Classical Theory of Income and Employment

The basic contention of classical economists was that “given flexible

wages and prices, a competitive market economy would operate at full
employment. That is, economic forces would always be generated to
ensure that the demand for labour would always equal its supply”.
In the classical model the equilibrium levels of income and employment
were supposed to be determined largely in the labour market. The demand
curve for labour shows the relationship between the real wage (equal to the
value of the marginal product of labour in a competitive economy) and the
demand for labour by employers.

The lower the wage rate, the more the workers will be employed. This is
why it is downward sloping. The supply curve of labour is upward sloping
for obvious reasons. The higher the wage rate, the greater the supply of
labour.

Assumptions of the Theory

1.Long run analysis.
2.Laissez Fair / Free or no intervention of the government or any authority.
3.Perfect competition in the commodity and factor market.
4.Full employment: In the long run, there is always full employment situation in
the economy.
5.Market law: “Supply creates its own Demand” Level of income and
employment are interrelated by the production function.
6. J. B. Say stated that there may be some disbalances in the short run but in the
long run “Supply creates its own demand”. In the other words in the long run,
demand and supply at macro level are always the same.
In the notation;
AD = C + I ……..(1)
AS = C + S ……..(2)
In equilibrium AD = AS, or,
C+I=C+S
The classical economists held the view that the economy consists of three
market-
- Labour Market
- Goods Market, and
- Money Market

Model

Fig. 1 shows the labour market situation. The equilibrium wage rate (W0) is
determined by the demand for and the supply of labour. The level of employ-
ment is OL0. The lower graph shows the relation between total output and the
quantity of the variable factor (labour).
The graph actually shows the short-run production function which may be ex-
pressed as Q =f (KL), where Q is output, K is the fixed quantity of capital and L
is the variable factor labour. Total output is OQ0 when OL0 units of labour are
employed.
According to classical economists this equilibrium level of employment is the
‘full employment’ level. So, the existence of unemployed workers was a logical
impossibility. Any unemployment which existed at the equilibrium wage rate
(OW0) was attributable to frictions or restrictive practices in the economy or
was voluntary in nature.
The classical economists assumed flexibility of wages and prices (or of real
wages). They believed that if the wage rate was flexible a competitive economy
would always be able to maintain full employment. In other words, aggregate
demand would be sufficient to absorb the full capacity output OQ1.
In fact, “whatever the full employment level of output, the income created in
producing it will necessarily lead to spending which will be sufficient to
purchase the goods produced”. In other words, the classical economists denied
the possibility of under-spending or overproduction. True enough, the classicists
had faith in Say’s Law, named after the French economist J. B. Say (1767-
1832).
Say’s Law. Say’s Law is the simple notion that the supply of goods and services
creates its own demand, i.e., the very act of producing goods and services
generates an amount of income equal to the value of the goods produced. That
is, the production of any good would automatically provide the wherewithal to
take the output off the market.
The essence of the Law—that supply creates its own demand—can be
envisaged most easily in terms of a simple barter economy. A farmer, for
example, produces or supplies wheat as a means of buying (or demanding) the
shoes, shirts and other things produced by shoe-makers and craftsmen. The
farmer’s supply of wheat is equivalent to his demand for other goods.
This is true for other producers and for the whole economy. Demand must be
the same as supply. In fact, the circular flow model of the economy and national
accounting both suggest this sort of relationship. For instance, “the income
generated from the production of any level of total output would, when spent,
be just sufficient to provide a matching demand”.
Say’s Law is equally applicable in a modern economy which uses money as a
medium of exchange and store of value. Here any excess supply of money
possessed by an individual implies excess demand for goods and vice versa. So,
for the economy to be in equilibrium the sum of the excess supply functions
must be zero.
If the composition of output is in accord with the tastes and preferences of
consumers, all markets would be cleared of their outputs. Thus all that
businessmen need to do to sell a full-employment output is to produce that
output; “Say’s Law guarantees that there will be sufficient consumption
spending for its successful disposal”.
Saving, Investment and the Rate of Interest:
There is, of course, a serious omission in Say’s Law. If the recipients of income
in this simple model save a portion of their income, consumption expenditure
will fall short of total output and supply would no longer create its own demand.
Consequently, there would be unsold goods, falling prices, cutbacks in produc-
tion, unemployment and falling incomes.
However, the classical economists ruled out this possibility by suggesting that
saving would not really in a deficiency of total demand, because each and every
rupee saved would be automatically invested by business firms. That is,
investment would occur to fill any consumption ‘gap’ caused by saving leakage.
In fact, businessmen produce not only consumption goods for sale to
households but investment (capital) goods for sale to other firms (or to one
another). The latter constitute a considerable portion of society’s total output. In
other words, investment spending by business will add to the income-
expenditure stream.
This may fill any consumption gap arising from saving. Thus, if private
business firms as a group intend to invest as much as households want to save,
Say’s Law will hold and the levels of national income and employment will
remain constant.
To illustrate Say’s law consider Fig. 2. It shows a simplified version of the
circular flow of income diagram. There are only two sectors—households and
private business firms. Households receive income exactly equal to the value of
goods and services produced.
Part of this income is spent on consumption goods, the balance is saved. Thus
consumption demand falls short of the total value of production (GNP) by the
amount of saving, which is made up by demand for capital goods (i.e.,
investment demand). Thus so long as investment and saving are equal,
aggregate demand (i.e., consumption demand plus investment demand) will
always be equal to the total value of production.

Thus, “weather or not the economy could achieve and sustain a level of
spending sufficient to provide a full-employment level of output and income
therefore would depend upon whether businesses were willing to invest enough
to offset the amount households want to save”.

The Money Market:

The classicists also argued that capitalism contained a very special market—the
money market—which would ensure saving investment equality and thus would
guarantee full employment. According to them the rate of interest (the price
paid for the use of money) was determined by the demand for and the supply of
capital. The demand for capital is investment and its supply is saving.
So the rate of interest is determined by the saving-investment mechanism. The
equilibrium rate of interest is one which brings about S-I equality. Any
imbalance between S and I would be brought about by changes in the rate of
interest (r). If S exceeds I, r will fall. This will stimulate investment. The
process will continue until and unless the equality is restored. The converse is
also true.
The converse is also true. See Fig. 3, which is self-explanatory.
 
ADVERTISEMENTS:
Price-Wage Flexibility:
The classicists also argued that the level of output which producers can sell
depends not only upon the level of aggregate demand but also upon the levels of
product prices. Thus even if the interest rate fails to equate the desired S of the
household sector with the desired I of private business firms, any resulting
decline in total spending would be neutralised by proportionate decline in the
price level.
That is, Rs. 100 will buy two shirts at Rs. 50, but Rs. 50 will buy the same
number of shirts provided their price falls to Rs. 25. Therefore, if households
somehow succeeded in saving more than what business firms were willing to
invest, the resulting fall in total spending would not result in a decline in real
output, real income, and the level of employment provided product prices also
declined in the same proportion as aggregate expenditure.
According to classical economists competition among sellers would ensure
price flexibility. A general decline in demand in product market will force
competing producers to lower their prices to clear their accumulated surpluses.
Thus the result of excess saving would be to lower prices. This will raise the
value of money and permit non-savers to acquire more goods and services with
a fixed money income. Saving would, therefore, lower prices but not output and
employment.
Wage-Price Flexibility:
But this is not perhaps the whole truth. A fall in product prices would reduce
resource prices—particularly wage rates—in the process. Thus wage rates have
to decline significantly to permit businesses to produce profitably at the new
lower prices.
The classical economists thought that & decline in product demand would
automatically be translated into a fall in demand for labour and other resources.
The immediate result would be an excess supply in the labour market, i.e.,
unemployment at the existing wage rate. The wage rate will fall.
The producers who were reluctant to employ all workers at the original wage
rate will now find it profitable to employ extra workers at lower wage rate. And
competition among unemployed workers would force them to accept lower
wages rather than remain unemployed. The process would come to a halt only
when the wage rate falls enough to clear the labour market. So a new lower
equilibrium wage rate would be established.
Thus, involuntary unemployment was a logical impossibility in the classical
model. Anyone willing to work at the market determined wage rate would be
able to find jobs readily and people would have substantial choice of jobs.
How the Product Market Adjusts:
Equilibrium in a typical market, of which there are many in the economy, is
shown in part a of Fig. 4. The intersection of the product demand curve (DD)
and the product supply curve (SS) determine the equilibrium price (P0) and
equilibrium output (Q0).

A fall in aggregate demand is reflected in a leftward shift in product market

demand curves throughout the economy. This is shown in part b, where the
aggregate demand curve shifts to the left to D1D1. The equilibrium price falls
from P0 to P1 and the equilibrium output from Q0 to Q1. This also occurs in other
product markets. Producers now cut back output and reduce their employment
of labour and the purchase of other resources.
The reluctant workers are now involuntarily unemployed because they are
willing to work at the yet unchanged wage rates. They will, therefore, compete
for the available jobs by bidding down wages. Similarly, suppliers of raw
materials will lower their prices to reduce their surpluses.
The lowering of wages and resources prices causes product market supply
curves to shift upward. This process continues until the initial output levels in
product markets are restored and all available workers are once again fully
employed.
This is shown in part c, where the product market supply curve has shifted from
S1S1 to the position S2S2. The initial output of Q0 is restored, but at a lower
equilibrium price P2, determined by the intersection of D1D1 and S1S1.

Keynes theory of Income determination

According to Keynes’ own theory of income and employment: "In the short
period, level of national income and so of employment is determined by
aggregate demand and aggregate supply in the country. The equilibrium of
national income occurs where aggregate demand is equal to aggregate supply.
This equilibrium is also called effective demand point".

Effective demand
Effective demand represents that aggregate demand or total spending
(consumption expenditure and investment expenditure) which matches with
aggregate supply (national income at factor cost).
Effective demand is the equilibrium between aggregate demand (C+I) and
aggregate supply (C+S).
This equilibrium position (effective demand) indicates that the entrepreneurs
neither have a tendency to increase production nor a tendency to decrease
production.
It implies that the national income and employment which correspond to the
effective demand are equilibrium levels of national income and employment.
Unlike classical theory of income and employment, Keynesian theory of income
and employment emphasizes that the equilibrium level of employment would
not necessarily be full employment. It can be below or above the level of full
employment.

Determinants of Income:
The determinants of effective demand and so of equilibrium level of national
income and employment are the aggregate demand and aggregate supply.
(1) Aggregate Demand (C+l):
Aggregate demand refers to the sum of expenditure households, firms
and the government is undertaking on consumption and investment in an
economy.
The aggregate demand price is the amount of money which the
entrepreneurs actually expect to receive as a result of the sale of output
produced by the employment of certain number of workers.

Determinants of Income:

An increase in the level of employment raises the expected proceeds

and a decrease in the level of employment lowers it.

The aggregate demand curve AD (C+I) would be positively sloping

signifying that as the level of employment increases, the level of output
also increases, thereby increasing of aggregate demand (C+l) for goods.

The aggregate demand (C+l) depends directly on the level of real

national income and indirectly on the level of employment.
Determinants of Income:
(2)Aggregate Supply (C+S):
The aggregate supply refers to the flow of output produced by the
employment of workers in an economy during a short period.

In other words, the aggregate supply is the value of final output valued at
factor cost.

The aggregate supply price is the minimum amount of money which the
entrepreneurs must expect to receive to cover the costs of output
produced by the employment of certain number of workers.

Determinants of Income:

The aggregate supply is denoted by (OS) because a part of this is

consumed (C) and the other part is saved (S) in the form of inventories of
unsold output.

The aggregate supply curve, (C+S) is positively sloped indicating that as

the level of employment increases, the level of output also increases,
thereby, increasing the aggregate, supply. Thus, the aggregate supply
(C+S) depends upon the level of employment through the economy's
aggregate production function

Determination of Level of Employment and Income

According to Keynes, the equilibrium levels of national income and

employment are determined by the interaction of aggregate demand
curve (AD) and aggregate supply curve (AS).
The equilibrium level of income determined by the equality of AD and
AS does not necessarily indicate the full employment level. The
equilibrium position between aggregate demand and aggregate supply
can be below or above the level of full employment as is shown in the
curve below.
Figure- Effective Demand

Explanation
In the above figure , the aggregate demand curve (C+l), intersects the
aggregate supply curve (OS) at point E1 which is an effective demand
point. At point E1 , the equilibrium of national income is OY1 .

Let us assume that in the generation of OY1 level of income, some of the
workers willing to work have not been absorbed. It means that E1
(effective demand point) is an under employment equilibrium and OY1 is
under employment level of income.

The unemployed workers can be absorbed if the level of output can be

increased from OY1 to OY2 which we assume is the full employment
level.

We further assume that due to spending by the government, the aggregate

demand curve (C+I+G) rises. As a result of this, the economy moves
from lower equilibrium point E1 to higher equilibrium point E2 . The OY
is now the new equilibrium level of income along with full employment.
Thus E2 denotes full employment equilibrium position of the economy.
 Thus government spending can help to achieve full employment. In case
the equilibrium level of national income is above the level of full
employment, this means that the output has increased in money terms
only. The value of the output is just the same to the national income at
full employment level.

Importance of Effective Demand

The importance of the principle of effective demand in macro economics,

in brief, is as under:

(i) Determinant of employment.

Effective demand determines the level of employment in the
country. As effective demand increases employment also
increases. When effective demand falls, the level of employment
also decreases.

(ii) Say's Law falsified.

It is with the help of the principle of effective demand that
Says Law of Market has been falsified. According to the concept
of effective demand whatever is produced in the economy is not
automatically consumed. It is partly saved. As a result, the
existence of full employment is not possible.

(iii) Role of investment.

The principle of effective demand explains that for achieving full
employment level, real investment must equal to the gap between
income and consumption. In other words, employment cannot
expand, unless investment expands. Therein lies the importance of
the concept of effective demand.

(iv) Capitalistic economy.

The principle of effective demand makes clear that in a rich
community, the gap between income and expenditure is large. If
required investment is not made to fill this gap, it will lead to
deficiency of effective demand resulting in unemployment.

Criticism on Keynesian Theory

From mid 1970 onward, the Keynesian theory of employment
came under sharp criticism from the monetarists.

The monetarists believed that J. M. Keynes laid more emphasis on

the determinants of aggregate demand and to a greater extent
ignored the determinants of aggregate supply.

The 'General Theory of Keynes is applicable to the developed

economies. The Keynesians concepts are not very useful for policy
purposes in less developed countries