Main features of the Classical theory of employment and income. Automatic equilibrium achievement of the market.

1. UNIT 2
CLASSICAL THEORY OF
EMPLOYMENT
Prof. Prabha Panth

2. 18-Jul-13 2
Classical theory
According to Classical theory:
• The economy is always in equilibrium,
• No government interference (laissez faire)
• Market forces ensure equilibrium.
• Full employment achieved due to flexible prices and
wages.
• Unemployment is due to high wage rate.
• If wage rate is reduced, employment increases. (Pigou’s
law of wages)
• If D S, prices adjust and restore equilibrium.

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Pigou’s law of wages
0
Employment
MP of L
Output
w1
a
N1
w2
b
N2
If w falls
from w1 to
w2, total
employment
increases
from N1 to
N2.
So low
wage rate,
high level of
employment

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Market Clearing
0
P
Q
Market D
Market S
P0
D0 S0
D < S,
P falls
P1
S1 D1
S < D
P rises
E, S = D
Pe

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Savings = Investment
According to Classical theory:
• Savings = Investment, and determines it (important).
• S is positively related to rate of interest. S = f(i)
• Investment is negatively related to rate of interest.
I = - f(i)
• Those who save are same as those who invest.
• So S will always be equal to Investment.
• If they are not equal, then rate of interest will adjust to
achieve equilibrium.

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Savings = Investment
0
Interest %
Funds
Investment
Saving
i0
I0 S0
I < S,
i falls
i1
S1 I1
S < I
i rises
E, S = Iie

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Say’s Law of Markets
Say’s Law: “Supply creates its own demand”
At the macro level, total output = total
expenditure = total income.
Y = C + S.
Y = C + I
Therefore there cannot be over production,
or unemployment in the economy.
The Macro economy is always at full
employment equilibrium.

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Say’s Law of Markets
Output
= Rs.1000
C = 800
S = 200
I = 200
Y = C+ S
Y = C + I

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Full employment, full capacity
equilibrium
• So in a capitalist market, with perfect
competition, there is:-
1. Full employment due to adjustment in w-
rate
2. Market clearing, because D = S, due to
adjustment by Ps.
3. No inflation, no deflation.
4. No trade cycles.

10. Classical Fallacies
• Classical and Neo-classical economists were unable to
explain why trade cycles occur.
• According to them the market prices will always adjust to
bring about equilibrium.
• But during the Great Depression of 1929, prices,
incomes, and employment fell continuously.
• The Market could not ensure equilibrium.
• Keynes showed that what is true at the Micro level is not
true at the Macro level.
• We look at Keynesian arguments in the next lesson.
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