THE CLASSICAL THEORY OF INCOME, OUTPUT AND EMPLOYMENT

The classical economists believed in the existence of full employment in the economy. According to them, an economy based on laissez-faire principles, is always in the state of equilibrium at full employment. The workers are fully employed at the market wage rate.

There is neither underproduction nor overproduction. The entire market system works automatically and it maintains the economy in equilibrium.

Its Assumptions

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

  • There is the existence of full employment.
  • There is a laissez-faire capitalist economy without government interference.
  • It is a closed economy without foreign trade.
  • There is perfect competition in labor and product markets.
  • Labor is homogeneous.
  • Total output of the economy is divided between consumption and investment expenditures.
  • The quantity of money is given and money is only the medium of exchange.
  • Wages, prices and rate of interest are perfectly flexible.
  • Savings are automatically invested and equality between saving and investment is brought by the rate of interest.
  • The law of diminishing returns operates in production.
  • Money wages and real wages are directly related and proportional.

Classical theory of employment and output is based on the following two basic notions:

  1. Say’s Law of market
  2. Flexibility of wages, and prices.

We explain below these two notions of classical theory.

Say’s Law

Say’s law states that “supply creates its own demand.”

The logic behind this law is that supply of goods itself generates sufficient income to generate a demand equal to the supply of goods.

This law can be explained in the context of both a barter system and a monetized economy.

In a barter economy, people tend to specialize in the production of goods or services which they can produce relatively more efficiently, though they consume many other goods and services.

When they offer their produce in barter for other goods, they create demand for other goods.

Say’s law applies equally well to the monetized economy. Money is used as medium of exchange in a monetized economy.

Producer employ factors of production such as land, labor, capital, and entrepreneur for the production of goods and gives salary to them in the form of wages, interest, rent and profits. Factors of production create demand by spending their money income on the goods they produce,

Thus, supply creates its own demand.

It can be described as follows:

  • Value of Total Production = Cost of Production
  • Cost of Production = Wages + Rent + Profit + Interest
  • Wages + Rent + Profits + Interest = Factor Incomes
  • Factor Incomes = Total Expenditure
  • Total Expenditure = Value of Total Production
  • Total Demand = Total Supply

According to classical economists, the factors which participate in productive activity and earn incomes from it, they spend maximum of their incomes on consumer goods and some part they save. But the savings by the individuals are actually spent on investment. Saving is equal to investment, and it is the rate of interest which makes investment equal to saving. When savings increase, the rate of interest declines and demand for investment rises due to fall in the rate of interest. Thus, savings automatically comes back in the economy in the form of investment expenditure, therefore, income flow continues unchanged and supply goes on creating its own demand.

Thus, 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 goods become equal.

Determination of output and Employment:

In the classical theory, output and employment are determined by the production function and the demand for labor and the supply of labor in the economy.

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 the capital stock, technical knowledge and other factors, a precise relation exists between total output and number of workers.

Q = f (N)

which shows that output is a function of the number of workers. Output increases as the employment of labor rises, but after a point when more workers are employed, diminishing marginal returns to labor start.

In the above diagram, the curve Q = f(N) is the production function and the total output OQ2 corresponds to the full employment level N2. But when more workers N2N3 are employed beyond the full employment level of output OQ2, the increase in output Q2Q3 is less than the increase in employment N2N3.

Pigou Effect on Wage Cut and Full Employment

Pigou expressed the view that if the wage rates were cut down, demand for labor would increase so that all would get employment. It is called Pigou effect or real balance effect. When money wages are reduced, they lead to reduction in cost of production and consequently to the lower prices of products. When prices fall, demand for products will increase and sales will be pushed up. It will increase the demand for labor and ultimately full employment will be attained.

Thus, a fall in wages of labor ensures that all workers will get employment.

According to classical economists, those workers who do not want to work at lower wages and thus remain unemployed are only voluntarily unemployed and are not considered unemployed. All those workers who want to work at the going wage rate determined by market forces will get employment.

Labor Market Equilibrium

According to Pigou, real wage is equal to the marginal product of labor and marginal Productivity diminishes as employment increases, so for the equilibrium position and full employment, it is must that real wage rate should be decreased with the increase in employment.

In the labor market, the demand for labor and the supply of labor both determine the level of output and employment. Producers demand for labor and they will employ labor until the marginal product of labor is equal to the given real wage rate.

Real wage rate is given by nominal wage rate divided by the general price level, that is, real wage rate = W/ P where, W is the nominal or money wage rate and P is the average price level. Thus, a producer will employ so much labor at which W /P = MPN, where MPN is the marginal product of labor.

The level of full employment is determined where labor supply equals labor demand. According to the classical economists specially Pigou, the demand for labor is a decreasing function of the real wage rate:

DN = f (W/P)

where DN = demand for laborW = wage rate and P = price level.

Dividing wage rate (W) by price level (P), we get the real wage rate (W/P).

Supply of labor increases with the rise in wage rate, thus, supply of labor is an increasing function of the real wage rate: SN = f (W/P), where SN is the supply of labor.

In the above diagram, the DN and SN curves intersect at point E, the full employment level NF is determined at the equilibrium real wage rate W/P0. If the wage rate rises from W/P0 to W/P1, the supply of labor will be more than its demand by ds. Consequently, the wage rate will fall from W/P1 to W/P0 due to excess supply. It will again decrease the supply of labor and increase the demand for labor 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 labor will be more than its supply. Excess demand 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.  Since every worker is paid wages equal to its marginal productivity, therefore full employment level NF is reached when wage is reached from W/P1 to W/P0 [shown in Panel B]. Form the diagram it is clear, that the quick changes in the real wage rate upward or downward ensures that neither excess supply of labor, nor excess demand for labor will persist and thus equilibrium will be reached with full employment of labor in the economy.

Determination of Income (Output) and Employment with Saving and Investment:

Say’s law that supply creates its own demand was based on this assumption that entire income earned by the households will be actually spent. Although it is correct that production of output generates an equal amount of income but all income earned by factors/households will not be actually spent on goods and services produced. In fact, households save a part of their income. According to classical economists, money income saved by households will be invested by businessmen, and investment expenditure will be equal to savings done by households. In fact, output produced consists of consumer goods and capital goods. Income earned from production will be partly spent on consumer goods and partly on investment in capital goods. Thus, when investment equals saving at full-employment level of output, supply goes on creating its own demand to maintain full employment.

The goods market is in equilibrium when saving equals investment.

If there is any divergence between the two, the equality is maintained through the mechanism of the rate of interest. Both saving and investment are the functions of the interest rate, S = f[r] Saving is the direct function of rate of interest.

I = f[r] Investment is the indirect function of rate of interest.

S = I.

In the diagram, SS is the saving curve and II is the investment curve. Both intersect at E which is the full employment level where at Or interest rate S = I. If the interest rate rises to Or1, saving is more than investment by ab. Since, S > I, the investment demand for capital being less than its supply, the interest rate will fall to Or, investment will increase and saving will decline. Consequently, S = I equilibrium will be re-established at point E. On the contrary, with a fall in the interest rate from Or to Or2, investment will be more than saving (I > S) by cd, 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 E.

Money Market Equilibrium

According to classical economists, quantity of money determines only the price level of output and in no way affects the real magnitude of savings and investments. 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 total money supply MV equals the total value of output PT in the economy.

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.

Income velocity of money is defined as the number of times a unit of money is used for purchase of final goods and services in a period, say during a year. In classical theory velocity is assumed to be constant.

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 shown in the diagram where the price level is taken on the X axis and the total output on the Y axis. when the output level OQ is given, price level OP is 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. This rise in the price level is exactly proportional to the rise in the quantity of money PP1 = MM1 when the full employment level of output remains OQ.

CLASSICAL AGGREGATE SUPPLY CURVE

Aggregate supply curve describes the relationship between aggregate supply of output with price level. Classical theory regards aggregate supply curve to be perfectly inelastic as the aggregate output (Y) is held constant at full-employment level of output in the short run.

Therefore, aggregate supply curve as a vertical straight line which shows that whatever the price level, aggregate output remains constant.

In the diagram, aggregate expenditure [MV] or aggregate demand (AD) curve which slopes downward to the right.

With aggregate supply curve AS and aggregate demand curve AD1 price level OP1 is determined at E1.

Now, with increase in money supply to M2V, new aggregate demand curve will be AD2. Aggregate demand curve AD2 intersect aggregate supply curve AS at E2, it determines a higher price level OP2.

Thus, in classical theory, aggregate supply of output does not depend on money and prices.

COMPLETE CLASSICAL MODEL

Criticism of classical theory

Keynes in his renowned book ‘General Theory’ severely criticized the classical theory of income and employment on the following bases:

(1) Underemployment Equilibrium: Keynes considered the fundamental classical assumption of full employment equilibrium as unrealistic. According to him, underemployment equilibrium is a normal situation and full employment equilibrium is abnormal. This is so because the capitalist society does not function according to Say’s law, and supply always exceeds its demand. We find millions of workers are prepared to work at the current wage rate, and even below it, but they do not find work.

(2) Refutation of Say’s Law: Keynes refuted Say’s Law of markets that supply always created its own demand. According to Keynes, it was demand that created supply. When aggregate demand rises, firms produce more and employ more people.

(3) Self-adjustment not Possible: Keynes did not agree with the classical view of the laissez-faire policy which believes in an automatic and self-adjusting process of full employment equilibrium. He pointed out that there are two principal classes, the rich and the poor. The rich possess much wealth but they do not spend the whole of it on consumption. The poor don’t have sufficient money to purchase consumption goods. It creates general deficiency in aggregate demand  and brings the gap between aggregate demand and aggregate supply which results overproduction and unemployment in the economy. Keynes, therefore, advocated state intervention for adjusting supply and demand within the economy through fiscal and monetary measures. The state may directly invest to raise the level of economic activity or to encourage private investment. It may pass legislation recognizing trade unions, fixing minimum wages and providing relief to workers through social security measures.

(4) Equality of Saving and Investment through Income Changes: The classical economists believed that the equality between saving and investment was brought about by the mechanism of rate of interest, but according to Keynes, the level of saving depended upon the level of income and not on the rate of interest. Similarly, investment is determined not only by rate of interest but by the marginal efficiency of capital. A low rate of interest cannot increase investment if business expectations are low. If saving exceeds investment, it means people are spending less on consumption. As a result, demand declines. There is overproduction and fall in investment, income, employment and output. It will lead to reduction in saving and ultimately the equality between saving and investment will be attained at a lower level of income. Thus, it is variations in income rather than in interest rate that bring the equality between saving and investment.

(5) Money not Neutral: classical economists believe that money does not affect the economic activities of the markets and is only the medium of exchange. On the other hand, Keynes has given importance to money. According to him, Money is held for income and business motives. Individuals hold money for unforeseen contingencies while businessmen keep cash in reserve for future activities.

(6) Rejection of Quantity Theory of Money: Keynes rejected the classical Quantity Theory of Money on this basis that increase in money supply will not necessarily lead to rise in prices. It is not essential that people may spend all extra money. They may deposit it in the bank. So the velocity of circulation of money (V) may slow down and not remain constant. Thus, V in the equation MV = PT may vary. Instead, an increase in money supply, may lead to increase in investment, employment and output, and the price level (P) may not be affected.

 Keynes proved Pigou’s view that cut in money wages will restore full employment as fallacious- Keynes put forward the view that wages are not only the cost of production, they are also incomes of the workers. When there is a general wage-cut, the income of the workers is reduced and aggregate demand will fall. As a result of decline in aggregate demand, level of production will have to be reduced and less labor will be employed than before. This will create more unemployment rather than reducing it.

From the practical view point, Keynes never favored a wage cut policy.

(8) No Direct and Proportionate Relation between Money and Real Wages:  According to Keynes, there is an inverse relation between the money and real wages. When money wages fall, real wages rise and vice versa. Therefore, a reduction in the money wage would not reduce the real wage, because the money wage cut will reduce cost of production and prices by more than the former. Thus, the classical view that fall in real wages will increase employment breaks down. Keynes, however, believed that employment could be increased more easily through monetary and fiscal measures rather than by reduction in money wage.

(9) Long-Run Analysis Unrealistic: The classicists believed in the long run full employment equilibrium through a self-adjusting process. Keynes had no patience to wait for the long period for he believed that

“In the long-run we are all dead”.

His analysis is confined to short-run phenomena. He neglects long-run influences on demand. Instead, he emphasizes on increasing investment to remove unemployment.

Thus, the classical theory of employment is unrealistic and is incapable of solving the today’s economic problems of the capitalist world.

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