Classical Theory of Employment

& Output
• The economic thought of the economists such
as Ricardo, Adam Smith, J.S. Mill, Marshall,
Pigou taken together is termed as classical
economists.
• Classical economists were of the opinion that
there would always be full employment in the
economy.
• Full employment is a situation in which all who
are willing to work at the current wage rate can
get employment without much difficulty.
• If there is unemployment in the economy that
is short lived and is automatically solved by
flexibility in wages, prices ad rate of interest.
Assumptions
• Supply created its own demand. In other
words, aggregate demand is always equal to
aggregate supply.
• There is perfect competition in the labour and
product market.
• Government does not interfere in economic
activities.
• Economy is flexible that prices, wages and rate
of interest are flexible.
• Savings are always equal to investment and
this equality is brought by rate of interest.
• Money is only a medium of exchange.
• Supply of labour is an increasing function of real wage
rate that more labour will be offered at higher wage
rate.
• Demand for labour is a decreasing function of real
wage rate that less labour will be demanded at higher
wage rate.
• There is no change in technology, tastes, expectations
etc.
• There is a closed economy.
• The theory assumes long period
• Law of diminishing marginal returns holds. It means
that as we apply more and more units of labour,
marginal productivity goes on diminishing
Explanation of Theory
• Level of full employment in the economy
depends upon the demand for labour and
supply of labour, given there is perfect
competition in the economy.
• Demand for Labour: Demand for labour in the
entire economy is calculated by the summation
of demand for labour by different production
units in the economy.
• In order to maximise his profits, a rational
producer will employ number of labour upto
the point at which marginal physical productivity
of a worker is equal to his real wage.
• Mathematically:
MPP= W/P
• As more and more workers are employed by a
production unit, MPP goes on decreasing.
Demand for labour curve of production unit
can be derived as below:
• The demand curve is negatively sloped which
implies that more and more labour is
demanded at decreasing real wage rate.
• The demand curve for labour of the economy
as a whole will have a negative slope.
• Supply of Labour: Level of employment and
output in the economy depends upon supply of
labour.
• Supply of labour is positively dependent upon
the real wage rate.
• It means more and more labour is supplied at
higher real wage rate.
• The curve shows that real wage rate and supply
of labour are positively correlated.
Determination of Employment & Output level

• Classicals prove that economy will always be

in equilibrium position at full employment
level.
• Equilibrium is possible only if demand for
labour is equal to supply of labour. It means
that those who are ready to work at the
prevailing wage rate get work.
• Diagram I shows equilibrium in the labour market.
E is the point of equilibrium where demand for
labour is equal to supply of labour.
• If wage rate rises, Supply of Labour> Demand for
Labour, as a result wage rate will have tendency to
fall.
• On the other hand, if wage rate falls, Supply of
Labour<Demand for labour, as a result wage rate
will have tendency to rise.
• Diagram II shows production function.
• It shows the different levels of output
corresponding to different levels of employment,
other factors like capital, technology etc is kept
constant.
• The function has a diminishing slope which
means that marginal physical productivity of
labour goes on decreasing as we employ more
and more labour force.
• Corresponding to Nf full employment level,
output is Yf.
• Classical theory of employment assumes that
there is always sufficient aggregate demand
which results in a state of full employment.
• Any tendency to go away from full employment
is corrected by the flexibility of wages, interest
rate and prices.
• Flexibility of Wages: It is assumed that wages
are completely flexible. If in the economy
supply of labour is more than demand for
labour, real wages will fall. As a result supply of
labour will decrease and demand for labour
will increase. Automatically, both will become
equal. Reverse will happen if demand for
labour is more than supply of labour
• In case wages are rigid, trade unions do not
allow wages to fall. Rigidity of wages results in
unemployment in the economy.
• In diagram I, E is point of equilibrium.
Economy is at full employment level. If trade
unions protest for higher wages (W/P) 1, then
it results in unemployment. As a result output
is also reduced.
• Flexibility in Prices: According to classical
economists, prices are in equilibrium through
automatic forces of demand for good and
supply of good at level of full employment.
• Relationship between money supply and prices
is given by the quantity theory of money.
• According to this theory there is direct and
proportional relationship between money
supply and prices in the economy.
• Mathematically:-
• MV=PQ
• M- money supply in the economy
• V- velocity of money
• P- price level
• Q- total output
• Velocity of money and total output is assumed
to be constant. Change in money supply is
accompanied direct proportionate change in
prices.
• Flexibility in rate of interest: In every economy
production level depends on the level of
investment which in turn depends on savings.
• Savings and investment are always equal in the
economy. This equality between savings and
investment is brought by rate of interest.
• I=f(r) Investment is inverse function of interest
rate.
• S= f(r) Saving is the direct function of interest
rate.
• Changes in the rate of interest makes savings
and investment equal.
• I is the investment curve & S is the saving
curve. Both curves intersect each other at point
E. E is the point of equilibrium. At E point I=S, rE
is equilibrium rate of interest.
• Criticism: Classical model was criticized by
Keynes because of its inapplicability during
great depression of 1930s. Classical model was
criticized on following grounds:
1. Under-employment Equilibrium: Classical
economists were of the view that economy was
always in equilibrium position and this
equilibrium was at full employment level.
• Keynes hold the view that in any economy level of
income and employment will be determined at
point where aggregate demand is equal to
aggregate supply.
• It is not necessary that this equilibrium
corresponds to full employment level. It may be
before full employment level.
2. Wage cut cannot check employment: According
to classicals, rigidity of wages results in
unemployment.
• Keynes argues that unemployment in the economy
was not because of rigidity of wage rate but was
because of shortage of aggregate demand.
• Reduction in the wage rate will reduce the
purchasing power of the workers and hence
aggregate demand in the economy.
• Reduction in wage rate will not increase the
level of employment in the economy but reduce
it.
3. Aggregate Demand Not Always Equal to
Aggregate Supply: Classicals hold that
aggregate demand is always equal to aggregate
supply.
• Keynes argues that aggregate demand is not
always equal to aggregate supply.
• Critics says that humans save part of income.
• This savings act as leakage in aggregate
demand as result it is less than aggregate
supply.
4. Saving Investment Equality: Classicals
suggested that savings and investment were
always equal and this equality is brought by
changes in the rate of interest.
• Keynes argues that savings and investment are
not interest elastic.
• The equality between saving and investment is
brought by changes in the level of income.
• If investment is more than savings, then level of
income rises, savings will rise in the economy. As
a result savings will rise and will become equal
to investment.
• On the other hand, if investment is less than
savings, level of income will fall. As a result
savings will fall and will become equal to
investment.
5. Government Interference is must: According to
classicals, government does not interfere in
economic activities.
• Keynes argues that there is always possibility
• of overproduction and unemployment in the
economy. These problems can be checked by
timely intervention by the government.
• For example, during depression due to low rate
of profitability there is no private investment.
Government should make investment in the
economy which will increase purchasing power
and aggregate demand in the economy.
6. Money is not neutral: Keynes argues that
money perform not only the function of
medium of exchange but also act as store of
value and acts as a link between present and
future.
7. Relationship between Money Supply and
Prices: Classicals hold that there is direct and
proportionate relationship between money
supply and pricelevel.
• Keynes argues that there is no direct and
proportionate relationship between money
supply and prices.
• Money supply affects prices indirectly through
rate of interest.
8. Historically Wrong: History does not support
classical model and it was proved to be
incorrect.
• During 1930s there was world-wide
depression. As a result of which there was
large scale production and unemployment.
The automatic forces of demand and supply
were unable to solve such situation.
Conclusion: Classical model is not totally
useless. Keynesian model has its roots in the
classical model.