Classical Theory of EmploymentCLASSICAL APPROACH OF EMPLOYMENT Meaning of determination of output and employment: The word “Determination” refers to determination of equilibrium level, hence, determination of output and employment means to determine the equilibrium level of output or National Income and employment resources of an economy. It is a macro study and relates to the economy as a whole. The equilibrium output of a good by an industry is determined by the equality of marked demand and market supply of that good. The study of determination of national income is a macro study and relates to all goods and services taken together called aggregate output. Equilibrium level of national income is determined by the aggregate demand and aggregate supply. Aggregate refers to the country as a whole. The maximum level of national income is reached when all available resources are fully employed. Such a situation is technically termed as full employment. Employment is influenced by the level of economic activity. When output rises, employment is also likely to rise. More workers will be taken on to produce the higher level of output. However there may be a time lag between changes in output and employment. In the short run, firms observing changes in demand may alter their output but may delay changing their employment levels until they are certain that the new level of demand will last. There are two sets of views they are: 1. The Classical view or traditional view which is based on economic thinking of Adam Smith, David Ricardo, J.B. Say and Others. 2. The modern view which is based on economic thinking led by John Maynard Keynes. 1. The Classical view or traditional view : The classical view of the economy was based on Say’s Law (Jean-Baptiste Say 1776-1832): ‘Supply creates its own demand’. In the circular flow of income each of the leakages creates funds for an injection, saving (S) provides funds for investment (I), tax revenue (T) generates funds for govt. spending (G) and imports (M) give money to foreigners to purchase exports (X). Thus every time a good or service is produced, sufficient income and expenditure are generated to purchase them, therefore Aggregate Demand (AD) = Aggregate Supply (AS). The classical economists believed in the existence of full employment in the economy. To them, full employment was a normal situation and any deviation from this regarded as something abnormal. According to Pigou, the tendency of the economic systems is to automatically provide full employment in the labour market when the demand and supply of labour are equal. Unemployment results from the rigidly in the wage structure and interference in the working of free market system in the form of trade union legislation, minimum wage legislation etc. Assumptions of Classical Theory are: 1. There is subsistence of full employment exclusive of inflation 2. There is a laissez faire capitalist economy without government interference 3. It is a closed economy without foreign trade 4. There is a perfect competition in labour and product markets 5. Labour is homogenous 6. Total Output of the economy is divided between consumption and investment expenditure 7. The quantity of money is given and money is only the medium of exchange 8. Wages and Prices are perfectly flexible 9. There is a perfect information on the part of al market participants 10. Money wages and real wages are directly related and proportional 11. Capital Stock and technical knowledge are given in short run. 12. The law of diminishing returns operates in production Say’s Law of Markets According to J. B. Say, when goods are produced by firms in the economy, they pay reward to the factors of production. The households after receiving rewards of the factors of production spend the amount on the purchase of goods and services. From this it follows that each product produced in the economy creates demand equal to its value in the market. This conclusion came to be known as Say’s Law of Market. Say’s Law of market states that supply creates its own demand. The income a person receives from production is spent to purchase goods and services by others. For the economy as a whole, therefore, total production equals total income. From this it implies that when the production of goods generate income sufficient to purchase goods, then there will be no deficiency of demand for goods, there will be no over production of goods and so no lay off or general unemployment for the workers. The essence of Say’s law is that whatever the economy generates is automatically spent. J. B. Say’s Law states that "Supply creates its own demand." It means that every increase in the productive capacity or the stock of fixed capital will be sold in the market and there will be no problem of lack of demand. This law meticulously meets with serious restrictions when an attempt is made to formulate it appropriate to the labor market and to the circumstances of employment level. Therefore, classical economists rule out the possibility of overproduction as there was no problem in selling the output produced. If there is general overproduction in the economy, then some laborers may be asked to leave their jobs. The problem of unemployment arises in the economy in the short run. In the long run the economy will automatically tend toward full employment when the demand and supply of goods become equal. When a producer produces goods and pays wages to workers, the workers in turn buy goods in the market. Thus the very act of supplying goods implies a demand for them. It is in this way that supply creates its own demand. According to Say's Law a produced good represents demand for other goods, not for itself. Say's Law does not equate supply & demand but makes supply a precondition for demand. Supply equals demand at the clearing price on a supply-demand curve for particular goods and aggregates. Supply constitutes demand, but demand does not constitute supply — one cannot have the means to buy without first having something to sell. Supply of a good can constitute demand for other goods. Classical economists did not refer to the principle that "supply constitutes demand" as "Say's Law", but called it "the law of markets". Say's Law is not an obscure and insignificant economic tenant. It is regarded as the most important issue in economics: how a society creates wealth. Say’s Law is equally applicable in a modern economy. The circular flow of income model suggests this sort of relationship. For instance, the income created from producing goods would be just sufficient to demand the goods produced. Classical economists believed that when price mechanism in a capitalist economy is acceptable to work generously exclusive of any intrusion by the Government then there is always a tendency to full employment in it. Of course, they believed that in an advanced capitalist economy time and again certain circumstances arise due to which economy is not in full employment equilibrium. But they definitely assumed that there was always a propensity to full employment in the economy and certain economic forces involuntarily maneuver so as to shift the economy towards full employment. Therefore, according to the classical economists when ever there are lapses from full employment level, then these are removed automatically by the working of free price mechanism. Price Flexibility and Employment Price flexibility s defined as the proposition that prices adjust in the long run in response to market shortages or surpluses. This condition is significant for long-run macroeconomic activity and long-run aggregate market analysis. Price flexibility ensures that long-run aggregate production is equal to full-employment production. The classical model of employment states that the changes in money wages and real wages are directly related and are proportional. Wherever there is cut in the money wage, the real wage is also abridged to some level which reduces unemployment and eventually leads to full employment in the economy. This affiliation is based on the postulation that prices are comparative to the quantity of money. It is criticized that in a competitive economy a reaction in the money wage diminishes the cost of production and prices of products by elevating their demand. Therefore more workers are employed for the production in order to meet the increased demand for the products. While employment amplifies, total output also augments unless full employment is accomplished. In case the economy is at the full employment level, total output becomes stable. Consequently, given the stocks of capital, technological knowledge and resources, a specific relation exists between total output and the amount of employment. Total output is an increasing function of the number of workers. Q = f(K,T,N) Where Q = total output K = capital stock T = technological knowledge N = number of workers This production function illustrates that in the short run the total output is an escalating function of the number of workers specified with the capital stock and technological acquaintance. Keyne’s Criticism of Classical Theory: Keynesian employment theory is based on the assessment of the classical theory. In this assessment, Keynes argued that savers and investors have contrary strategy which may not guarantee that equilibrium exists in the money market, that prices and wages tend to be rigid and equilibrium may not exist in the product and labor markets, and that periods of severe unemployment have occurred (which the classical theory denied). J.M. Keynes criticized the classical theory on the following grounds: Keynes has severely criticized the classical theory of employment in his book “General Theory”. He has attacked the classical theory on various grounds they are: 1. According to Keynes, saving is a function of national income, and is not affected by changes in the rate of interest. Therefore, saving-investment equality through adjustment in interest rate is ruled out. So Say’s Law will no longer hold. Accordingly, Say’s Law will no longer hold any significance. 2. The labour market is imperfect to large extent because of the existence of trade unions and government intervention in imposing minimum wages laws. Thus, wages are unlikely to be flexible and are more inflexible downward than upward. Therefore, a fall in demand (when S exceeds I) will lead to a fall in production as well as a fall in employment. 3. Keynes also argued that even if wages and prices were flexible, a free enterprise economy would not always be able to achieve automatic full employment. 4. Keynes rejected the fundamental classical assumption of full employment equilibrium in the economy. It was because he considered it to be as unrealistic and regarded full employment as a special situation. The general situation in a capitalist economy is one of underemployment. 5. Keynes refuted Say’s Law of markets that states “supply always created its own demand”. He maintained that all income earned by the factory owners would not be spent in buying products which they helped to produce. A part of the income is saved and is not automatically invested because saving and investment are two distinct functions. Therefore, when all earned income is not spent on consumption goods and a portion of it is saved, it results in a deficiency of aggregate demand. This shows the way to general over production because all that is produced is not sold. Consequently, it leads to general unemployment. 6. The classicists’ believed that saving and investment were equal at the full employment level. In case of any divergence, the equality was brought about by the mechanism of rate of interest. Keynes apprehended that the level of saving depended upon the level of income and not on the rate of interest. Likewise, investment is determined by rate of interest and also by the marginal efficiency of capital. A low rate of interest cannot increase investment if business expectations are low. 7. Keynes disagreed with the classical view that the laissez-faire policy was essential for an automatic and self adjusting process of full employment equilibrium. He indicated that the capitalist system was not automatic and self –adjusting because of the on-egalitarian structure of its society. Keynes, therefore, advocated state intervention for adjusting supply and demand within the economy through fiscal and monetary measures. 8. The classical economists considered money as unbiased. Therefore, they excluded the theory of output, employment and interest rate from the monetary theory. According to them, the level of output and employment, and the equilibrium rate of interest were determined by real forces. Keynes criticized the classical view that the monetary theory was separate from the value theory. He integrated monetary theory with value theory, and brought the theory of interest in the field of monetary theory. 9. Keynes disapproved the Pigovian formulations that a cut in money wage would achieve full employment in the economy. The greatest fallacy in Pigou’s analysis was that it extended the argument to the economy which was applicable to a particular industry. Besides this, Keynes also rejected the classical view that there was a direct proportionate relationship between money wages and real wages. According to him, there is an inverse relation between the two. It can be reciprocated as- When money wages fall, real wages rise and vice versa. 10. The classicists believed in the long run full employment equilibrium through a self adjusting process. Keynes had no patience to wait for the long period for he believed that “In the long run- we are all dead.” 10. The classicists believed that through a self adjusting process, a long run full employment can be achieved. Keynes was impatient to wait for the long period as he believed that “In the long run- we are all dead.” Conclusion Classical economics is based on three key assumptions--flexible prices, Say's law, and savings-investment equality. The theoretical structure of classical economics is based on the analysis that the macroeconomy operates in aggregate in accordance to the same basic economic principles that guide markets and other microeconomics phenomena. The economic principles of classical economics indicate that aggregated markets, especially resource markets, automatically achieve equilibrium, assuring the full employment of resources. The classical economics indicates that full employment is achieved and maintained without the need for government intervention and that government intervention is more likely to cause than to correct macroeconomic problems. Classical economics maintains to play an important role in modern macroeconomics. Although commonly discredited by the Great Depression and the theory of Keynesian economics, classical economics persisted and reemerged in the 1980s (when the flaws of Keynesian economics emerged). The core classical notions of unrestricted markets, laissez faire, limited (or no) government intervention, and emphasis on supply rather than demand surfaced in modern macroeconomic theories, including supply-side economics and rational expectations theory. Conceivably, the most important inheritance of classical economics is the aggregate market analysis, or AS-AD analysis. It represents the state-of-the-art in modern macroeconomics. AS-AD analysis combines many of features of classical economics and Keynesian economics. To be precise, the long-run aggregate supply and the long-run adjustment of the AS-AD model to full employment capture the essential features of classical economics.