Classical model of Income

determination
 Classical Economics
🠶 Believed in the economy will always operate at full
employment.
🠶 Unemployment would be an unusual exception.
🠶 The term classical economists was invented by Marx as
pointed out by Keynes in his book General Theory of
Employment, Interest and Money.
🠶 Believed that left to themselves, markets would self
correct.
 Classical Economics
🠶 Two assumptions of classical economics:
🠶 1. There is always enough expenditure or aggregate demand
to purchase total production at full employment level of
resources.
🠶 2. Deficiency of aggregate demand will lead to wages
and prices to self adjust so that equilibrium is restored
at full employment
 Classical Economics
🠶 During 1929 when the capitalist economies were in the grip
of great depression, the neoclassical economist A.C. Pigou
suggested the cut in wage rates in order to increase
employment.
🠶 The cause of depression according to him was the trade
unions not allowing the wage cut revisions.
🠶 However, Keynes attributed the decline in private
investments as the primary reason for unemployment and
recession.
 Classical Economics
🠶 Keynes stressed that investment decision were greatly
influenced by how the investors felt about the future.
🠶 He used the term ‘animal spirits’ to refer to the expectations
of the investors.
🠶 He was thus focused on the demand side economics as
against his classical counterparts.
 Classical Economics
🠶 The say’s law of Markets: The classical view that there was no
problem of deficiency of expenditure or demand .
🠶 J.B. Say was the famous French economist.
🠶 Says Law: Supply creates its own demand.
🠶 Assumptions:
1. Savings will be zero, Income = Expenditure
2. No government regulation
3. Economy is closed
4. Prices are flexible
Classical Economics
🠶 Only function of money is to facilitate
an exchange.
🠶 Basically avoid problems faced with
barter economy.
🠶 Hence, the aggregate of demand in all
markets will be accompanied by the
aggregate of supply .
 Classical Economics
🠶 Output and Employment in classical Model:
🠶 The Production function: (Short run Analysis)
🠶 Describes the input and output relationship:
🠶 Y= f (L, K)
🠶 Short run hence, the technology or the capital in production
does not vary.
🠶 The diagram 4.1 depicting Short run Aggregate Production
function
🠶 It is obvious that firm will stop hiring labour once
diminishing returns set in.
 Classical Economics
OUTPUT

Y=f(K,L)
Y2

Y1

LABOUR
L1 L2
 Labour markets in classical theory
🠶 Assumption:
🠶 A. Workers have complete knowledge about prices.
🠶 B. There is flexibility in the wages and prices.
🠶 Demand for labour:
🠶 The profit maximizing firm will increase output till its
🠶 MR= MC.
🠶 MPL= Real Wage
🠶 Individual firm’s demand curve can be summed up to arrive
at aggregate demand curve for labour.
 Labour markets in classical theory
🠶 The short run aggregate demand for labour curve is
downward sloping.
🠶 This indicates that the decrease in real wage rate will lead to
an increase in the aggregate demand for labour.
 Classical Economics
🠶 Supply of Labour:
🠶 Explanation of the diagram:
🠶 1. Indifference curve shows different combinations of income
and leisure which give same level of satisfaction. Higher the
Indifference curve, higher is the level of satisfaction.
🠶 2. Slope of budget line (∆Y/ ∆X) is the (∆Real income/ ∆hours)
shows the real wage rate. Larger the real wage, steeper the
budget line.
🠶 The individual maximizes his utility for a given real
wage.
🠶 He will do so by choosing that particular point on
indifference curve where the budget line is tangential to
the indifference curve.
🠶 At this point, slope of budget line = slope of indifference
curve.
🠶 Which are the three points in the diagram
🠶 Part A of the Diagram
🠶 When the real wage is lowest, the individual is in equilibrium at
point Q working for TL0 and enjoying OL0 leisure.
🠶 As the real wage increases, the working hours increase and
leisure hours go down
🠶 Joining the three points, we arrive at the supply curve for labour.
🠶 The aggregate supply curve for labour can be thus arrived by
summing up horizontally the individual supply curves of
labour.
🠶 The aggregate supply curve of labour can be expressed as
🠶 Ls = Ls (W/P)
🠶 The aggregate supply curve has two characteristics:
🠶 1. The wage is the real wage rate
🠶 2. The curve is positively sloped showing that supply of labour
increases as the real wage rate increases. This relationship
may not exist at some very high wage rate and in that case,
the supply curve of labour may bend backward.
🠶 The Determination of Employment, Real wage and Output.
🠶 The aggregate DD and SS curve for labour can then be used
to determine equilibrium level of output, employment and
real wage rate.
🠶 In the first diagram (Diagram above), aggregate DD and
aggregate supply intersects at point E (equilibrium level of
employment and real wage)
🠶 Classical economists proposed this to be the full employment
level in long run
🠶 Second Diagram (Diagram below) depicts short run
production function.
🠶 Given the equilibrium level of employment at L*, the
corresponding equilibrium level of output can be determined
from the production function at Y* (capital and technology
fixed)
🠶 Hence, in classical economics, the main role in the
determination of output, employment and real wage is
played by the supply side in the labour market.
🠶 Criticisms of the Classical Model:
🠶 1. Keynes argued that the wage price flexibility assumption is
totally unrealistic. In light of the monopoly or other
imperfections in the market structures, this would be a
flawed assumption to make.
🠶 2. Keynes negated the belief of self correcting markets.
Government intervention was argued to be necessary in
times of depression.
🠶 3. Criticized Say’s Law as truism. Debated that it would only
hold in case of barter economy.