CLASSICAL THEORY OF INCOME OR EMPLOYMENT

According to classical Theory of income, full employment is a normal feature of capitalist economy. If there is an unemployment in these economies, it will be for a short period , because under unemployment situation economic forces themselves change in such a manner as to remove unemployment. In a situation of unemployment, demand for labor is less than their supply. Due to low demand, money wages of the laborers will fall. Low wage rate, in its turn, will raise the demand for laborers.

Determination of Income and Employment According to classical economists, income and employment in an economy are determined by production function and the equilibrium of demand for and supply of labour. Production function expresses the relation between factors of production and volume of production. In other words, production (P) is the function of labour (N), capital (K), land (L) and technique (T), i.e., p = f(L,K,N,T} In short period, capital (K), land (L) and production technique (T) remain constant. Volume of production therefore, depends on the level of employment, (N) i.e., P f(N)

Production function is explained diagrammatically as under: In this diagram, level of employment or number of labourers is shown on OX -axis and output (production) on -OY-axis. Curve OS is output curve. It expresses the relation between employment and output. It is clear from this curve that as the level of employment increases output too increases. When level of employment is ON, output is OF when employment increases to ON1 output increases to OP1. Similarly, with the increase in employment to ON2 there is increase in volume of output to OP2. This diagram shows that increases in the Figure 1 proportion of output is less than the proportion of employment. Level of employment in an economy is known by the equilibrium of demand for and supply of labour.

Explanation of the Classical Theory of Employment According to classical theory of employment, full employment is a normal feature of capitalistic economy. In the short run, it may be possible that due to certain reasons unemployment situation may arise in the economy but the self-adjusting economic forces will bring it to an end and restore full employment situation. Classical Theory of Income is mainly based on the following two facts: (i) Flexibility of Wages, Interest and Prices (ii)Say’s Law of Markets

Flexibility of Wages, Interest and Prices In case of unemployment in the economy, demand and supply will change is such manner as to bring the economy back to full employment level. Changes in these prices during unemployment situation on full employment can be made clear as under: (i) Flexibility of wages or change in wages : Wage rate is determined in the labour market. Demand for and supply of labour depend on real wages. The same can be calculated by dividing the money wages by the prevailing price-level, i.e., Real Wages = Money Wages Price

Demand for labour increases with fall in their real wage Demand for labour increases with fall in their real wage. Demand for labour is less than its supply when there is unemployment in the economy; then fall in money wages will lead to fall in real wages. Fall in real wages will increase demand for labour & remove unemployment thereby resorting full employment situation in the economy.

(ii) Flexibility of Rate of Interest or Changes in the Rate of Interest or equilibrium in the goods market: That part of income which is not spent on consumption goods is called saving in an economy. If this saving is not turned into investment or spent on buying capital goods, then aggregate demand will fall, production will fall and unemployment will rise. it is therefore, essential that in order to maintain full employment situation, the entire saving must be invested, in other words, saving & investment (S=I) must be equal. Classical Economists held the view that in the the event of equality of saving and investment, there will be equality of aggregate demand and aggregate supply.

Consequently, there will bee in the goods market Consequently, there will bee in the goods market. If, however, saving and investment are not equal, then according to classical economists, changes in the rate of interest will equate saving & investment Equilibrium in the Goods Market will be re- established. (iii) Flexibility of Price level or Change in Prices or Equilibrium in Money Market : According to classical theory of employment, in the short period unemployment in an economy arises when aggregate demand falls short of aggregate supply. Aggregate demand is estimated by multiplying the supply of money (M) by its velocity of circulation (V), i.e., MV

Aggregate supply is estimated by multiplying price-level Aggregate supply is estimated by multiplying price-level. (P) and trade transactions (T) i.e., PT. In other words, it can be said that under equilibrium situation: (Aggregate demand) MT= PT (Aggregate Supply) (Here M = supply of money; P = price-level ; V = velocity of circulation of money; T = goods traded) This equation tells that if velocity of circulation of money (V) and volume of goods traded (T) remain constant, then there will be direct relation between price-level and supply of money: P= f(M) (It reads : Price-level (P) is a function (f) of money (M))

Equation (1) is called Quantity Theory of Money Equation (1) is called Quantity Theory of Money. It tells that in order to maintain full employment situation, it is necessary that there should be equilibrium in money market as well. Money market is in equilibrium when total demand (MV )is equal to total supply (PT) . If there is unemployment in an economy, money-wage will fall. Because of low wage-rate entrepreneur will provide more employment to labourers. There will be more production.

OUTPUT REAL INCOME OUTPUT THE REAL ECONOMY With supply and demand determining the level of labor input, the production function indicates the corresponding level of output. Note that when the demand curve is extended to the horizontal axis (at which point the demand price of labor is zero), the marginal productivity of labor is also zero. LABOR INPUT REAL WAGE RATE The output of the economy, which includes both consumer goods and producer goods, is sold at competitive prices, generating the revenue to pay the incomes of both laborers and capitalists. Those incomes, then, are precisely enough to buy the economy’s output. S D LABOR INPUT

S D THE REAL ECONOMY Y/P = Q Q = f(K, N) OUTPUT REAL INCOME THE REAL ECONOMY Y/P = Q Q = f(K, N) K = K0 Q is the economy’s real output. Y is nominal income. P is the price level. Y/P is real income. N is the variable labor input. K is the given capital input. W is the nominal wage rate. W/P is the real wage rate. (Y/P)N is real labor income. Y/P − (Y/P)N is capitalist income. N LABOR INPUT REAL WAGE RATE W/P S D (Y/P)N N LABOR INPUT

CRITICISM OF CLASSICAL THEORY OF INCOME OR EMPLOYMENT Weaknesses of Say’s Law of markets. Employment cannot be increased by general money wage-cut. Possibility of under-employment equilibrium. Absence of automatic adjustment. Money is not merely a veil. Saving &investment are not interest –elastic. Rejection of laissez – faire policy. It ignore the problems of short period. It is not a Analysis of General Equilibrium.