INSTITUTE –University School of

Business
DEPARTMENT -Management
M.B.A
Managerial Economics (24BAT-605)
Faculty Name : Dr. Akriti Gupta(Assistant Professor)

Lecture 3.2.1 DISCOVER . LEARN . EMPOWER

Classical theory of
Employment
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 COURSE OBJECTIVES

• To integrate economic theory with business practice and highlight the application of
economic theory for business decision making.

• To learn how economics analysis can be used in formulating business policies and take
rational managerial decisions.

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 • Space for
visual (size
24)
Classical Theory
of Employment
Course Outcome
CO Title Level Will be covered in this
Number lecture
CO4 Evaluate the methods of Evaluate
measurement of national income
and its impact on the economy.

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 Classical Theory
• 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. the tendency of the economic systems is to automatically provide full
employment.
• Theory of Classical economics can trace its roots to Adam Smith in 1776. In The Wealth of
Nations Adam Smith presented a comprehensive analysis of economic phenomena based on
the notions of free markets and actions guided by individual self interests in a laissez
faire environment.

Source : www.slideshare.net
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• 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.

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Assumptions:
Source : www.slideshare.net

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1. There is the existence of full employment without inflation.

2. There is a laissez-faire capitalist economy without government interference.

3. It is a closed economy without foreign trade.

4. There is perfect competition in labour and product markets.

5. Labour is homogeneous.

6. Total output of the economy is divided between consumption and investment expenditures.

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7. The quantity of money is given and money is only the medium of exchange.

8. Wages and prices are perfectly flexible.

9. There is perfect information on the part of all market participants.

10. Savings are automatically invested and equality between the two is brought about by the
rate of interest

11. It Assumes Long Run

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Say’s law of Market

• According to Says Law, when an economy produces a certain level of real GDP, it also
generates the income needed to purchase that level of real GDP. In other words, the economy
is always capable of demanding all of the output that its workers and firms choose to produce.
Hence, the economy is always capable of achieving the natural level of real GDP.
• Say’s law of market “Supply creates its own demand”
• Production creates demand for goods
• General over production is impossible
• Saving investment equality
• Rate of interest as determinant factor
• Labour market

Source : www.economicsdiscussion.com
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Say’s law of Market

• 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.

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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 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.

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• 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 N F. 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 N 1N2.

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Source : www.economicsdiscussion.com 13
Source : www.marketbusinessnews.com 14
Say’s law in Barter Economy

• Say’s law hold true for most of the cases in a barter system. In a traditional barter system,
goods and commodities are consumed either for consumption or for exchange with some other
goods. Supply of a commodity is possible only if there is a demand for it.

• For instance, a person producing goods in excess should find another person in the market
who is searching for that good. This applies to all the other producers and consumers in the
economy. So, in a barter economy, products are exchanged for products, and supply creates in
own demand.
• Moreover, people in a barter economy are self-employed which means that involuntary
unemployment doesn’t exist. Production is carried out in small scale and any earnings made
from the sale of the produced goods are invested in the business itself.

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Say’s Law in Money Economy

• Say’s law remains valid even in the money economy because classical economists view
money only as a medium of exchange with no active role in influencing the real sector of the
economy.
• In a money economy, the purchase and sale of goods and services is made possible by money.
People use money only as an easy and reliable source of exchange. The earnings made after
selling a product are used for the purchase of other necessary goods rather than for hoarding or
saving. However, not all money earned is spent as soon as it is earned. It is only a medium that
bridges the gap between receipts and payments.
• Further, classical economists did not consider saving as bad thing. Rather, they saw it as a way
through which investment could be increased in the economy. They believed that the
disequilibrium between saving and investment will lead to a decline in the interest rates. This
will discourage saving and encourage investment. The interest rates would continue to fall till
the level where equilibrium is gained and there are no un-invested savings among households.

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Criticism of Say’s Law

1. Supply does not create its Demand

Say‘s law assumes that production creates market for goods. Therefore, supply creates its own
demand. But this proposition is not applicable to modern economics where demand does not
increase as much as production increases. It is also not possible to consume only those goods
which are produced within the economy.

2. Unrealistic Assumptions of Full Employment

According to Keynes, the basic assumption of full employment itself is unrealistic. An
economy can be in a state of equilibrium. In under employment situation also full employment
equilibrium is just one possible equilibrium condition according to Keynes.

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3. Self-Adjustment not Possible
According to Say‘s Law, full employment is maintained by an automatic and self adjustment
mechanism in the long run. But Keynes had no patience to wait for the long period for he
believed that “In the long run we are all dead”. It is not the automatic adjustment process which
removes unemployment. But unemployment can be removed by increase in the rate of
investment.

4. Money is not Neutral

Say‘s Law of market is based on a barter system and ignores the role of money in the system.
Say believes that money does not affect the economic activities of the market. Conversely,
Keynes has given due importance to money. He regards money as a medium of exchange.
Money is held for income and business motives. Individuals hold money for unforeseen
contingencies while businessmen keep cash in reserve for future activities.

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5. Over Production is Possible
Say‘s Law is based on the proposition that supply creates its own demand and there cannot be
general over production. But Keynes does not agree with this proposition. According to him, all
income accruing to factors of production is not spent but some fraction out of it is saved which
is not automatically invested. Therefore, saving and investment are always not equal and it
becomes the problem of overproduction and unemployment.

6. Underemployment Situation
Keynes regards full employment as a special case for the reason that there is underemployment
in capitalist economies. This is since the capitalist economies do not function according to Say‘s
Law and supply always exceeds its demand. For example millions of workers are prepared to
work at the current wage rate and even below it, but they do not find work.

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7. State Intervention
Say‘s Law is based on the existence of laissez faire policy. But Keynes has highlighted the need
for state intervention in the case of general overproduction and mass unemployment. Laissez
faire, in fact led to the Great Depression, had the capitalist system been automatic and self
adjusting. This would not have occurred. Keynes therefore advocated state intervention for
adjusting supply and demand within the economy through fiscal and monetary measures

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 Summary

• Classical economists believed that full employment prevailed in the economy through wage
and price adjustments, and any deviation from the phenomena was considered to be an
abnormal event. In order to understand the classical view of employment, Say’s law of market
should be analysed.
• Say’s law of market, named after the proprietor Jean Baptiste Say, is a classical economic idea
which states that supply creates its own demand. The law views that aggregate output
produced generates aggregate demand at the same level, and argues that prices and wages are
flexible and maintain an equilibrium state in a self-regulating economy.

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References

• T1: Pindyck, Robert and Rubinfeld, Daniel (2017), Microeconomics, 8 th Edition, Pearson
Publication
• T2: Varian, R and Hal, J (2014), Intermediate Microeconomics, 8th Edition, East-West Press.
• T3: Dwivedi, D.N, (2015), Macroeconomics – Theory and Policy, 4th edition, Tata McGraw
Hill Publications.
• REFERENCE BOOKS
•
• R1: William J. Baumol, Alan S. Blinder, (2016), Micro Economics – Principles and policy,
13th edition, Cengage Learnings
• R2: Mankiw, Gregory N, (2014), Principles of Macroeconomics, 8th edition, Cengage
Learning.

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• Web Link
https://www.cliffsnotes.com/study-guides/economics/classical-and-keynesian-theories-output-
employment/the-classical-theory

• Video Link

https://www.youtube.com/watch?v=tZvjh1dxz08

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THANK YOU