Classical Economics

The classical economists took full employment for granted, believed in the automatic
adjustment of the economy, and, therefore, felt no need to present a proper theory of
employment. Keynesian theory of employment was a reaction against the classical economics.
Keynes found that the classical economics provided no solution to the actually prevailing
problem of wide-spread unemployment during the Great Depression of 1930s. This led him to
develop a systematic theory of employment, explaining the phenomenon of unemployment and
suggesting the remedial measures.
By the classical economists, Keynes meant “the followers of Ricardo, those, that is to say, who
adopted and perfected the theory of the Ricardian economics, including (for example) J.S. Mill,
Marshall, Edgeworth and Prof. Pigou.”
Propositions of Classical Theory of Employment:
The main propositions of the classical theory of employment are given below:
(i) Full employment is a normal feature of a capitalist economy.
(ii) Full employment means absence of involuntary unemployment. Even at full employment,
there may exist, voluntary unemployment, frictional unemployment, seasonal unemployment,
structural unemployment or technical unemployment.
(iii) The economy attains equilibrium only at full employment.
(iv) General unemployment or general overproduction is not possible.
(v) Under conditions of perfect competition, flexibility of wages tends to establish full
employment. Reduction in wages can increase employment.
(vi) The government should not interfere in the automatic working of the economic system and
should follow the policy of laissez faire.
(vii) People spend their entire income either on consumption or on investment.
(viii) Interest rate flexibility establishes equality between saving and investment.
Assumptions of the Theory:
The classical theory of employment is based on the following assumptions:
(i) Individuals are rational human beings and are motivated by self-interest.
(ii) Perfect competition exists both in product market and factor market.
(iii) Individuals do not suffer from money illusion.
(iv) Laissez-faire condition prevails, i.e., government does not interfere in the economic
activities,
(v) There is closed economy which has no international trade relations,
(vi) Techniques of production and business organisation do not change.
(vii) Money is only a medium of exchange.
Assumption of Full Employment:
Classical theory is based on the assumption of full employment of labour and other resources
of the economy. The classical economists believed in the stable equilibrium at full employment
level as a normal situation. If there is not full employment in the actual life, then there is always
a tendency towards full employment. Less-than-full employment is an abnormal situation
which will disappear in the long run through automatic mechanism of the economic system.
The situation of full employment is consistent with the prevalence of certain amount of
voluntary unemployment. Voluntary unemployment arises when the workers refuse to accept
the going wage rate. Thus, by full employment, the classical economists mean the nonexistence
of involuntary unemployment. In the words of Prof. A.P. Lerner, “Full employment is a
situation in which all those who want to work at the existing rate of wage get work without any
undue difficulty.”

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Similarly, the classical economists also considered frictional unemployment as consistent with
their assumption of full employment. Frictional unemployment is a temporary phenomenon
which arises due to the imperfections in the labour market, such as, ignorance of job
opportunities, immobility of labour, seasonal nature of work, shortage of raw materials,
breakdowns of machinery, etc.
In short, when the classical economists assume full employment, they mean to say- (a) that
involuntary unemployment does not exist; (b) that there is a possibility of some amount of
frictional unemployment, and (c) that such frictional unemployment will disappear in the long
run i.e., there is always a tendency towards full employment.

Say’s Law of Markets:

Say’s law of markets provides justification to the assumption of full employment. Say’s law in
its simplest form means that supply creates its own demand. In a barter economy, a good is
produced with a purpose of exchanging it for another good. Thus, additional supply represents
additional demand.
In a money economy, money serves as medium of exchange. When a factor of production (say
labour) is employed, it results in the production of commodities on the one hand and generates
income (in the form of payments of the factor of production) on the other.
The income received is spent in the market on the purchase of goods. Thus, the employment
of a factor of production pays its own way because it increases income by an amount equal (in
equilibrium conditions) to the amount taken out of the income stream by way of selling its
products.
Hence, Say’s law, which rules out the possibility of general over-production and general
unemployment, applies both in barter as well as in a money economy.

Faith in Policy of Laissez-Faire:

Full employment is assured through the policy of laissez-faire or government non-intervention.
Whenever there exists involuntary unemployment, it is due to the interference with the free
working of the competitive system. Such interference can be in the form of action by trade
unions to raise wages, unemployment insurance, minimum wage legislation, etc. Remove these
obstructions, allow the natural working of the economic system, and the unemployment will
automatically end.

Explanation of Classical Theory of Employment:

The classical theory of employment is based on the assumption of flexibility of wages, interest
and prices. This means that wage rate, interest rate and price level change in their respective
markets according to the forces of demand and supply. Changes in these variables
automatically adjust the economic system in such a way as to ensure full employment.
The working of self- regulating mechanism under the classical system can be understood in the
three markets of the economy.
1. Labour market,
2. Product market, and
3. Money market.

1. Labour Market:
According to the classical theory of employment, other things being constant, wage rate
flexibility assures that, in a competitive market, full employment is provided and full
employment output is produced.

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Real wage rate is determined by the forces of demand and supply in the labour market. Demand
for labour is a negative function of real wage rate; demand for labour increases with a fall in
the real wage rate and decreases with a rise in the real wage rate.
Supply of labour is a positive function of real wage rate; supply of labour increases with a rise
in the real wage rate and decreases with a fall in the real wage rate. Real wage rate is determined
at the level where demand for labour and supply of labour are equal. This level also represents
full employment equilibrium level.
If there exists some unemployment, the unemployed will compete for jobs and the real wage
rate will fall. A fall in the real wage rate will lead to an increase in the demand for labour and
decrease in the supply of labour. This will remove unemployment. Thus, flexibility of real
wage rate ensures full employment.
According to the classical theory, unemployment is the result of rigidity of wage structure and
interference in the automatic working of the labour market. When government intervenes by
recognising trade unions, passing minimum wage legislation, etc., and labour adopts
monopolistic behaviour, wages are pushed up which lead to unemployment.
Only flexibility of wages, under the conditions of perfect competition, can ensure full
employment. In the words of Pigou, “With perfectly free competition…. there will be at work
a strong tendency for wage rates to be related to the demand that everybody is employed.”

2. Production Function:

Product Market:
Maintenance of full employment level, according to Say’s law, requires that the whole of the
income generated at full employment level must be spent on the purchase of the whole of the
output produced at that level. Total output comprises of consumer goods (C) and investment
goods (I).
Again, total income is partly spent on consumer goods (C) and partly saved (S). Hence, the
part of income which is not consumed (i.e. S) must be spent on investment goods.
Thus, saving-investment equality (S = I) gives the market clearing condition in the product
market at full employment level. It assures that whole of full employment output in the product
market will be purchased.
Or, in other words, if saving plans by the households are equal to investment plans by
businesses, neither unemployment (overproduction) nor inflation (underproduction) will result.
According to the classical economists, equality between saving and investment is brought about
through interest rate flexibility. Saving is a positive function of rate of interest; saving will be
more at higher interest rate and less at lower interest rate.
Investment is a negative function of interest rate; investment increases at low interest rate and
decreases at higher interest rate. The equilibrium rate of interest is determined at the level where
saving and investment are equal.
At this level whole of the full employment output is purchased. If saving exceeds investment,
the rate of interest will fall. This will discourage saving and encourage investment, thus making
saving and investment once again equal.

4. Money Market:
Irving Fisher’s equation of exchange, MV= PY, states that total expenditure on final goods and
services (MV) is equal to total value of output (PY). According to the classical economists, the
long- run rate of output of final goods and services (Y) remains constant at full employment
level.
They also assume that velocity of money (V) is stable because the payment habits of the people
change very slowly. Thus, Y and V being constant, the price level (P) is determined by the

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supply of money (M) and there is a direct relationship between M and P; changes in the money
supply lead to proportional changes in the price level.

Classical Model of Employment:

The classical theory of employment can be summarises in equation model given below:
Product Market:

1. S=S(i) Saving Function

2. I=I(i) Investment Function
3. S=I Product Market Clearing Condition
4. S=Y-C Definition of Saving
5. Y=f(N) Production Function
Labour Market
6.DL=f,= F(W/P) Labour Demand Function
7.SL=N= F(W/P) Labour Supply Function
8. DL=SL Labour Market Clearing Condition

Money Market
9. Md=L1=kY Money demand function
10. Md=Ms Money market Clearing Condition

The description of the various equations in the model is as follows:

1. Saving (S) is an increasing function of rate of interest (i).
2. Investment (I) is a decreasing function of rate of interest (i).
3. Saving equal to investment (S = I) gives the market clearing condition in the product market.
4. Saving (S) is equal to total income (Y) minus consumption expenditure (C).
5. Total output (Y) is the function of number of workers employed (N). It is subject to the law
of diminishing marginal returns.
6. Demand for labour (D1) is a decreasing function of real wage (W/P).
7. Supply of labour (SL) is positive function of real wage (W/P).
8. Demand for labour equal to supply of labour (DL = SL) gives the market clearing condition
in the labour market.
9. People demand money (Md) for transactions and precautionary purposes (LI) and demand
for these purposes is a function of income (Y).
10. Demand for money equal to supply of money (Md = Ms) gives the market condition in the
money market.
11. Wage rate, interest rate and the price level are determined in their respective markets
through the equality of demand and supply forces.
12. Flexibility of wages, interest rate and prices ensures full employment equilibrium in the
economy in the long run.