Unit - 4

Theory of income and employment

Classical Theory of Employment and Output
The classical theory of employment is developed by J.B
say it is also known as "Say's law of Market". The
classical economist like J.S. Mill, Marshall, Pigou, etc.
has supported this law of J.B Say. Classical economists
assumed full employment, free market economy without
government intervention and perfect competition market.
According to them the unemployment is a temporary
phenomenon it will be disappear in long run in perfect
competition market. For the realization of full
employment, there shouldn't be government intervention,
monopoly market and labour unions.
Assumptions
1. Individuals are rational human beings and are
motivated by self interest.
2. There is perfect competition in both product and real
3. People do not have money illusion.
4. Laissez- false condition prevails.
5. There is a closed economy.
6. Technique of production does not change.
7. Money is only medium of exchange.
8. Wages and prices are flexible.
9. The labors are homogenous.
10. There is full employment in the economy.
Components of classical theory of employment and
output
1. Labours Market: According to the classical theory of
employment other things remaining same, wage rate
flexibility assumes that in a competitive market full
employment is provided and full employment output is
produced. Wage rate is determined by the force of
demand and supply of the labour in labour market.
Demand for labour is negative function of real wage
rate and supply of labour is positive function of real
wage rate. The wage rate is determined where the
demand for and supply of labour are equal to each
other. According to the classical theory unemployment
is caused by government interventions, passing
minimum wage legislation. This concept can be
explained with the help of given figure.
In the figure A, X- axis shows the employment Y -axis
shows the real wage rate. DL is the demand curve for
labour and SL is the supply curve of labour. E is the
equilibrium point where DL and SL curve intersect each
other and wage rate and full employment are determined
by (W/P) and ON respectively. If real wage rate is (W/P) 1,
supply of labour is more than its demand so wage rate is
reduced to (W/P) if real wage rate is (W/P) 2 supply of
labour is less that its demand which push the real wage
rate to (W/P). So, the flexibility of wage creates full
employment in the labour market at ON.
In the figure B, X- axis shows the employment and Y-
axis shows the output Y= f (N) and curve represents the
total production function. At full employment level, ON,
the corresponding full employment output is OY.
2. Product market: According to Say's law, full
employment is maintained when whole income is spent
on the purchase of whole output. Total output
comprises of consumer goods (c) and investment goods
(I) and total income is partly spent on consumer
goods(c) and partly saved (S). It can be expressed as :
Total income = Total output
C+S = C+I
S=I
where,
C = consumption
S = saving
I = investment
So, saving investment equality gives the market clearing
situation in the product market. It means saving of
household is scan by business sector in investment.
According to the classical economist interest rate
flexibility makes saving and investment equals. Saving is
the positive function of rate of interest and investment is
the negative function of interest rate. The equilibrium rate
of interest is determined at the level where saving and rate
of interest are equal. It can be explained with the help of
given figure.

In the above figure, x-axis shows the saving and

investment y-axis shows the rate of interest. II represents
investment curve and SS represents the saving curve.
These two curves are intersected at point E. So, rate of
interest is determined by OR and saving investment is
determined by OM. If the rate of interest is OR 1, there is
excess saving and if the rate of interest is OR 2, there is
excess investment. Both the situation is disequilibrium
situation. Hence, rate of interest and saving and
investment are determined OR and OM respectively.
3. Money Market: The classical economists believed in
quantity theory of money. According to this theory the
supply of money determines the price level. Irving
Fisher's equation of exchange status that total
expenditure on final goods and services (MV) is equal
to total value of output (PY).
MV=PY
P= MV/Y.
where ;
P = price level
M = quantity of money
Y = level of aggregate output
V = velocity of circulation of money
According to classical economists, Y and V remain
constant. So, the price level is determined by the quantity
of money (M) and there is positive relationship between
M and P. It can be explained with the help of given figure.
In the figure A, X- axis shows the price level and Y- axis
shows the output. MV is the initial money supply curve.
At full employment level of output OY the price level is
OP. When supply of money increases from MV to M 1V at
constant full employment output OY, the price level
increases to OP1.
In figure B, x-axis shows price level y - axis shows
money wage. (W/P) is the real line. At OP price level, the
money wage is OW when the price level rises to OP 1,
money wage rises to OW1. The price wage combination
OW1 = OP1 is consistent with the full employment real
wage level (W/P) determined in the labour market.

Criticisms of classical theory of employment and

output
The classical theory is criticized by Keynes's criticized
that the classical theory of employment can't solve the
economic problems. The main criticisms are:
1. Under employment equilibrium: According to the
classical economists there is situation of full
employment in free market economy. Flexibility of
wages always tends to full employment equilibrium but
according to Keynes economy is under employment not
full employment.
2. Supply does not create its own demand: According to
J.B say "supply creates its own demand". But Keynes
further told that a part of increased income is spent on
consumer goods and other is saved. There is not any
guarantee that all saved income will be spent on
investment. If investment does not increase in
employment that creates deficiency of demand.
3. No automatic adjustment: Classical economists
 believed that economic system is automatic adjusting in
character. But Keynes rejects these automatic adjusting
system due to following preference are;
 When liquidity preference is perfectly elastic.
 When investment function becomes interest rate
inelastic.
 When due to money illusion.
4. Government intervention: Classical economists are
against the government intervention. But Keynes
recommended that government should intervene in
economic activities through economy from
uncertainties.
5. Role of money: According to classical economists
money is only the medium of exchange. Keynes
focused that money has other functions too i.e. star the
value.
6. Saving investment equality: classical economists
emphasized that saving and investment are equal and
this equality is maintained by the rate of interest rate
adjustment mechanism. But investment is determined
by rate of interest and marginal efficiency and capital.
7. Long run analysis: The classical theory of
employment is long run analysis. But Keynes told that
in long run we are dead. Actual problems and they must
 be given greater importance.
8. Assumption of perfect competition: The classical
theory's based on the unrealistic assumption of perfect
competition which does not exist in the real world.
9. Not a general theory: The classical theory is not a
general theory it only deals within situation of full
employment but there may be the situation of full
employment, underemployment and employment.
10. Not practical: The classical theory has little practical
significance it does not provide any solution of the
problems of unemployment and trade cycles.

Say's law of Market

Say's law of market is an important law of economics. It
is the foundation of classical economics. The classical
theory of employment and output is based on J.B Say's
law of market. According to Say, "Supply creates its own
demand." This means the production of goods will create
demand for them too because the production not only
supply the goods it also provides the employment to the
people. If employment increases, income and demand for
goods also increases. There is not the possibility of over
production and unemployment in the economy. Say's law
of market applies both in barter and monetary economy.
Assumptions
1. There is existence of free market economy.
2. There is no government intervention and international
trade.
3. Money is only medium of exchange.
4. There is no leakage in the circular flow of income
between different economic units.
5. Wages and prices are flexible.
6. Saving equals to investment.
On the basis of above assumption, we can explain say's
law of market with the help of given figure,
The above figure shows the circular flow of income and
expenditure between business sector and household
sector. It shows that all the resources required by business
sector are provided by the household and all the goods
and services produced by business sectors are purchased
by household sector from the above figure it is clear that
the business sector pay Rs. 4000 to the household sector
for the resources and the household sector also pay Rs.
4000 to the business sector to purchased goods and
services. So, classical economists argued that all the
resources available with household sector are used by
business sector and all the goods and services produced
by business sector are consumed by household sector.
There is not over production and unemployment problems
in the economy.

Implications of Say's law

1. Self- adjusting economy: According to J.B Say's there
is an automatic adjustment in the working of the
economy. If supply increases demand also increases and
adjustment takes place between them.
2. No general over production: There is not the
possibility of over production in the economy .If
 production increases, the income of the factor of
production also increases and new demand is created.
3. No general unemployment: There is no general
unemployment and over production. Even if there is
unemployment it is temporary and disappears in the
long run.
4. Flexibility in wages creates full employment:
According to J.B Say if there is unemployment the
wages rate will be decreased and employment is
provided to more workers. For this the government
should not adopt the policy of wages rigidity.
5. Policy implication: The say's law of market is
important for policy implication. According to this law
economy is automatically adjustable; there is no need of
government intervention.