23-06-2012, 01:00 PM
Classical Theory of Income and Employment
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Introduction to classical theory
Classical economists : Adam smith, Ricardo, Edge Worth, Pareto, J.B Say and Marshal etc
According to these economists there is always full employment in the economy.
The classical believed in “Laissez-faire Economy”
means a free enterprise economy.
J.B Say (1797-1832) was a classical French economist, who was a follower of Adam smith, he was of the view that, when a product is created in the economy, it creates an immediate demand in the economy equals to its own value. As a result of that demand equals to supply.
This conclusion came to be known as Say`s Law of Market.
The simple statement of the Say`s Law is “ supply creates its own demand”.
The very act of producing goods and services generates an amount of income equal to the value of the goods produced.
According to this, whatever is produced in a free enterprise economy is automatically demanded and over a long period of time when a supply of a good and services increases, the demand for them also increases and vice versa.
Say's Law of Markets
Say's law of markets is the core of the classical theory of employment. He enunciated the proposition that "Supply creates its own demand".
Production creates market (Demand) for goods
Barter system at its basis
General over-production impossible
Saving Investment Equality
Rate of interest as a determinant factor
Labour Market
Saving-Investment Equality
There is a serious omission in Say’s Law. If the recipients of income in this simple model save a portion of their income, consumption expenditure will fall short of total output and supply would no longer create its own demand.
Consequently there would be unsold goods, falling prices, reduction of production, unemployment and falling incomes.
However, the classical economists ruled out this possibility because they believed that whatever is saved by households will be invested by firms. That is, investment would occur to fill any consumption gap caused by savings leakage.
Thus, Say’s Law will hold and the level of national income and employment will remain unaffected.
Saving-Investment Equality in the Money Market
The classical economists also argued that capitalism contained a very special market – the money market – which would ensure saving investment equality and thus would guarantee full employment.
According to them the rate of interest was determined by the demand for and supply of capital.
The demand for capital is investment and its supply is saving. The equilibrium rate of interest is determined by the saving-investment equality. Any imbalance between saving and investment would be corrected by the rate of interest. If saving exceeds investment, the rate of interest will fall. This will stimulate investment and the process will continue until the equality is restored. The converse is also true.
Price Flexibility
The classical economists further believed that even if the rate of interest fails to equate saving and investment, any resulting decline in total spending would be neutralized by proportionate decline in the price level. That is, Rs 100 will buy two shirts at Rs 50, but Rs 50 will also buy two shirts if the price falls to Rs 25. Therefore, if households saves more than firms would invest, the resulting fall in spending would not lead to decline in real output, real income and the level of employment provided product prices also fall in the same proportion.
Wage Flexibility
The classical economists also believed that a decline in product demand would lead to a fall in the demand for labour resulting in unemployment. However, the wage rate would also fall and competition among unemployed workers would force them to accept lower wages rather than remain unemployed. The process will continue until the wage rate falls enough to clear the labour market. So a new lower equilibrium wage rate will be established. Thus, involuntary unemployment was logical impossibility in the classical model.
Classical Theory of Employment
Basic Assumptions
There is the free market price system.
There is a closed laissez faire capitalist economy.
Wages and prices are flexible.
A barter model of money – "products are paid for with products;"
Flexible prices – all prices can rapidly adjust upwards or downwards;
No government intervention.
Basic Assumptions
Capital stock and technological knowledge are given in the short-run.
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.
Propositions and its implications of the Say's law.
Full employment in the Economy
Proper Utilization of Resources
Perfect Competition
Laissez-faire Policy
Saving as a social virtue
Explanation of classical model in various markets
Classical model is explained with the help of four markets of economy.
Money market
Good market
Credit market
Labor market
J.B say Law of Market
1 J.B say Law in Goods Market
In barter economy goods produced either for their own use or to exchange for other good. 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.
J.B say Law of Markets (cont….)
For example one person produces wheat, while other produce cloth they will exchange the products with one another so nothing remain unsold and no producer will face losses, as a result there will be no unemployment.
Say’s law of market 2 money market
Say law of market is equally valid in a money economy
In money economy goods and services are produced throughout the year by the combination of four factors of production. They are given reward in form of rent, interest, wages and profit. These rewards are simply used for purchasing the goods and services . So consumer pay back these rewards in the form of prices to the firms for the goods and services purchased.
conclusion
Hence aggregate supply= aggregate demand.
So no question for over and under production and similarly no unemployment.
Labor market in classical model
In this market we will discuss supply of labor and demand for labor.
Furthermore demand for labor will be discussed from the point of view of single firm as well from economy point of view.
Demand for labor by a single firm:
We know that a firm will hire labor unless and until the value of labor is equal to wage of labor.
The above condition for hiring labor is profit maximizing condition for the firm demanding labor.
So demand for labor is the demand which depends on MPL.
Inverse relationship exist between demand for labor and MPL.
It means that at higher real wage rate(w*) the demand for labor will be low, while at lower real wage rate the demand for labor will be high.
Explanation of graph
A firm will not employ OL1 units of labor as here MPL >W2, as a result it will increase the employment of labor.
Similarly a firm will not be interested to demand OL3 units of labor, as here MPL < W2.
Thus a firm will be in equilibrium at OL2 where MPL= W2
Labor market in classical model (cont….)
Aggregate demand for labor
Aggregate demand means demand for labor by all firms.
Negative slope, ADL shows different amounts of labor at different wage rates
Supply of labor
The individual supply of labor shows how much work an individual is willing to offer at different wage rate.
Wage rate is positive related with supply of labor.
Market supply or aggregate supply means all individual workers willing and able to work.
Equilibrium in labor market
Equilibrium in labor 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 to cut down the extra cost. So according to classical economist there is self adjustment process in economy so again wage rate tends to decrease and economy come back towards equilibrium.
Equilibrium in labor market cont`d
Similarly if wage rate decreases, it will create an an excess demand for labor, this will lead to increase in wages and economy once again come towards equilibrium.