CLASSICAL THEORY OF INCOME
AND EMPLOYMENT
The
Theory of Income and employment was propounded
INTRODUCTION
by such economists as David Ricardo, J.B. Say etc.
J.B.Says was a classical french economist, Who was a
follower of Adam smith, he was of the view that, when a
product is created in economy, it creates an immediate
demand in the economy equal to its own value. As a result of
that demand equals to supply
ASSUMPTION OF THE THEORY
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There is the free market price system.
There is a closed laissez faire capitalist economy.
Wages and prices are flexible.
There is close coordination between money wages and real
wages.
Since supply creates its own demand, there can never be
any deficiency in demand.
Total output of the economy is divided between consumption
and investment expenditures.
Capital stock and technological knowledge are given in the
short-run.
CLASSICAL MODEL OF EMPLOYMENT
Production function
Y=F(N)
Labour supply=real wage rate
NS=F(W/P)
Labour demand=real wage rate
Nd=f(w/p)
NS=ND
S=F(r)
I=F(1/r)
S=I
STATEMENT OF THE THEORY
The classical theory states that full employment is
a normal feature of a capitalist economy. Full
employment is defined as a situation in which all
those who want to work at the existing rate of
wages get work without any undue difficulty. The
classical theory rules out the possibility of
unemployment in a free market economy. The
economy would always be in a full employment
equilibrium. According to classical economists
there is always full employment in the economy.
The classical believed in laissez faire economy.
CLASSICAL MODEL IS EXPLAINED
WITH THE HELP OF FOUR MARKETS OF
ECONOMY.
MONEY MARKET
GOOD MARKET
LABOUR MARKET
CREDIT MARKET
J.B SAYS LAW OF GOOD MARKETS
In barter economy goods produced either for their
own use or to exchange for other goods. So
concept of aggregate demand and aggregate
supply works and process of value equalization
starts till the equilibrium is settled in market.
 Supply creates its own demand means whatever is
produced in barter economy is sold out.
 Hence no possibility of over production and no
unemployment in economy.
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MONEY MARKET
Says law of market is equally valid in a money
economy.
 In money economy goods and services are
produced through out the year by the combination
of four factors of production.
 They are given rewards in form of rent , interest,
wages and profits. These rewards are simply used
for purchasing the goods and services. So
consumer pay these rewards in the form of prices
to the firms for the goods and services purchased.
hence AS=AD
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LABOUR MARKET
In this markets we will discuss supply of labour
and demand for labour.
 Further more demand for labour will be
discussed from the from the point of view of
single firm as well from economy point of view.
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DEMAND FOR LABOUR BY A SINGLE FIRM
We know that a firm will hire labour unless and
until the value of labour is equal to wage of
labour.
 The above condition for hiring labour is profit
maximizing condition for the firm demanding
labour.
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So the demand for labour is the demand which
depend on MPL.
 Inverse relationship exist between demand for
labour and MPL .
 It means that at the higher real wage rate the
demand for labour will be low while at lower
real wage rate the demand for labour will be
high.
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THE RELATIONSHIP SHOW IN THE DIAGRAM
MPL
MPL>W
w1
E
w
MPL=W
w2
MPL<
W
l1
L
L2
labour
AGGREGATE DEMAND FOR LABOUR
Aggregate demand means demand for labour
for all firms.
 Negative slope, aggregate demand for labour
shows different amount of labour at different
demand for labour.
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W/P
Y
W
W0
DL
o
DL
DL0
X
SUPPLY OF LABOUR
The individual supply of labour how much
works an individuals is willing to offer at
different wage rate.
 Wage rate is possitive related with supply of
labour.
 Market supply or aggregate supply means all
individuals works willing and able to work.
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Y
ASL
ASL=(W/P)
W3
Wage rate
W2
w1
O
L1
L2
Labour supply
L3
X
EQUILIBRIUM IN LABOUR MARKET
Equilibrium in labour market is attain at w/p where
DL = SL.
 If wage rate increase due to any reason, then this
increase will cause unemployment for short
period, because firms will lay off some employees
is cut down the extra cost. So according to classic
economist there is self adjustment process in
economy so again wage rate tends to decrease an
economy come back towards equilibrium.
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CREDIT MARKET
According to classical economist at the level of
full employment saving is equal to investment.
 It is the rate of interest which equalizer the
saving and investment is decreasing function of
rate of interest.
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Y
I
r1
S>I
b
a
r
Interest rate
S
E
c
r2
d
I>S
I
S
o
Saving=Investment
X
If rate of interest increases from equilibrium
rate of interest, saving become greater then
investment it shows surplus saving.
 Credit market is in equilibrium at point E & rate
of interest is I.
 Similarly if the rated of interest decreases then
equilibrium rate of interest then investment
become greater then saving.
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This equality between saving and investment is
automatic adjustment process and there is no
need of govt. intervention.
 Market forces clear the market and there is a
full employment prevail in the economy.
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WHY IS EQUILIBRIUM POSSIBLE AT
FULL EMPLOYMENT
P
Real wage rate W/P
output
S
N
D
Labour
S
E
S
D
Employment
CRITICISM OF CLASSICAL THEORY
Possibility of deficiency in effected demanded.
 Saving and investment are not interest elastic.
 Criticism of flexibility of wages arguments.
 Employment can not be increased by gernal
money wage cut.
 Possibility of under employment equilibrium.
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