Explains the economic theory of income and employment

1. THE CLASSICAL THEORY OFTHE CLASSICAL THEORY OF
INCOME AND EMPLOYMENTINCOME AND EMPLOYMENT
BYBY
Andrew MohoniAndrew Mohoni

2.  Before explaining the Keynesian theory ofBefore explaining the Keynesian theory of
income and employment we first look at theincome and employment we first look at the
classical theory regarding income andclassical theory regarding income and
employment determinationemployment determination
 Classical economists believed that in a freeClassical economists believed that in a free
market economy there was always a tendencymarket economy there was always a tendency
towards the establishment of full employmenttowards the establishment of full employment
of labour and there was sufficient demand forof labour and there was sufficient demand for
the output produced.the output produced.

3.  Classical theory was propounded by RicardoClassical theory was propounded by Ricardo
and Adam Smithand Adam Smith
 Classical theory of employment and output isClassical theory of employment and output is
based on the following two basic notionsbased on the following two basic notions
-Says law-Says law
-Wage price flexibility-Wage price flexibility

4. Says Law and classical theorySays Law and classical theory
 Was put forward by French economist JB say: Supply createsWas put forward by French economist JB say: Supply creates
its own demandits own demand
 Every increase in production made possible by the increase inEvery increase in production made possible by the increase in
productive capacity (the stock of fixed capital) will be sold inproductive capacity (the stock of fixed capital) will be sold in
the market and there will be no problem of lack of demand.the market and there will be no problem of lack of demand.
 Thus over production is ruled out by classical economists.Thus over production is ruled out by classical economists.
 According to says law, greater production automatically leadsAccording to says law, greater production automatically leads
to a greator money income which creats the market for theto a greator money income which creats the market for the
greator flow of the goods produced.greator flow of the goods produced.

5.  Process of capital accumulation and expansion ofProcess of capital accumulation and expansion of
productive capacity continues till all people areproductive capacity continues till all people are
employed (no deficient demand)employed (no deficient demand)
 Income not spent on consumption is saved and itIncome not spent on consumption is saved and it
becomes investment expenditure. Hence investmentbecomes investment expenditure. Hence investment
equals savingsequals savings

6. Role of prices for full employmentRole of prices for full employment
determinationdetermination
 Prices should work freely and are fully adjustable.Prices should work freely and are fully adjustable.
 When ever there are lapses from full employment they areWhen ever there are lapses from full employment they are
removed automatically by the working of free priceremoved automatically by the working of free price
mechanism.mechanism.
 Incase savings increase and consumption is likely to fall,Incase savings increase and consumption is likely to fall,
prices are fully flexible and there will be no lack of demand.prices are fully flexible and there will be no lack of demand.
(real output and employment will not fall)(real output and employment will not fall)
 Prices of factors of production like wages are also fullyPrices of factors of production like wages are also fully
flexible.flexible.
 When prices are lowered wages will also be lowered to adjustWhen prices are lowered wages will also be lowered to adjust
for profitability.for profitability.

7.  Workers not willing to work at low wages thenWorkers not willing to work at low wages then
they are voluntarily unemployed (which is notthey are voluntarily unemployed (which is not
real unemployment).real unemployment).
 Hence it is the involuntary unemploymentHence it is the involuntary unemployment
which is not possible in a free capitalistwhich is not possible in a free capitalist
economy according to the classicaleconomy according to the classical
economists.economists.

8. Keynes’s criticism of says lawKeynes’s criticism of says law
 Keynes theory was constructed during the greatKeynes theory was constructed during the great
depression (1929-1933). that was characterized bydepression (1929-1933). that was characterized by
falling prices and rising unemployment. Keynesfalling prices and rising unemployment. Keynes
criticized says law especially the view that generalcriticized says law especially the view that general
cut in wages will increase employment.cut in wages will increase employment.

9.  According to Keynes wages are not only costs ofAccording to Keynes wages are not only costs of
production but are also income for households andproduction but are also income for households and
affect demand for goods and services.affect demand for goods and services.
 According to classical economists the level ofAccording to classical economists the level of
employment depended on money wages. but keynesemployment depended on money wages. but keynes
argued that it depended on Aggregate demand.argued that it depended on Aggregate demand.
 According to your own judgment do you see anyAccording to your own judgment do you see any
problem with classical theory of economics?problem with classical theory of economics?
 If so What?If so What?
 Further reading on classical economics refer:Further reading on classical economics refer:
Macroeconomics theory and policy by Ahuja Chap 3Macroeconomics theory and policy by Ahuja Chap 3

10.  Keynes theory of income andKeynes theory of income and
employment determination is a short runemployment determination is a short run
theory.theory.
 Employment depended on the level onEmployment depended on the level on
national income and production.national income and production.
 Principle of effective demand occupies aPrinciple of effective demand occupies a
significant place.significant place.

11.  Classical theory concerning wages and employmentClassical theory concerning wages and employment
is valid for the single firm. Even if prices fall, theis valid for the single firm. Even if prices fall, the
firm can sell more to other consumers who are notfirm can sell more to other consumers who are not
necessarily the ones whose incomes have beennecessarily the ones whose incomes have been
reduced.reduced.
 The fundamental flow in pigous analysis is that heThe fundamental flow in pigous analysis is that he
applied partial equilibrium analysis which is valid inapplied partial equilibrium analysis which is valid in
the case of one industry.the case of one industry.
 The determination of the level of aggregate incomeThe determination of the level of aggregate income
and employment in the whole economy should beand employment in the whole economy should be
analyzed using a general equilibrium analysis ratheranalyzed using a general equilibrium analysis rather
than with partial equilibrium analysisthan with partial equilibrium analysis