Classical Macroeconomic Theory and the Concept of Full Employment, Summaries of Sports Law

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The Classical Theory of

Output and Employment

Classical Macroeconomics

• The “classical views” refer to the views and thoughts of the classical economists.
• (^) The classical economists are referred to the economists from Adam Smith , the founder of economics, to

those of 18

th

and 19

th

century.

• (^) The views, thoughts and theories formulated by the classical economists mainly by David Ricardo, John

Stuart Mill, Robert malthus, Alfred Marshal and Arthur C. Pigou are regarded as classical economists

• These classical economists had not developed any coherent macroeconomic theory. The

macroeconomic views of the classical economists, as envisaged by the economists of the post-Keynesian

era are treated as the classical macroeconomic postulates

• The classical postulates of full employment and equilibrium of the economy are based on the

assumption that the economy works on the principles of laissez-faire. The following are the features of

laissez-faire system:

There is no government control or regulation of private enterprises. If there is any government

interference, its objective is to ensure free competition.

There are no monopolies and restrictive trade practices – if there are any, they are eliminated by

law.

There is complete freedom of choice for both consumers and the producers.

Market forces of demand and supply are fully free to take their own course depending on the

demand and supply conditions.

• (^) Money – only medium of exchange

The classical economists treated money only as a medium of exchange. According to the classical

economists, the role of money is only to facilitate the transactions. It does not play any significant role in

determining the output and employment. The levels of output and employment are determined by the

availability of the resources – labour and capital.

Overall summary of Classical Economy

• (^) The classical economists held the view that an economy working on laissez-faire principles is always in

the state of equilibrium at full employment.

• (^) The free market mechanism ensures optimal allocation of resources so that marginal productivity of

factors of production in all industries is the same.

• The labour force is fully employed at the market wage rate
• (^) Actual output equals potential output. There is neither underproduction nor overproduction. The entire

market system works automatically and it maintains the economy in equilibrium. Whenever there is

deviation from the equilibrium, the ‘invisible hands’ of demand and supply come into operation

and restore the equilibrium.

Two Major derivatives of Say’s Law

• No General Overproduction or Underproduction

Say’s Law was refined by a group of classical economists and especially by David Ricardo. The

contribution of David Ricardo is known as reformulation of Say’s law.

The classical reformulation of Say’s law states that, in a capitalist economy, the total supply always

equals total demand. There cannot be any ‘general overproduction’ or ‘general underproduction’. This

means, an economy under the laissez-faire system is always in equilibrium.

The presence of overproduction or underproduction, if any, are only transitory and are caused by

external factors. This means, there might be some short-term imbalances in the demand for and supply

of some goods and services caused by the exogenous factors.

When, there is underproduction, there is excess demand in the economy, leading to price rise. The rise

in price results in the reduction of demand on one hand and the increase in supply on the other.

Again, if there is overproduction, there is excess supply in the economy, leading to fall in price. This

decrease in price leads to fal in supply on one hand, and increase in demand on the other hand.

Thus, in both the cases, the demand-supply adjustment restores the equilibrium. Thus, in the long run, a

market economy is always in equilibrium

• (^) No Unemployment under the Classical System

As per the classical postulates, in a free enterprise economy, full employment is maintained. This means

that there cannot be general unemployment in a free enterprise.

The classical economists argue that full employment ensures that the actual output is equal to the

potential output and the total production is always sufficient to maintain the economy at the level of full

employment.

Unemployment, if any, is a temporary phenomenon. When unemployment exists, it pushes the wage

rate down which makes the employment of labour more profitable. This results in the increase in

demand for labour and unemployment disappears.

One important point here is, there can be voluntary and frictional unemployment present even in the

state of full employment.

Voluntary unemployment arises when

I. Potential workers are unwilling to work at the prevailing wage rate

II. Workers go on a strike

Frictional unemployment arises when workers remain temporarily out of job due to labour

market imperfections, immobility of labour, seasonal nature of occupation as in agricultural

activities, technological changes, natural calamities, wars, etc.

1. Aggregate Production Function

• According to the classical economists, the national output of a country at any point of time depends on

the employment of capital and labour. It is denoted as

Where Y is the real output, K is the capital and L is the number of labour.

• (^) This aggregate production function determines the aggregate output and employment simultaneously.
• The assumptions of classical production function are

The stock of capital, K is fixed

Technology of production used by the firms is given

Population is constant

The labour is homogenous in nature

Diminishing marginal productivity of labour, which means that with an increase in the employment

of labour, the marginal productivity of labour decreases.

• (^) This classical framework has been constructed in a short run framework. Thus, we can say that the

national output in the short run is the function of the employment of labour drawn from a constant

population.

• (^) The level of output at which the marginal productivity of labour is zero, the level of employment and

national output is maximum.

• This figure shows the short-run aggregate

production function

• (^) The shape of the total product curve shows

the existence of diminishing marginal

productivity of labour.

• The output is maximum at when labour is

ON and the total amount of output is MN.

• The demand for labour depends on the marginal revenue productivity of labour ( and real wage.
• (^) The is defined as the product of the marginal productivity of labour and price of the commodity labour

produces.

• (^) Since the firms are profit maximizing units, they will hire labour which maximizes the profit, the

necessary condition for profit maximization of a firm is MR = MC.

• (^) Let us assume that labour cost is the only cost of production, then the marginal cost incurred for the

production of one additional unit of output can be expressed as marginal wage (MW).

• Again, the marginal revenue (MR) earned from the sell of one additional unit of output can be defined as

the marginal revenue productivity of labour. Thus, the profit maximizing condition can be expressed as

• (^) This means that labour demanded per day equals the number at which

• (^) In this figure, the curve represents the labour

demand curve.

• It shows that as the wage rate increases, labour

demand decreases. If the wage rate is Rs 80, the

demand for labour is 4 workers as it this level,. As

the wage rate declines to Rs 40, the demand for

labour increases to 5 workers.

0

L

MW

80

40

4 5

Important Observation of Classical Theory

• One of the most important feature of the classical model is that factors operating on he supply side of

the market determine the level of employment.

• (^) It is already shown that the labour market equilibrium is determined by the labour demand and the

labour supply curve. However, labour demand is determined from the production function based on a

given technology, which is determined exogenously. The labour demand thus, can be termed as a given

law or fact.

• (^) According to classical theory, the labour supply depends on the real wages and it plays a more

important role in the determination of labour market equilibrium and employment. In turn,

employment determines the level of output.

• (^) Thus, in classical model, employment and output are determined solely by the factors operating

on the supply side of the labour market.