ECONOMICS 2nd Sem

Classical assumptions, Classical theory of

Employment, output, prices & intrest
Limitation of Classical Theory

Hari Chand
Assistant Professor

1|Page
 Introduction to Classical Economies

Adam Smith‟s The Wealth of Nation in 1706 is usually considered to be to be the mark of beginning of
classical economy.

Classical economist observed that markets generally regulate themselves when free of coercion. Adam
Smith referred to this a metaphorical „Invisible hand‟ this describe the unintentended social benefits of
Individual actions.

Keynesian said all those theories which are based on the following assumption fall in the category of
classical theory of INCOME, OUTPUT, EMPLOYMENT (I,O,E)

1). The freely competition (laissez faire economy) which an economy operates at full employment level,,
than according to Keynesian not only the theory of I,O, &E written by Adam Smith, J.B. Say, Ricardo, J.S.
Mill falls in the category of classical theories but also the theories written by Marshall, Pigou, Harberlor &
Walras. Although they were Neo-Classical economist but Keynesian included their writing in the Classical
Theories of I, O, E.

Classical Assumptions

The traditional Classical Theoretic apparatus is based upon the following basic assumptions:

1) There is a state of full employment without inflation.

2) There is closed laissez faire economy.
3) Supply always creates its own demand.
4) There is perfect wage-price flexibility.
5) The quantity of money is given.
6) Money acts only as a medium of exchange.
7) The level of employment is determined by money wage rate.
8) The stock of capital is given & state of the technology remains constant.
9) There is a perfect competition in the product and labour market.
 Labour market deals with the aggregate demands for supply of labour. The Equilibrium
position is determined by that wage rate corresponding to which demand for labour &
supply of labour.
2|Page
 Product market deals with the aggregate demand savings & investment. The equilibrium
position is determined by that rate of interest corresponding to which demand for many is
equal to supply for money

3|Page
  Money market deals with aggregate demand for & supply of money, the equilibrium
position is determine by that Price level corresponding to which demand for money is equal
to supply for money.
Labour market & Product are combined together & due to that these market deals with real
forces ( Real sector of economy)

Classical Theory of Employment, Output, Price & Interest

The classical theory is the theory of full employment. It outlines a model which ensures the maintenance of
equilibrium at full employment. The equilibrium levels of aggregate output and employment, according to
this theory, arc determined by the aggregate production function and the demand and supply schedules of
labour.
The aggregate production function, given‟ a fixed stock of capital and technology in the short period
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.

The demand function of labour is derived from the aggregate production function which depends upon the
labour input. As employment expands, the level of output also increases but marginal physical product of
labour diminishes.

Output (Q) Employment (E) MPL

2000 400 -
2200 450 4.0
2350 500 3.0
2450 550 2.0
2500 600 1.0

Given the different levels of production at different levels of production at different levels of labour inputs, the
marginal physical product of labour (MPL) declines. Marginal physical product of labour curve which incidently is the
demand curve of labour, will thus have a negative slope. Any business firm, hiring workers, will provide employment
to labour up to an extent where the real wages paid out to workers become equal to marginal physical product of
labour. The essential conditions for profit-maximizations on the part of the firm, thus, are:

W/P = MPL

Since the demand for labour is determined by the MP L which diminishes with an increase in output and employment
and the real wage (W/P) equals the MPL, the demand for labour is also a function of real wages

DL = f (W/P)

The demand function of labour varies inversely with the real wage rates.

On the supply side, it may be pointed out that work involves strain, exertion and sacrifice of leisure. This makes
additional work-load or a large number of labour-hours quite disgarable to the workers and is generally known as the
marginal disutility of labour. Unless this disutility of work is neutralized through the payments of additional real
wages, the workers cannot be induced to put in additional labour input. Thus the supply of labour-hours is related
positively to the real wages of the workers.

SL = f (W/P)

Given the demand and supply functions of labour, it is possible to determine the equilibrium level employment, when
the demand for labour gets equa1ised with the supp1y of labour at the equilibrium real wage rate (W/P) o. If the real
wage rate (W/P)1 is higher than this equilibrium rate, the labour supply will be in the excess of the demand for labour
denoting a state of unemployment among the workers and initiating a tendency among the workers bid down the
wages for securing more job opportunity. The decline Of real wages will reduce the unemployment gap and there
would be a tendency towards the at full employment (N 0). If the real wage, on the other hand, is lower than the
equilibrium wage rate, say (W/P) 2, the employers. Will like to absorb more I workers. But the Workers will be
reluctant to take up the jobs offered by the employers since the disutility of works more in proportion to the real
wages. Consequently the employers will have to raise real wages in order to hire more workers. The equilibrium is
determined ultimately at the full employment level N 0.

7|Page
At (W/P)1 real wage rate, there is an unemployment gap equal to AB which tends to be wiped out by the competition
among the workers for more jobs and the equilibrium at (W/P) 0. wage rate is finally determined at N 0 full employment
level. At a lower real wage rate (W/P) 2, there is an over- employment gap equivalent to A 1B1 which denotes a state of
excess demand for labour. This will push up the wage rate and tend it to approximate to (W/P) 0.
The equilibrium level of employment N0 represents a state of full employment is presumed that all the persons who
willing and able to work at (W/P)0 wage rate have been absorbed, except a real wage rate which is perfectly consistent
with the marginal product of labour, if a certain number of workers are not willing to work, it will clearly mean that
these people do not offer their services voluntarily and the level of employment, existing in the economy denotes full
employment of the employable workers. In the classical system, the unemployment and over- employment gaps tend
to be automatically adjusted, over time, through the adjustment mechanism manifest in the wage-flexibility. Any lapse
from full employment, assuming the price level to be unchanged would be easily overcome
through the variations in wage rates.

8|Page
 Classical system without saving and investment

The classical system of full employment equilibrium involves adjustment of the variables in labour market,
goods market and product market.

The functional relationships involved in three market classical system without saving & investment are
given below:

Q = f (N, K, T)

DL= f (W/P) SL

= f (W/P)

MV = PT

Here, M is Quantity of money, V is Velocity of money, P is General Price level & T is Volume of
transaction.

MV = Supply of Money

PT = Volume of Goods Sold

 Classical system with saving & investment

The classical analysis so far has been perused on the assumption that the community spends entire earning
by way of consumption & no part of income is saved.

The basic of this strategic classical notion is the equilibrating mechanism of the rate of interest, which is
supposed to transform savings into an equivalent amount of investment money, does have a store value.

Y=C+S

Y=C+I

S=I

S = f (r)

I = f (r)

S=I

S = f (r) & d (s)/d (r) > 0

I = f (r) & d (I)/ d (r) <0

 Limitation of Classical Theory

The economic and political developments in the first half 20th century pushed the classical system
Of analysis and policy on the brink of a precipice. The eventual collapse was, however, expedited
by the blistering attack that Keynes launched against the classical ideas in his General Theory.
Keynes and post-keynesian economist attacked the classical theory and policy on the
following grounds:

1) According to classical the level of I, O, Y is determined by the quantity & quality of inputs.
But according to Kenney‟s the level of I, O, Y is not determined by quantity & quality of
inputs but it is determined by aggregate effective demand.
2) According to Kenneys the behaviour of the workers by the illusion, therefore the cut in
money wades will not be allowed by the workers therefore the level of employment can be
increased not only by cutting the money wages as has been suggested by the classical. But by
reducing the real wage.
3) According to classical the wages are flexible upward as well as downward but kenneys stated
that due to the formation of trade union, wages are flexible upward & rigid downward.
4) Cut in money wages acts as double edge counting.
5) According to J.B. Say money as a medium exchange. It does not have a store of value.
Therefore people will not save anything but according to kenneys it has a store value.
6) Classical I, O, Y is a long run theory but kenneys said that in the long run we all are dead.
Therefore our theories should be based on short run analysis.
7) Classical assumed savings and investment interest elastic but according to kenneys saving
depends on level of income & investment depends on ration of interest & marginal efficiency
of capital.
8) Classical is not based on empirical facts. This law fails to explain why during great
depression full employment was not a normal feature of capitalist economy.
9) Laissez faire economy will not attain equilibrium at full employment automatically as has
been suggested by classical but according to kenneys equilibrium in the economy will take
place at less than full employment. The full employment equilibrium will attain by
implementing the fiscal policy in the economy.