Classical Theory of National Income Determination Unit-3

UNIT 3:CLASSICAL THEORY OF NATIONAL

INCOME DETERMINATION
UNIT STRUCTURE
3.1 Learning Objectives
3.2 Introduction
3.3 Say's Law of Market
3.3.1 Say's Law of Market: Important Facts
3.3.2 Say's Law of Market: Its Propositions and Implications
3.4 The Classical Theory of Employment and Income
3.4.1 Assumptions
3.4.2 Aggregate Production Function
3.4.3 Demand Function for Labour
3.4.4 Supply Function for Labour
3.4.5 Equilibrium Level of Income and Employment
3.5 Keynes’ Criticisms on Full Employment Equilibrium
3.6 Let Us Sum Up
3.7 Further Reading
3.8 Answers to Check Your Progress
3.9 Model Questions

3.1 LEARNING OBJECTIVES

After going through this unit, you will be able to-

 explain Say's law of market and also its propositions and implications
discuss the operation of economic system as conceived by the
classical economists
 get a clear idea on the demand for and supply of labour
 discuss how income and level of employment are determined in
classical system
 explain the loopholes of full employment in classical analysis as
conceived by Keynes.

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3.2. INTRODUCTION

In the last unit, we have learnt about circular flow of national income
within different sectors of the economy. Thus, now, we have ideas regarding
how production of goods and services; and how distribution and
consumption of the same is managed within the economy. As the modern
economies are becoming complex day by day, the ideas relating to the
functioning of the macroeconomic systems also started differing. Today's
macroeconomic concepts differ widely from that of the classical era. In this
unit we will look into the macroeconomic foundation of earlier days.

3.3 SAY'S LAW OF MARKET

Jean Baptiste Say's law is the benchmark of classical school of thought.

According to the law, the market economy is governed by the principle
"supply creates its own demand". That is, production of goods and services
automatically creates their demand. Whatever is produced gets
automatically sold in the market and thus consumed. Therefore, there cannot
be general overproduction of goods and services in the economy. As a
result, problem of unemployment also does not arise.

3.3.1 Say's Law of Market : Important Facts

Production Creates Market for Goods: In the production

process productive factor inputs (for example, labour) earn
income as remuneration for their contribution to the production
process. With this income they purchase the goods from the
market for their own use. This in turn creates own demand, that
is, for the already produced goods.
Barter Economy as the Basis: Whatever is produced, a part
of it is kept for self consumption. The others are exchanged for
products of other producers. In this way, whole produce get
exhausted. In a free-exchange economy, factor income
generates demand for goods and services. Thus, the existence
of money does not alter the Say's law.

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Impossibility of General Over -Production: According to the

law, the very act of supplying goods implies a demand for them.
If, for instance, overproduction of any commodity occurs, there
will be re-determination of exchange ratio of this commodity with
others. Thus, more amount of this commodity will be exchanged
with the same amount of the others. At the same time, its current
production is also reduced. The process will continue until
overproduction disappears. Thus, this law rules out the possibility
of general overproduction.
Savings-Investment Equality: To avoid general
overproduction, equality of savings and investment is
maintained. A part of factor income in the form of rent, wage
and interest is saved. The saved amount is automatically
invested for further production. Thus whatever is saved, invested.
Rate of Interest as a Determinant Factor: Equality between
saving and investment is maintained through the rate of interest.
If at any given time investment exceeds saving, the rate of
interest will rise. To maintain the equality, saving will increase
and investment will decline. This is because while saving and
rate of interest is positively related, investment is inversely related
to the rate of interest. In the opposite situation, when saving is
more than investment, the rate of interest falls, investment
increases and saving declines till the two are equal at the new
interest rate.

3.3.2 Say's Law of Market: Its Propositions and

Implications

Main propositions and implications of Say's law can be

understood from the following.
Full employment: Full employment is a natural phenomenon
of the economy. As more and more goods are produced, more
and more factors of production get employment. In the process,
the level of full employment is reached. Full employment is a
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situation where all productive factors engage in the production

of goods and services. Volume of production becomes maximum
in this stage.
Resource utilisation: As there is full employment in the
economy, none of the resources remain idle. More and more
income get generated via proper and increasing use of
productive resources.
Perfect competition: Entire analysis of J.B. Say and other
thinkers of the classical era is based on the proposition of perfect
competition in both product as well as factor market. Thus, as a
feature of perfectly competitive market, many buyers and sellers
of factors as well as products operate simultaneously.
Automatic adjustment: There exists automatic and self-
adjusting mechanism in different markets. For example, in the
capital market, investment and saving are always equal. It is so
through the adjustment of the rate of interest. Similarly, in the
labour market, adjustment in wage (real) rate bring equality
between demand and supply of labour.
Money is neutral: Money functions only as a medium of
exchange. It does not affect the production process at all.
Policy of Laissez-faire: Automatic and self-adjusting process
can function smoothly only when the economy runs under the
policy of laissez-faire. The law assumes a closed capitalist
economy running with laissez-fair policy.
Saving as a social virtue: A part of factor income is saved and
automatically invested. It contributes to production as well as
consumption process further.

CHECK YOUR PROGRESS

Q 1: State whether the following statements are

true (T) or false (F)
(a)In Say's law, supply depends on demand. (T/F)

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Classical Theory of National Income Determination Unit-3

(b)Say's law is applicable both in barter as well as in money

economy. (T/F)
Q 2: Mention the Say's law? (Explain in 40 words)
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Q 3: State the main implications of Say's Law ?( Explain in about 60
words)
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3.4 THE CLASSICAL THEORY OF EMPLOYMENT AND

INCOME

The classical theory employment and income is the theory of full

employment. It is only the analysis of adjustment through which equilibrium
is maintained at the level of full employment.Thus full employment is
regarded as a normal situation. Any deviation from this level get
automatically corrected. Given wage-price flexibility, several economic forces
operate in the economy and they together tend to maintain full employment,
and produce output at that level.

3.4.1 Assumptions

The classical theory of employment and income determination is

based on the following assumptions:
There is a state of full employment without inflation.
There is perfect competition in product and labour markets.
There is closed laissez-fair economy.

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Supply creates its own demand

There is perfect wage-price flexibility
The quantity of money is given
Money acts only as a medium of exchange.
Given the assumptions, according to this theory, in its simplest
form, equilibrium levels of employment and income/output are
determined by the aggregate production function and the
demand and supply schedules of labour. Thus, the determination
of output and employment in classical theory occurs in labour,
goods and money markets of the economy.

3.4.2 Aggregate Production Function

Given a fixed stock of capital and technology in the short period,the

Aggregate Production Function postulates a positive relationship
between output and employment. A higher level of output is
associated with a higher level of employment and vice versa.
Q=f (N, K, T)
Where Q denotes the level of output, N is the level of
employment and K and T represent the fixed stock of capital and
technology respectively.

3.4.3 Demand Function for Labour

As additional laboursare employed, output goes on increasing.

However, productivity of additional labourers employed starts falling
gradually. In other words, marginal physical productivity (MPL)
diminishes. Table 3.1 depicts this scenario.
Table 3.1: Output, Employment and Marginal Product of Labour
Output Employment MP L
2000 400 -
2200 450 4.0
2350 500 3.0
2450 550 2.0
2500 600 1.0

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Classical Theory of National Income Determination Unit-3

Any business firm will provide employment to labour up to

an extent where the real wages paid out to the workers become
equal to the marginal physical product of labour. Thus, wheather a
labour gets employment or not depends on its marginal physical
productivity. The profit maximising condition of a firm is:
W/P=MPL
Since demand for labouris determined by the MPL, and the
real wage (W/P) equals the MPL, the demand for labour is also a
function of real wages. It varies inversely with real wages.
DL=f (W/P)

3.4.4 Supply Function for Labour

Getting employmentis generally known as sacrifice of leisure on

the part of workers. Additional work-load means increase in marginal
disutility of labour. Because work involves strain, exertion and
sacrifice of leisure. Workers can be induced to put in additional
labour input only when this disutility is neutralised through payments
of additional real wages. Thus,the supply of labour is positively
related to the real wage.
SL=f (W/P)

3.4.5 Equilibrium Level of Income and Employment

Given the demand and supply functions of labour, it is possible to

determine equilibrium level of employment and income. In figure
3.1, demand and supply of labour get equalized at real wage rate
(W/P) o and employment level ONo. So, these two are the
equilibrium real wage rate and employment level respectively. If the
real wage rate (W/P)1 is higher than the equilibrium rate, there will
be excess supply of labour (equal to the amount AB) in relation to
demand. So, there occurs competition among workers to get a job.
Ultimately, real wages will come down to the level (W/P)o. The
decline of real wages will reduce unemployment gap and there will

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be a tendency towards the achievement of equilibrium at full

employment ONo.
Figure 3.1: Determination of Equilibrium Levels of Employment and
Income

On the other hand, if the real wage rate is lower than

equilibrium wage rate, say (W/P)2, the employers will try to absorb
more workers. This excess demand (equal to A1B1) for workers will
bid up the wage rate to the level (W/P)0, and employment to ON0.
The equilibrium level of employment (ONo) represents a state of full
employment and maximum possible national output. Thus, who are
willing and able to work at wage rate (W/P)o, have been absorbed,
except a very small proportion of frictionally unemployed labour
force.
It becomes clear that in the classical system, the
unemployment and over employment gaps tend to be automatically
adjusted through flexibility of wages. In other words, employment
(output) can be increased only through reducing wages. Thus, the
key to full employment is a reduction in real wage.
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Classical Theory of National Income Determination Unit-3

The determination of the price level (P) here is explained by

the famous Classical Quantity Theory of Money. It states that price
level is a function of the supply of money. Algebraically, MV=PT;
where M,V, P,T are the supply of money,velocity of circulation of
money, price level and the volume of transaction (or total output)
respectively. This identity represents money market equilibriumwhich
states that total money supply MV equals the total value of output
PT in the economy. T, the total output represents the full employment
output. Assuming V and T constant, M and P varies proportionately
with each other. Thus, a change in money supply (M) causes a
proportional change in the price level. In other words, it exhibits the
medium of exchange function of money.

CHECK YOUR PROGRESS

Q4: State whether the following statements are

true (T) or false (F)
a) In the classical system, unemployment is a natural situation in
the economy (T/F).
b) Unproductive labours also get employment in the classical
theory of employment and income(T/F)
Q 5: What is Aggregate Production Function? (Explain in about 40
words)
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Q6: Explain supply function for labour. (Answer in about 40 words)
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Unit-3 Classical Theory of National Income Determination

3.5 KEYNES’ CRITICISM ON FULL EMPLOYMENT

EQUILIBRIUM

Keynes repudiated the classical theory of full employment equilibrium

and demonstrated the possibility of less-than full employment equilibrium.
He considered that classical argument was correct, but only for a particular
industry or firm. It cannot be generalised for the economy as a whole. Keynes
attacked the classical theory on the following grounds:
 A capitalist society does not function following Say's law. In reality, supply
normally exceeds its demand. There exist millions of workers who are
willing to work at the current wage rate and even below it, but they fail to
get the same. Thus there exists involuntary unemployment in capitalist
economies and equilibrium is established at a situation of less than full
employment situation.
 A part of factor income earned by factor inputs is saved and is not
consumed. It results in a deficiency of aggregate demand. Because of
this deficiency there will be general overproduction and further
unemployment.
 Keynes pointed out that capitalist society comprises of two sections:
rich and the poor.The former possess much wealth, but they do not
spend the whole of it on consumption due to low marginal propensity to
consume. The poor, with high marginal propensity to consume, cannot
consume as per their aspiration with low income. Thus there is general
deficiency of aggregate demand in relation to aggregate supply which
leads to overproduction and unemployment in the economy.
 Wage cut as prescribed by classical economists will certainly reduce
cost of a particular firm or industry. It will not reduce demand for the
product of the firm/industry. If all the industries of the economy as whole
cut wage, it will certainly reduce demand for goods and services.
Because, according to Keynes, wages are not only the costs of
production, but also the income of the labourers. Wage cut will definitely
decrease demand and hence national income and employment.

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Classical Theory of National Income Determination Unit-3

 Moreover, in modern times, wage cut policy cannot be formulated. The

workers have formed strong trade unions which resist a cut in money
wage. There are also legislations across countries on minimum wages.
 The classical economists believed that savings and investment are
always equal via the rate of interest. But the equality of these two is
brought about not by interest rate, but by variations in income. According
to Keynes, level of saving depends on income and not on the rate of
interest. Similarly, it is not only the rate of interest but also the marginal
efficiency of capital, which determine the level of investment. If savings
exceeds investment, it means people are spending less on consumption.
As a result, demand declines. There is overproduction. In such a situation,
investment cannot increase due to low business expectation. It happens
even if the rate of interest falls. It will lead to fall in income, employment
and output. Ultimately, saving will reduce and it becomes equal with
investment at a lower level of income.
 To attain full employment, according to Keynes, State intervention is
necessary. As the capitalist system is not self adjusting, the state can
directly invest in order to supplement private investment or to raise
economic activity.
 Economic activities are dictated by short run variables. Because, Keynes
believed that in the long run we are all dead. During short run, economic
variables such as tastes, habits, (as a result consumption demand),
techniques of production etc. remain static. Under such a situation,
emphasis should be on increasing investment-the other constituent of
aggregate demand. Otherwise, there will be mass unemployment. The
equilibrium so reached cannot be at the level of full employment.
 Thus, classical theory of income determination is totally unrealistic and
fails to solve complex problems of modern capitalist economies.

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CHECK YOUR PROGRESS

Q7: State whether the following statements are

true (T) or false (F)
a) According to Keynes full employment is a natural phenomenon
in the economy.(T/F)
b) In regard to Keynesian view, there exists an automatic
adjustment mechanism in the economy(T/F)
Q8: What will happen, according to Keynes, to employment and output
when wages are cut? (Answer in about 60 words)
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Q9: What is the nature of unemployment in a capitalist economy
(Answer in about 50-60 words)
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3.6 LET US SUM UP

 Say's law of market states that:

 Supply creates its own demand.
 Economic systems are self-adjusting.
 Perfectly competitive market structure paves the way for this self
adjustment.

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 There cannot be general overproduction of goods and services in

the economy.
 Thus full employment is a natural phenomenon of the economy.
 Resources are efficiently utilised in this way.
 Based on same background of Say's Law, Classical Theory of Income
Determination was postulated. It states that:
 Employment and income/output are determined by the aggregate
production function and the demand and supply schedules of labour.
 Demand for labourvaries inversely with real wages.
 Supply of labour varies positively with real wages.
 Employment of labour can be increased only trough wage-cut.
 Keynes vehemently opposed classical thinking on the following grounds.
 There exists involuntary unemployment in capitalist economies.
 Equilibrium is established at a situation of less than full employment
situation.
 Unemployment arises due to deficiency of aggregate demand.
 Wage cut policy reduces aggregate demand and as result, the
employment level.
 Equality of savings and investment arises through changes in
income and not through changes in the rate of interest.
 To increase employment autonomous investment in necessary.
 Short run is the relevant period for analyzing economic activities.

3.7 FURTHER READING

1) Ahuja, H.L. (2007). Macroeconomics: Theory and Policy, New Delhi:

S.Chand& Co.
2) Mueller, M.G. (ed) :Readings in Macroeconomics. Art 1 by E.E. Hagen
entitled, "The classical Theory of the level of output and employment"
(1969).
3) Rana, K.C.&Verma, K.N. (2009). Macro Economic Analysis. New Delhi:
Vishal Publishing Co.
4) Shapiro, E.(1988). Macroeconomic Analysis , New Delhi: Galotia
Publications Pvt. Ltd
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Unit-3 Classical Theory of National Income Determination

3.8 ANSWERS TO CHECK YOUR PROGRESS

Ans to Q No 1: a) False b) True

Ans to Q No 2: Say's law of market states that additional factors employed
in the production process produce additional output. Total factor
income of these additional factors employed often equals with the
market value of the additional output produced by these factors.
Thus, whatever is produced, automatically sold in the market. Thus
supply creates its own demand.
Ans to Q No 3: Say's law states that supply creates its own demand. Since
produced goods are automatically sold in the market, there cannot
be general overproduction in the economy. In such a situation,
production continues to the level of full employment. Thus economic
resources are efficiently utilised. This efficiency get reflected through
perfectly competitive market conditions. Large and perfectly
competitive labour and goods market are self-adjusting. These
markets maintain equilibrium at full employment level. Neutrality of
money and laissez fair policy of the economy makes self adjustment
process easy. Thus, money acts only as a medium of exchange.
Saved money is automatically invested for further production.
Ans to Q No 4: a) False b) False
Ans to Q No 5: Giventhe stock of capital, technical knowledge and
resources, a precise relation exists between total output and the
amount of employment. This relation is termed as Aggregate
Production Function. Thus, Aggregate Production Function shows
that in the short run the total output is an increasing function of the
number of workers given the capital stock and technological
knowledge.
Symbolically, Q=f(N,K,T)
Where Q denotes the level of output,N is the level of employment
and K and T represent the fixed stock of capital and technology
respectively.

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Ans to Q No 6: Labour supply is an increasing function of real wage rate.

Thus, supply function of labouris positively related to the real wage.
It implies that real wage must increase in order to get more labour.
Symbolically,
SL=f (W/P)
Where, SL= Labour Supply
W=Money Wage Rate
P= Price Level
Ans to Q No 7: a) False b) False
Ans to Q No 8: Keynes refuted classical formulation that a cut in money
wage is a prescription for achieving full employment. The policy
can be applied to a particular industry only and not to the economy
as a whole.Wages are not only costs but also they are the income
of labourers. A cut in wage will definitely reduce their income.
Ultimately, aggregate demand falls leading to a decline in
employment and output.
Ans to Q No 9: Unemployment in advanced capitalist countries, according
to deficiency of effective demand. In these countries, people have
high marginal propensity to save and not to consume. As a result,
as output increases, consumption expenditure does not increase
at the same rate. Investment is also inadequate because of its
dependence on future expectations. The result therefore in
overproduction and unemployment.

3.9 MODEL QUESTIONS

A) Short Questions (Answer each question in about 150 words)

Q 1: "Supply creates its own Demand" Examine the statement.
Q 2: Write the important facts about Say's law.
Q3: What are the main assumptions of classical theory of determination
of income andemployment?
Q 4. How the equilibrium rate of employment is determined in the Classical
theory?

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B) Essay-typeQuestions (Answer each question in about 300-500

words)
Q 1: "General overproduction and general unemployment are impossible"
Discuss.
Q 2: Explain clearly the Classical Theory of Determination of Income and
Employment.
Q 3: What are the Keynesian objections against the classical analysis?
*** **** ***

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