Chapter-3

Classical theory of employment

# concept of unemployment

Unemployment is defined as the situation where people are able and willing to work at
current wage rate of the market but they don’t get any work.

It is a problem of developed countries of the world. It creates the problems of poverty, inequality,
crime, robbery, etc in a Country. Therefore, unemployment problems are Solving by the help of
employment opportunities.
The people who are physically and mentally fit but don’t want to work are excluded from
the category of unemployment for eg: Sadhus.

Types of Unemployment.

I. open unemployment.
It is the situation in which some workers have no any work to do. They are willing to work at the
existing rate but they are forced to remain unemployed.

II. Under employment

It is the situation in which employed persons are working but less than they are really capable of
it. Due to the non-availability of suitable occupation as per their abilities and expertise, they join
inferior occupation.

III. Disguished unemployment.

It is defined as the situation in which a person Seems as employed but infact he is not
employed. In this type of unemployment, the unemployed person is not visible or hidden.
IV. Cyclical unemployment
A situation where people are unemployed due to cyclical phase of depression in an economy.
The term ‘depression’ refers to the decrease In investment, decrease in Output. Similarly
income of People.

V. Frictional unemployment.
Frictional unemployment is defined as the situation in which people are looking for new or better
job and employers are looking for the right workers. It is also known as the search
unemployment because it occurs when people leave job and searching for a new job.

VI. Seasonal unemployment.

It is defined as the situation in which people are out of work during the off-season and looking
for another Job. It is common type of unemployment in both developed & developing countries
For eg: Ice-cream Vendors.

Sag’s Law of market.

Concept
Soy’s Law of market is one of the basic Pillar of classical theory of employments which is
introduced by French’s economist J.B say in 19th century. The main theme of say’s Law market is
“Supply creates its own Demand.” It means that production of goods will Create demand for
them too. Therefore, Say’s Law of market is based on assumption economy is always in full
employment situation.
Say’s Law of market applies both in barter as well monetary economy. In barter economy, a
good is produced with a Purpose of exchanging it for another good. Thus, additional supply
represent Additional demand. In monetary economy, money serves as a medium of exchange.

Assumptions
 1. There is existence of free market economy.
2. There is absence of government intervention in the economy.
3. The size of market is flexible.
4. Money is only medium of exchange.
5. There is a closed economy without export and import (international trade).
6. There is perfect competition in both factor and Product market.
7. Wages and prices are flexible.
8. Saving equal to investment.

Implication of Say’s Law

Following are the main implications of Say’s Law of Market.

a. Self-adjusting economy:
The important implication of the law is that there is automatic adjustment between aggregate
demand and aggregate supply and production and consumption with the working of the
economy. Supply creates its own demand, there is no need to government intervention in the
automatic functioning of the system.

b. Full employment in the economy.

The law assumes that there is full employment in the economy. Increase in production means
more employment to factors of production.

c. Proper utilization of resources:

If there is full employment in the economy, idle resources will be properly utilized which will
further help to produce more output and also generate more income. The economy will be in
prosperity under this situation

d. Perfection competition in the market:

Say’s law is based on assumption of perfect competition. There is perfect competition in both
product and factor market according to this law. The perfect competition helps to make both
product and factor market fair.
 e. Equality between saving and investment:
When factors spend their all income in consumption, it will help to clear the market. Whatever of
income saved by factors will be automatically invested and contributes to increase production
and income.

Criticisms of say’s Law of market.

Say’s law of market is criticized by Modern economist J.M. Keynes and gave a new theory. The
main criticisms are given belows :-
1. Supply does not creates its own demand.
2. Economy is not self adjusting.
3. Wrong assumption of full employment.
4. Money is demanded for other Purposes.

1) Supply does not created its own demand.

Say’s Law of market is based on the supply creates its on demand it means that aggregate supply
is always equal to demand in the market. But according to Keynes Supply does not creates its
own demand. Higher the aggregate demand, higher will be aggregate supply. It means demand
creates its own supply.

2) Economy is not sells adjusting.

According to J.B. says, “economy is self adjusting economy. It means aggregate supply is always
equal to aggregate demand. But according to keynes it is not self adjusting because sometimes
Aggregate supply (As) is higher than Aggregate demand (AD) and Aggregate supply (As) is
lower than Aggregate demand (AD)

3) Wrong assumption of full employment

According to J.B. Say’s economy is always in full employment Situation due to supply creates its
own demand. The problem of economy is short run. But full employment is abnormal situation
but under employment is normal situation in the concept of J.M. Keynes.
 4) Money is demanded for other purposes.
According to J.B. says, “the money is the demanded as a medium of exchange only and there is
Store of value function of money. But keynes says that money also functions as the store of
value. Money is also demanded for other Purpose like transaction motive, precautionary motive,
speculative motive.

Classical Theory of Employment.

Classical Theory of employment is Based on book “An enquiry into the nature and cause of
wealths of nations published in 1776 A.D. By Adam smith. The economists of this theory were
J.B. say, David Ricardo and J.S. Mill, etc. This theory war developed classical economists, it is
also known as classical theory of employment. Classical economists Believed that the Stable
equilibrium at full employment level as normal situation. The problem of unemployment was not
primary concern of this theory.

Assumption

i. There is perfect competition in both product Market and factor Market.

ii. There is the existance of full employment in an economy.

iii. There is a closed laissze faire capitalized economy.

iv. The quantity of money is given and money is only a medium of exchange.

v. Wages and Prices are flexible.

vi. There is closed economy without international trade.

vii. The theory is active in the long period.

Components of classical theory of employment or Determinant or level of employment.

a. Labour market
b. Product market.
c. Money Market

a) Labour market.
According to classical economist the equilibrium level of employment and real wage
rate is determined in labour market by forces of demand for labour and supply of labour.
In other words, the demand for labour and supply of labour curves intersect each
other determined by equilibrium level of employment and real wage rate.

b) Product market (Real Market)

According to classical economist, the equilibrium rate of interest and level of
employment is determined by saving equals to investment. Saving is the positive function of rate
of interest and investment is inverse function of rate of interest. i.e. s=f(r) → positive function.

I = F(r) → Inverse function.

Similarly,
Total income = Total expenditure
Or, ¢ + s = ¢ + I
Or, s = I (Equilibrium level of full employment.)

c) Money market.
 According to classical economist, the quantity theory of money is foundation of
Theory of employment. Money market equilibrium in the Classical theory is based on quantity
theory of money which states that the general price (P) in the economy depends on the supply of
money. Quantity theory of money is generally explained by Fisher’s equation of exchange:-
Fisher’s equation:
MV = PT
Or, P = MV / T
Where. M = Quantity of money.
P = Price level
T = Total Volume of output
V = Velocity of money.

Criticisms of Classical Theory

J. M. Keynes in his book “The General Theory of Employment, Interest and Money” made a
vigorous attack on the classical theory of employment. The classical theory was criticized in
1930s on the account of following reasons. They are:

a) Assumption of full employment:

Keynes rejected the fundamental assumption of full employment in the labour market. He
considered it as an unrealistic assumption. He regarded full employment as a special situation.
This is because the millions of labours are ready to work at the current wage and even below it
but they have not found any work.

b) Supply does not create its own demand:

Keynes refused Say’s law of market that supply creates its own demand. He said that all
income earned by factor owners are not spent on consumption but a part of it is saved and not
automatically invested because saving and investment are different functions made by
different economic units.

c) Assumption of flexible wage rate:

The classical theory assumes that wage rate is flexible upwards and downwards based on
demand and supply situation. But the downward flexibility is not possible in the modern age
where trade unions are strong. Therefore, there is no flexible wage rate as assumed by classical
economists.

d) Money is not only the medium of exchange:

Classical economists believe that money is used only as a medium of exchange. Keynes
forwarded the idea that money is also demanded for speculative purpose. This is against the
quantity theory of money, which is the foundation of classical theory.

e) Concept of long run:

The classical economists believed that in the long run full employment equilibrium is achieved
through a self-adjusting process. Keynes has no patience to wait for long period because he
believed that ‘in the long run we are all dead.’ His analysis was confined to short run phenomena.