JAYOTI VIDYAPEETH WOMEN'S UNIVERSITY,

JAIPUR
Government of Rajasthan established
Through ACT No. 17 of 2008 as per UGC ACT 1956
NAAC Accredited University
Faculty of Education and Methodology
Faculty Name- JV’n Dr. Md Meraj Alam

Program- BA B.Ed 3rd Semester

Course- Macroeconomics

Digital session name – Classical Theory of Employment

Introduction:
John Maynard Keynes in his General Theory of Employment, Interest and Money published
in 1936, made a frontal attack on the classical postulates. He developed a new economics
which brought about a revolution in economic thought and policy.

The General Theory was written against the background of classical thought. By the
“classicists” Keynes meant “the followers of Ricardo, those, that is to say, who adopted and
perfected the theory of Ricardian economics.” They included, in particular, J.S. Mill,
Marshall and Pigou.
Keynes repudiated traditional and orthodox economics which had been built up over a
century and which dominated economic thought and policy before and during the Great
Depression. Since the Keynesian Economics is based on the criticism of classical economics,
it is necessary to know the latter as embodied in the theory of employment.

The Classical theory of Employment.

The classical economists believed in the existence of full employment in the economy. To
them, full employment was a normal situation and any deviation from this regarded as
something abnormal. 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.
Unemployment results from the rigidity in the wage structure and interference in the working
of free market system in the form of trade union legislation, minimum wage legislation etc.
Full employment exists “when everybody who at the running rate of wages wishes to be
employed.”
Those who are not prepared to work at the existing wage rate are not unemployed because
they are voluntarily unemployed. Thus full employment is a situation where there is no
possibility of involuntary unemployment in the sense that people are prepared to work at the
current wage rate but they do not find work.

The basis of the classical theory is Say’s Law of Markets which was carried forward by
classical economists like Marshall and Pigou. They explained the determination of output
and employment divided into individual markets for labour, goods and money. Each market
involves a built-in equilibrium mechanism to ensure full employment in the economy.

Assumptions
The classical theory of output and employment is based on the following assumptions:
 There is the existence of full employment without inflation.
 There is a laissez-faire capitalist economy without government interference.
 It is a closed economy without foreign trade.
 There is perfect competition in labour and product markets.
 Labour 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 and prices are perfectly flexible.
 There is perfect information on the part of all market participants.
 Money wages and real wages are directly related and proportional.
 Savings are automatically invested and equality between the two is brought about by
the rate of interest
 Capital stock and technical knowledge are given.
  The law of diminishing returns operates in production.
 It assumes long run.

Explanations of the theory

The determination of output and employment in the classical theory occurs in labour, goods
and money markets in the economy.
Say’s Law of Markets:
Say’s law of markets is the core of the classical theory of employment. An early 19th century
French Economist, J.B. Say, enunciated the proposition that “supply creates its own
demand.” Therefore, there cannot be general overproduction and the problem of
unemployment in the economy.
If there is general overproduction in the economy, then some labourers may be asked to leave
their jobs. 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.
When a producer produces goods and pays wages to workers, the workers, in turn, buy those
goods in the market. Thus the very act of supplying (producing) goods implies a demand for
them. It is in this way that supply creates its own demand.
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 (AO which shows that output is a
function of the number of workers. Output is an increasing function of the number of
workers, output increases as the employment of labour rises. But after a point when more
workers are employed, diminishing marginal returns to labour start.
This is shown in Fig. 1 where the curve Q = f (N) is the production function and the total
output OQ1 corresponds to the full employment level NF. But when more workers NfN2 are
employed beyond the full employment level of output OQ 1, the increase in output Q1Q2 is
less than the increase in employment N1N2.

Source: Internet

Labour Market Equilibrium:

In the labour market, the demand for labour and the supply of labour determine the level of
output and employment. The classical economists regard the demand for labour as the
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).
The demand for labour is a decreasing function of the real wage rate, as shown by the
downward sloping DN curve in Fig. 2. It is by reducing the real wage rate that more workers
can be employed.
Source: Internet

The supply of labour also depends on the real wage rate: SN =f (W/P), where SN is the supply
of labour. But it is an increasing function of the real wage rate, as shown by the upward
sloping SN curve in Fig. 2. It is by increasing the real wage rate that more workers can be
employed.
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. If the wage rate rises from WP0 to WP1 the supply of
labour will be more than its demand by ds.
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/P 1-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 N r On the contrary, if the wage rate
falls from W/P0 to WP2 the demand for labour (W/P2-d1) will be more than its supply (W/P2-
s1). Competition by employers for workers will raise the wage rate from W/ P 2 to W/P0 and
the equilibrium point E will be restored along with the full employment level NF.

Wage Price Flexibility:

The classical economists believed that there was always full employment in the economy. In
case of unemployment, a general cut in money wages would take the economy to the full
employment level. This argument is 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.
Pigou explains the entire proposition in the equation: N = qY/W. In this equation, N is the
number of workers employed, q is the fraction of income earned as wages, Y is the national
income and W is the money wage rate. N can be increased by a reduction in W. Thus the key
to full employment is a reduction in money wage. When prices fall with the reduction of
money wage, real wage is also reduced in the same proportion.
As explained above, the demand for labour is a decreasing function of the real wage rate. If
W is the money wage rate, P is the price of the product, and MP N is the marginal product of
labour, we have W=P X MPN or W/P = MPN
Since MPN declines as employment increases, it follows that the level of employment
increases as the real wage (W/P) declines. This is explained in Figure 3. In Panel (A), S N is
the supply curve of labour and D N 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/P 0 that unemployment disappears
and the level of full employment is attained.

Source: Internet
This is shown in Panel (B), where MPN is the marginal product of labour curve which slopes
downward as more labour is employed. 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. Contrariwise, with the fall in the wage from W/P 0 to W/P2, the demand
for labour increases more than its supply by s 1d1, the workers demand higher wage. This
leads to the rise in the wage from W/P2 to W/P0 and the full employment level NF is attained.

Goods Market Equilibrium:

The goods market is in equilibrium when saving equals investment. At that point of time,
total demand equals total supply and the economy is in a state of full employment. According
to the classicists, what is not spent is automatically invested.
Thus saving must equal investment. If there is any divergence between the two, the equality
is maintained through the mechanism of the rate of interest. To them, both saving and
investment are the functions of the interest rate.
S=f(r) …(1)
I=f(r) …(2)
S=I

Where S = saving, I = investment, and r = interest rate.

To the classicists, interest is a reward for saving. The higher the rate of interest, the higher
the saving, and lower the investment. On the contrary, the lower the rate of interest, the
higher the demand for investment funds, and lowers the saving. If at any given period,
investment exceeds saving, (I > S) the rate of interest will rise.
Saving will increase and investment will decline till the two are equal at the full employment
level. This is because saving is regarded as an increasing function of the interest rate and
investment as a decreasing function of the rate of interest.
Assuming interest rates are perfectly elastic, the mechanism of the equality between saving
and investment is shown in Figure 4 where 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.
If the interest rate rises to Or1 saving is more than investment by ha which will lead to
unemployment in the economy.
 Source: Internet

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 relation between quantity of money, total output and price level is depicted in Figure 5 where the
price level is taken on the horizontal axis and the total output on the vertical axis. MV is the /money
supply curve which is a rectangular hyperbola.
This is because the equation MV = PT holds on all points of this curve. Given the output level OQ,
there would be only one price level OP 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 M 1V
curve.

Source: Internet
As a result, the price level would rise from OP to OP 1 given the same level of output OQ. This rise in
the price level is exactly proportional to the rise in the quantity of money, i.e., PP 1 = MM1 when the
full employment level of output remains OQ.