Chapter 7: Classical
Economics
The Economy at Full
Employment
Issues in 2006 for the Midterm
Elections
How does increased immigration affect wages and
the level of output in the economy?
What are the benefits of increased investment?
What happens to wages, jobs, GDP if employers
must pay higher taxes for hiring labor?
If our government spends more, does this mean
we must have a lower level of consumption or
investment in the economy?
Classical Economics

A school of thought
that provides insights
into the economy
when it operates at or
near full employment.
Supply-Siders

Economists /
politicians who
emphasize the role of
taxation for
influencing economic
activity.

Favored by the
Republican Party
New School: Real Business
Cycle Theory

Tries to explain why
there are booms and
busts in the economy.
REMEMBER!

With the classical
model, wages and
prices are assumed
to adjust freely and
quickly according to
the laws of supply
and demand.

No Keynsian price
controls
KISS: What determines output?

Stock of Capital (K)


Labor (L)


The total of all machines,
equipment and buildings in
the economy.
The total effort of all
employed workers in an
economy
Y = F(K,L)

Y = Income = GDP
Y = F (K,L)

Aggregate Production
Function: How much
output is produced
from the inputs of
capital or labor.

More inputs of either
leads to increased
output.

Could this be a factor in
the immigration battles?
Aggregate Production Function


In most situations we
assume capital is
fixed at a constant
level!
LABOR is the only
variation that changes
the level of output in
the economy!
SO: What is the relationship
between labor and Output?



If capital is fixed?
Increases at a
decreasing rate.
WHY?

See page 133 for
graph 7.1
Principle of Diminishing Returns


Suppose that output is produced with two
or more inputs and that we increase one
input while holding the other inputs fixed.
Beyond some point – called the point of
diminishing returns – output will increase
at a decreasing rate.

See pgs. 133 - 135
Short-Run Production Function

Show how much
output is produced
when capital stock is
constant and labor
varies.
The Demand and Supply of Labor

Firms hiring depends
on the REAL WAGE.


The wage paid to
workers adjusted for
changes in prices.
What determines the
REAL WAGE?
The Marginal Principle
determines the Real Wage

Marginal Benefit >
Marginal Cost


Marginal Cost >
Marginal Benefit


Increase level of
activity
Reduce activity
Marginal Cost =
Marginal Benefit

IDEAL!
Huh!?

Marginal Benefit:
Benefit a firm
receives from hiring
an additional worker
is the VALUE of the
EXTRA OUTPUT
from the hiring.
Huh?!

Marginal Cost: Is the
REAL WAGE a firm
pays to hire the
additional worker

See page 135 for
wage scenario.
Here’s the Payoff

If real wages fall, then
MB > MC and more
people can get
employed.

Is that why some
politicians / employers
favor undocumented
workers?
Changes in Real Wages Affect
Workers Two Ways:

SITUATION: Workers
have to decide how
many hours they want
to work and how
much leisure time
they want.
#1 Way: Increasing Real Wages

Make working more
attractive and raise
the opportunity costs
of NOT working.

SUBSTITUTION
EFFECT: Substitution
of work for leisure
time.
#2 Way: Raising Real Wages

Higher wage raises
workers income for
the same hours
worked. Workers
may choose more
leisure over work.

INCOME EFFECT:
Leads to decreased
supply of labor.
Substitution Effect v. Income
Effect

Do NOT work
together.

See pages 136 – 137
scenarios.
Capital Stock Changes?

Marginal Benefit for
hiring workers
increases.

Workers are becoming
more productive with
the additional capital.
Labor Market Equilibrium and Full
Employment

Read scenario pg.
138 - 139
SO: Y = F (K,L)
Potential output increases
as the supply of labor
increases or the stock of
capital increases.
Liberal immigration plans
will shift the labor curve
RIGHT and lead to higher
level of employment.
OUTPUT increases.
Investors are
happy
Voters are
happy
Make sure to read
VARIATIONS IN LABOR
SUPPLY
Page 140.
Other Names in Classical
Economics



Jean Baptiste Say,
David Ricardo, John
Stuart Mill, Thomas
Malthus, etc.
ACTUALLY a term
created by Keynes to
contrast his theory
from “theirs.”
Theories from 18th –
early 20th Century.
Say’s Law


The doctrine that
states that supply
creates its own
demand.
Demand would
always be sufficient to
purchase the goods
and services
produced.
Questions to ponder:



Why would Say’s Law appeal to classical
economists?
Could you give an example of Say’s Law?
Why would Say’s Law apply to the labor
situation in the US?

Would you agree or disagree with the
statement that “undocumented workers do
the jobs Americans don’t want to do.”
Role of Taxes in Classical
Economics

What do you think Republicans / Classical
Economists think about taxes?



Taxes only to cover infrastructure (small)
More independence for individuals /
businesses
Trickle-down taxes

Regressive taxing not progressive.

Reason?
 MC>MB = less jobs
Can a tax cut create more
government revenue?

Economist Arthur Laffer
said YES!

KEEP IN MIND! Laffer’s
example was with net
exports and tariffs.
Politicians applied it to
income taxes / payroll
taxes!

Laffer’s Curve

IF government
RAISES the tariff
taxes on imports –
they will actually
collect LESS tax,
because no one can
afford the goods.

Inverse relationship
Laffer’s Curve and Capital Gains
Taxes


Capital Gains: Profit you
get from selling a stock at
a higher price than you
bought it at.
Since the tax on capital
gains is too high, people
don’t sell their stock –
bringing down Y and
decreasing govt.
revenue.
Laffer’s Curve and Capital Gains
Taxes

Some politicians say
lowering – or
removing – the capital
gains tax would
increase Y and
maybe other ways to
tax people since they
will have more jobs.
Real Business Cycle Theory

What causes
fluctuations in
economic activity?



Natural disasters
Shifts in technology
Small shocks at the
same time
Real Business Cycle Theory

Theory that
emphasizes how
shocks to technology
an cause fluctuations
in economic activity.
Examples of Real Business Cycle
Theory


Changes in
technology will
change the level of
full employment or
potential output.
Adverse
developments will
cause shocks that
cause output and
employment to fall.
Real Business Cycle School of
Thought




Very influential
Very controversial
Doesn’t explain some
historical situations.
Makes the
assumption that labor
is always at
equilibrium between
demand and supply.
Proponents of Real Business
Cycle Theory


Other models handle
unemployment.
So far, it hasn’t made
it into the macro
policy circles.

BUT it is an area of
active research in
classical economics.
Division of Output Among
Competing Demands


Y = f(L,K)
In a full employment
economy, total GDP
is determined by the
factors of production
(K).
Division of Output Among
Competing Demands

Full-employment
must be divided up
between C, I , G, X-M

OR C + I + G + NX

Governments – for
whatever reasons –
increase government
spending.
Division of Output Among
Competing Demands

Government
spending might affect
other types of
expenditures (C, I, XM)

CROWDING OUT.
Crowding Out (See pg. 145)

NOTE: US Consumes
67% of its GDP and
invests a smaller portion
than Germany or Japan.


Is it due to savings rates
cutting into consumption?
Is it due to higher payroll
taxes cutting into
Consumption?
Closed Economy: GDP =
C+I+G+X


Closed Economy: No
international trade.
Increasing
government spending
comes at the expense
of other uses of GDP.

Higher taxes means
less money to spend.

Crowding out
Crowding Out in an Open
Economy: GDP = C+I+G+X-M



An economy with
international trade.
Government
spending does not
need to crowd out
either C or I
What does get
crowded out?

Net exports
Crowding In?

IF output (GDP) is
fixed:

Decreases in Govt.
spending means other
aspects of C, I, X-M
are going to “crowd in”

Net exports could
increase.
Crowding In in a Closed Economy



C or I will increase if
G decreases.
BUT inflationary
pressures will be on.
There is no “leakage”
for the excess money.