and interference in the working of free market system in the form of trade union legislation, minimum wage legislation etc. Full employment exists “when everybody who at the running rate of wages wishes to be employed. “Those who are not prepared to work at the existing wage rate are not unemployed because they are voluntarily unemployed. Thus full employment is a situation where there is no possibility of involuntary unemployment in the sense that people are prepared to work at the current wage rate but they do not find work.

The basis of the classical theory is Say’s Law of Markets which was carried forward by classical economists like Marshall and Pigou. They explained the determination of output and employment divided into individual markets for labour, goods and money. Each market involves a built-in equilibrium mechanism to ensure full employment in the economy.

Assumptions

The classical theory of output and employment is based on the following assumptions :

  1. There is the existence of full employment without inflation.
  2. There is a laissez-faire capitalist economy without government interference.
  3. There exists closed economy without foreign trade.
  4. There is perfect competition in labour and product markets.
  5. Labour is homogeneous.
  6. Total output of the economy is divided between consumption and investment expenditures.
  7. The quantity of money is given and money is only the medium of exchange.
  8. Wages and prices are perfectly flexible.
  9. There is perfect information on the part of all market participants.
  10. Money wages and real wages are directly related and proportional.
  11. Savings are automatically invested and equality between the two is brought about by the rate of interest
  12. Capital stock and technical knowledge are given.
  13. The law of diminishing returns operates in production.
  14. It assumes long run.

Explanation

Given these assumptions, the determination of output and employment in the classical theory occurs in labour, goods and money markets in the economy.

Say’s Law of Markets

Say’s law of markets is the core of the classical theory of employment. An early 19th century French Economist, J.B. Say, enunciated the proposition that “supply creates its own demand.” Therefore, there cannot be general overproduction and the problem of unemployment in the economy. If there is general overproduction in the economy, then some labourers may be asked to leave their jobs. The problem of unemployment arises in the economy in the short run. In the long run, the economy will automatically tend toward full employment when the demand and supply of good become equal. When a producer produces goods and pays wages to workers, the workers, in turn, buy those goods in the market. Thus the very act of supplying (producing) goods implies a demand for them. It is in this way that supply creates its own demand.

Determination of output and Employment

In the classical theory, output and employment are determined by the production function and the demand for labour and the supply of labour in the economy. Given the capital stock, technical knowledge and other factors, a precise relation exists between total output and amount of employment, i.e., number of workers. This is shown in the form of the following production function:

Q = f(K,T,N)

where, total output (Q) is a function (f) of capital stock (K), technical knowledge (T), and the number of workers (N)

Given K and T, the production function becomes Q = f (N) which shows that output is a function of the number of workers. Output is an increasing function of the number of workers , output increases as the employment of labour rises. But after a point when , more workers are employed , diminishing marginal returns to labour start.

Labour Market Equilibrium

In the labour market, the demand for labour and the supply of labour determine the level of output and employment. The classical economists regard the demand for labour as the function of the real wage rate:

DN = f(W/P)

where DN= demand for labour, W = wage rate and P = price level.

Dividing wage rate (W) by price level (P), we get

the real wage rate (W/P).

The demand for labour is a decreasing function of the real wage rate, as shown by the downward sloping DN curve in Fig. 1. It is by reducing the real wage rate that more workers can be employed.

FIGURE 1

The supply of labour also depends on the real wage rate : SN = f (W/P),where SN is the supply of labour. But it is an increasing function of the real wage rate, as shown by the upward sloping SN curve in Fig. 1. It is by increasing the real wage rate that more workers can be employed.

When DN &SN curves intersect at E , the full employment level at NF is determined at the equilibrium real wage rate W/P0. If the wage rate rises from WP0 to WP1, the supply of labour will be more than its demand by ds. Now at W/P1 wage rate, ds workers will be involuntary unemployed because the demand for labour is less than their supply W/P1-s . With competition among workers for work, they will be willing to accept a lower wage rate.

Consequently, the wage rate will fall from W/P1 to W/P0 . The supply of labour will fall and the demand for labour will rise and the equilibrium point E will be restored along with the full employment level NF. On the contrary, if the wage rate falls from W/P0 to WP2 the demand for labour (W/P2-d1) will be more than its supply (W/P2-s1). Competition by employers for workers will raise the wage rate from W/P2 to W/P0 and the equilibrium point E will be restored along with the full employment level NF.

Goods Market Equilibrium

The goods market is in equilibrium when saving equals investment. At that point of time, total demand equals total supply and the economy is in a state of full employment . According to the classicals what is not spent is automatically invested . Thus saving must equal investment. If there is any divergence between the two, the equality is maintained through the mechanism of the rate of interest. To them, both saving and investment are the functions of the interest rate.

FIGURE 2

To the classicists, interest is a reward for saving. The higher the rate of interest, the higher the saving, and lower the investment. On the contrary, the lower the rate of interest, the higher the demand for investment funds, and lower the saving. If at any given period, investment exceeds saving, (I>S) the rate of interest will rise. Saving will increase and investment will decline till the two are equal at the full employment level. This is because saving is regarded as an increasing function of the interest rate and investment as a decreasing function of the rate of interest.

Assuming interest rates are perfectly elastic, the mechanism of the equality between saving and investment. If the interest rate rises, saving is more than investment which will lead to unemployment in the economy. Since S > I, the investment demand for capital being less than its supply, the interest rate will fall ,investment will increase and saving will decline. Consequently, S = I equilibrium will be re-established . On the contrary, with a fall in the interest rate, investment will be more than saving (I > S) , the demand for capital will be more than its supply. The interest rate will rise, saving will increase and investment will decline.Ultimately, S = I equilibrium will be restored at the full employment level.

Money Market Equilibrium

The money market equilibrium in the classical theory is based on the Quantity Theory of Money which states that the general price level (P) in the economy depends on the supply of money (M). The equation is MV =PT, where M = supply of money, V = velocity of circulation of M, P =Price level, and T = volume of transaction or total output.

The equation tells that the total money supply MV equals the total value of output PT in the economy. Assuming V and T to be constant, a change in the supply of money (M) causes a proportional change in the price level (P). Thus the price level is a function of the money supply : P = f (M).

The relation between quantity of money, total output and price level is depicted in Figure 3 where the price level is taken on the horizontal axis and the total output on the vertical axis. MV is the money supply curve which is a rectangular hyperbola. This is because the equation MV = PT holds on all points of this curve. Given the output level OQ, there would be only one price level OP consistent with the quantity of money, as shown by point M on the MV curve. If the quantity of money increases,the MV curve will shift to the right as M1V curve. As a result, the price level would rise from OP to OP1, given the same level of output OQ.

The MV curve will shift to the right as M1V curve. As a result, the price level would rise from OP to OP1, given the same level of output OQ.

This rise in the price level is exactly proportional to the rise in the quantity of money, i.e., PP1 = MM1 when the full employment level of output remains OQ.

FIGURE 3

 

Criticism of Classical Theory

The classical theory of employment is criticized on the following grounds:



(1)    Equilibrium Level need not be full Employment Level. At the equilibrium level, it is not necessary that full employment may be attained. Aggregate demand may be equal to aggregate supply at less than full employment level. Keynes calls it ‘under-employment equilibrium’. He points out that all the factor income generated during the process of production need not be spent of consumption. A part of the factor income may be saved. Unless the investors are willing to invest an amount equivalent to the amount of saving, the total expenditure will not be equal to total output available for sale. In such a situation, producers will not sell their entire output. Consequently, the profit will fall and the producers will be compelled to reduce their output which will create unemployment.


(2)    Rate of Interest is not the true Determinant of Saving and Investment. In the classical system, both saving and investment are the functions of the rate of interest, and therefore, equality between saving and investment can be attained through changes in the rate of Interest. Prof. Keynes says that decisions about saving and investment are taken by the two fundamentally different groups of people. Saving is not only determined by the rate of interest but also by the level of money income. Likewise, investment is not influenced by the rate of interest alone, it also depends upon the marginal efficiency of capital.



(3)    Theory is applicable only in the long run. Full employment equilibrium in the classical system is attained in the long run. But, according to prof. Keynes, “in the long run we are all dead, and after death, there is no economic or non-economic problem. “Most of our problems arise in the short run (particularly the problem of employment) and their solutions must also be found in the short run. If unemployed workers are assured good jobs after three years, the questions arises that how will they survive for three years.


(4)    Employment and output are not eh function of wage rate. Classical thinkers believed that the level of employment and income can be raised by curtailing the wage rate. But, according to Keynes, employment is not a function of wage rate but of effective demand. Curtailment of wage rate brings a fall in aggregate demand, it will discourage investment, as a result, the level of output and employment will decrease.


(5)    Existence of over-production or under-production cannot be overruled. The classical assumption of no general glut (over-production) or under-production labour force was rendered unemployed in the USA. The producers found it difficult to sell off all their output and there was general glut in the economy.


(6)    Full employment is not a normal situation. The classical assumption of full employment as a normal situation is also unreal. According to Keynes, unemployment is a general situation and full employment is a rare exception. Full employment is an ideal situation which can rarely be attained by an economy.

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