Classical Theory of Employment

1. State the Say’s Law of Market.

Say’s Law of Market states that “Supply creates its own demand”.
2. Mention the implications of Say’s Law of Market.
The implications of Say’s Law of Market are as follows:
➢ Self-adjusting Economy and no need of government intervention
➢ No general overproduction
➢ No general unemployment
➢ Flexibility of wages creates full employment in the economy.
3. Mention any four assumptions of Classical Theory of Employment.
The assumptions of Classical Theory of Employment are as follows:
➢ Perfect competition in both product market and factor market
➢ Individuals as rational human beings and motivated by self-interest
➢ No change in state of technology
➢ Closed economy without international trade relations
4. Mention any four assumptions of Say’s Law of Market.
The assumptions of Say’s Law of Market are as follows:
➢ Perfect competition in both product market and factor market
➢ Individuals as rational human beings and motivated by self-interest
➢ Flexibility of wages and prices
➢ Closed economy without international trade relations
5. What is the cause of unemployment according to Classical Theory?
According to Classical Theory, rigidity in wages, interest and prices is the cause of
unemployment.
6. Write down the two propositions of Classical Theory of Employment.
The two propositions of Classical Theory are as follows:
➢ Supply creates its own demand.
➢ There is full employment in the long-run.
7. Describe Say’s Law of Market.
Say’s Law of Market developed by J.B. Say is the foundation of Classical Economics. This law
states that “Supply creates its own demand”. The main cause for the creation of demand is the
income obtained by factor-owners such as workers. When goods are produced, it not only fulfills
supply but also provides employment to the people. This will result into an increase in their
income and demand. So, it won’t create the situation of general overproduction and
unemployment in the economy. This law is applicable in both barter economy and monetary
economy.
In the above figure, all the resources such as land, labor, capital etc. required by the business sector
are supplied by households. Similarly, all the goods and services required by households are
produced and supplied by the business sector. In return for factor-services, the business sector will
pay Rs. 10,000 to households. The households will pay Rs. 10,000 to the business sector for the
goods and services. All the resources owned by the households will be used by the business sector
and all the goods and services produced by the business sector will be consumed by the households.
So, it is concluded that there won’t be general overproduction and general unemployment in the
economy. The economy is self-adjusting and functions automatically. It means if supply increases,
demand will also increase and vice-versa.

8. Explain the implications of Say’s Law of Market.

According to Say’s Law of Market, ‘Supply creates its own demand’. Following are the
implications of Say’s Law of Market:
a) Self-adjusting Economy: According to this law, there is an automatic adjustment of each factor
in the working of the economy and there should not any type of government intervention for
automatic adjustment in the economy. If supply increases, demand also increases and
adjustment takes place between them.
b) No general overproduction: With an increase in production, there is also an increase in the
income of factor-owners such as workers. As a result, new demand is created and the increased
stock of goods and services is sold in the market. So, the situation of general overproduction
will not be possible.
c) No general unemployment: Since the situation of general overproduction is not possible, the
situation of general unemployment is also never possible.
d) Flexibility in wages creates full employment in the economy: According to J.B. Say, the wage-cut
policy creates the situation of full employment. Unemployment arises due to the rigidity of
wages. The government should not adopt the policy of wage rigidity in the economy.
e) Policy Implications: According to this law, the economy is automatically adjustable and works
without any external stimulus. So, there is no need of government intervention in the economy.
 9. Explain the Classical Theory of Employment and Output.
Or “Flexibility of wages is required to maintain equilibrium in the labor market”. Explain.
The Classical Theory of Employment developed by classical economists like Adam Smith
assumed full employment in the free-market economy and under perfect competition,
unemployment will be temporary and after some time, it will disappear.
Assumptions
i. Perfect competition in both product market and factor market
ii. Individuals as rational human beings and motivated by self-interest
iii. No change in state of technology
iv. Closed economy without international trade relations
v. Money as a Medium of Exchange
vi. Flexibility of wages and prices
vii. Full employment in the economy
viii. Homogeneous units of labor
𝑾
Classical Theory states that the rate of real wages ( 𝑷 ) is determined by the forces of demand and supply
in the labor market. Demand for labor (DL) is the negative function of real wage rate whereas supply of
labor (SL) is the positive function of real wage rate.

The rate of real wages is determined at that level at which DL=SL. This level represents full employment
level of equilibrium. If the state of some unemployment occurs, workers will compete for the jobs and
rate of real wages will decrease, leading to an increase in demand for labor and a decrease in supply of
labor. This will remove unemployment. So, flexibility of real wage rate ensures full employment in the
economy. According to this theory, rigidity of wages and government intervention in the labor market
cause unemployment in the economy.
In the first above figure, DL=SL at E which is the point of equilibrium in the labor market. The equilibrium
𝑾 𝑾
rate of real wages = 𝑷
and ONF= Full employment level. If the rate of real wages > 𝑷 , SL>DL and the
𝑾
situation of unemployment arises. This will cause a fall in real wage rate to 𝑷 due to perfect competition
in the labor market. It will remove unemployment and the economy will reach the state of full
employment. So, flexibility of wages is required to remove unemployment and maintain full
employment in the economy.

The second above figure represents that output (Y) is the function of number of workers employed
[Y=f(N)]. At full employment level (ONF), OY is the full employment level of output.

Criticisms

J.M. Keynes criticized Classical Theory of Employment in the following way:

a) Under-employment Equilibrium: According to Classical Theory, full employment is a normal

phenomenon and flexibility of wages always ensures full employment in the economy. But
Keynes disagreed with this theory and said that unemployment is a normal phenomenon.
b) Assumption of Perfect Competition: The classical theory assumes that all markets, including the
labor market, operate under conditions of perfect competition. In reality, markets often show
imperfections, such as monopolies, oligopolies etc. which can prevent the labor market from
clearing.
c) Neglect of Demand-Side Factors: Classical economists focus primarily on the supply side,
assuming that supply creates its own demand. However, Keynes argued that demand-side
factors, such as insufficient aggregate demand, can lead to involuntary unemployment, which
the classical theory does not adequately address.
d) Unrealistic Assumptions about Labor Mobility: The classical theory assumes that labor is
perfectly mobile, meaning workers can move freely between jobs, industries, and regions. In
reality, workers may face significant barriers to mobility, such as skill mismatches, geographic
immobility, and personal or family constraints.
e) Long-run Analysis: This theory is based on long-run. But Keynes disagreed with this theory and
said that actual problems are short-run problems and they must be given greater importance.