UNIT 2- Theories of Output and

Employment
-Shilpa Lalwani
Assistant Professor
JIMS, KALKAJI
The Classical Theory of Output and
Employment
 The classical economists believed in the existence of full
employment in the economy.
 Full employment exists “when everybody who at the running
rate of wages wishes to be employed.”
 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.
 The basis of the classical theory is Say’s Law of Markets i.e.
Supply creates its own Demand.
 Assumptions
 There is the existence of full employment without inflation.
 There is no government interference.
 It is a closed economy without foreign trade.
 There is perfect competition in labour and product markets.
 Wages and prices are perfectly flexible.
 There is perfect information on the part of all market
participants.
 Labour is homogeneous.
 Money wages and real wages are directly related and
proportional.
 Assumptions (Cont.)
 Capital stock and technical knowledge are given.
 The law of diminishing returns operates in production.
 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.
 Savings are automatically invested and equality between the
two is brought about by the rate of interest
 It assumes long run.
 Say’s Law of Markets:
 An early 19th century French Economist, J.B. Say, enunciated the
proposition that “Supply Creates Its Own Demand.”
 When a producer produces goods and pays wages to workers, the
workers, in turn, buy those goods in the market.
 As an increase in supply leads to a simultaneous expansion of market
demand by an amount equal to the income generated.
 Therefore, there cannot be general overproduction and the problem
of unemployment in the economy.
 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
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 an increasing function of the
number of workers. 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 supply of labour is an increasing function of the real wage
rate : SN =f (W/P), where SN is the supply of labour.
 The classical economists regard the demand for labour as the
decreasing 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).
 When the DN and SN curves intersect at point E, the full
employment level NF is determined at the equilibrium real
wage rate W/P0.
 Now at W/P1 wage rate, ds workers will be involuntary
unemployed because the demand for labour (W/P1-d) 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 Nr
 Wage Price Flexibility
 Based on the assumption that there is a direct and proportional
relation between money wages and real wages.
 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. Increased sales will necessitate the employment of more
labour and ultimately full employment will be attained.
 The demand for labour, in turn, depends on the marginal
productivity (MP) of labour which declines as more workers are
employed.
 Since MPN declines as employment increases, it follows that the level
of employment increases as the real wage (W/P) declines.
 If W is the money wage rate, P is the price of the product, and MPN is
the marginal product of labour, we have W=P * MPN
or W/P = MPN
 In Panel (A), SN is the supply curve of labour
and DN is the demand curve for labour. The
intersection of the two curves at E shows the
level of full employment NF and the real wage
W/P0.
 If the real wage rises to W/P1, supply exceeds
the demand for labour by sd and
N1N2 workers are unemployed. It is only when
the wage is reduced to W/P0 that
unemployment disappears and the level of full
employment is attained.
 In Panel (B), Since every worker is paid wages
equal to his marginal product, therefore the
full employment level NF is reached when the
wage rate falls from W/P1 to W/P0.
 Goods Market Equilibrium
 The goods market is in equilibrium when saving equals investment.
 According to the classicists, what is not spent is automatically
invested.
 At that point of time, total demand equals total supply and the
economy is in a state of full employment.
 If there is any divergence between the two, the equality is
maintained through the mechanism of the rate of interest.
 Saving is regarded as an increasing function of the interest rate and
investment as a decreasing function of the rate of interest.
S=f(r) …(1)
I=f(r) …(2)
S=I
 Where S = saving, I = investment, and r = interest rate.
 S is the saving curve and I is the investment curve. Both intersect
at E which is the full employment level where at Or interest rate
S = I.
 Assuming interest rates are perfectly elastic, if at any given
period, investment exceeds saving, (I > S) the rate of interest will
rise.
 If the interest rate rises to Or1,
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.
 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 classicists favoured a flexible price-wage policy to maintain full
employment.
 Keynes’s Criticism of Classical Theory
 Underemployment Equilibrium: He regarded full employment as
a special situation. The general situation in a capitalist economy is one
of underemployment.
 Refutation of Say’s Law: He maintained that all income earned by
the factor owners would not be spent in buying products which they
helped to produce. There will be cases of deficient demand. He argued
that it was demand that created supply. When aggregate demand rises,
to meet that demand, firms produce more and employ more people.
Saving and Investment are distinct functions.
 Role of Government: Self-adjustment not Possible, there is general
deficiency of aggregate demand in relation to aggregate supply which
leads to overproduction and unemployment in the economy. This, in
fact, led to the Great Depression. Keynes favoured state action to
utilise fully the resources of the economy for attaining full
employment.
 Equality of Saving and Investment through Income Changes:
Keynes held that 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.Thus, it is
variations in income rather than in interest rate that bring the equality
between saving and investment.
 Importance of Speculative Demand for Money: The classical
economists believed that money was demanded for transactions and
precautionary purposes.
 Rejection of Quantity Theory of Money: an increase in money
supply, may lead to increase in investment, employment and output if
there are idle resources in the economy and the price level (P) may not
be affected.
 Money not Neutral: Keynes integrated monetary and real sectors of
the economy. For instance, when the quantity of money increases, the
rate of interest falls, investment increases, income and output increase,
demand increases, factor costs and wages increase, relative prices
increase, and ultimately the general price level rises.
 Refutation of Wage-Cut to achieve full employment in
the economy : Keynes never favoured a wage cut policy. When
there is a general wage-cut, the income of the workers is reduced.
As a result, aggregate demand falls leading to a decline in
employment.
 No Direct and Proportionate Relation between Money
and Real Wages: According to Keynes, there is an inverse
relation between the two. The money wage cut will reduce cost of
production and prices by more than the former. Moreover,
institutional resistances to wage and price reductions are so strong
that it is not possible to implement such a policy administratively.
 Long-Run Analysis Unrealistic: Keynes believed that “In the
long-run we are all dead”. The classical theory of employment is
unrealistic and is incapable of solving the present day economic
problems of the capitalist world.
The Keynesian Theory of Income,
Output and Employment
 Keynesian economics was developed during the Great Depression
(1930s). Keynesian theory provided an explanation for the severe
and prolonged unemployment of the 1930s.
 According to Keynes’ theory of income and employment: "In the
short period, level of national income and so of employment is
determined by aggregate demand and aggregate supply in the
country. The equilibrium of national income occurs where
aggregate demand is equal to aggregate supply. This equilibrium is
also called effective demand point".
 Keynes argued that wages and prices were highly inflexible,
particularly in a downward direction. Thus, he did not think
changes in prices and interest rates would direct the economy
back to full employment.
The Keynesian Theory of Income,
Output and Employment
 The Keynesian Theory of Income determination is illustrated
in three different models:
1. A simple economy model or two sector model
2. Closed economy model or three sector model
3. Open economy model or four sector model

 Throughout the three models of income determination,

prices are assumed to remain constant even if aggregate
demand and aggregate supply changes.
Two sector Model:
Aggregate Effective Demand:
 In the Keynesian theory, employment depends upon effective
demand.
 Effective demand is determined by two factors, the aggregate
supply function and the aggregate demand function.
 Effective demand results in output. Output creates
income. Income provides employment.
 The two components of aggregate demand are:
1. Private consumption expenditure and
2. Private investment expenditure.
References:
 http://www.yourarticlelibrary.com/macro-economics/theories-
macro-economics/the-classical-theory-of-employment-
assumption-and-criticism-2/30882/
 http://www.yourarticlelibrary.com/notes/macroeconomics/the
-keynesian-theory-of-income-output-and-employment/31036/
 http://www.economicsdiscussion.net/keynesian-
economics/keynesian-theory-of-income-and-
employment/keynesian-theory-of-income-and-
employment/12705
 http://www.slideshare.net/TejKiran2/keynesian-theory-of-
income-determination