Classical Theory of Output and Employment
The classical theory of output and employment, propounded in the 18th century, are the sets of assumptions and principals which primarily focuses on the existence of full employment, laissez-faire economy without foreign trade, perfect competition and wages & prices are constant. The main principle of this theory is that there is not need of government intervention in regulating the economy, the demand-supply equilibrium is self-adjusted in the economy. This theory is based on two basic theories: Say's law of market and quantity theory of money.
Summary
The classical theory of output and employment, propounded in the 18th century, are the sets of assumptions and principals which primarily focuses on the existence of full employment, laissez-faire economy without foreign trade, perfect competition and wages & prices are constant. The main principle of this theory is that there is not need of government intervention in regulating the economy, the demand-supply equilibrium is self-adjusted in the economy. This theory is based on two basic theories: Say's law of market and quantity theory of money.
Things to Remember
- The Classical economy is based on the assumption of full employment, perfectly competitive market without the intervention of government.
- Classic theories were valid until great depression of the 1930s when there was no any government intervention in the economy.
- The assumptions of the classical economy are not valid in today's world because the market is not self-adjusting and it requires government intervention.
- Classical theories are failed to explain the problem of unemployment and depression in today's world.
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Classical Theory of Output and Employment
Classical Theory of Output and Employment
The word, classical economics, was first used by Karl Marx to describe the thoughts and ideas of various economists such as Ricardo and Adam Smith. The classical theory was developed after the publication of “Wealth of Nations” by Adam smith in 1776. Adam Smith is considered as the pioneer of this school of thought while J.S. Mill, J. B. say were the follower of this theory.
Classic economics is the theory of economic principle developed in U.K. in late 18th and early 19th centuries which dominated the world economy till the great depression of the 1930s. The main objective of classical economics is to explain the functioning of the capitalist economy based on private property.
The classical economists did not propose any particular theory of output and employment. However, they have given a number of assumptions. There are two main assumptions of the classical theory of employment, namely, the assumption of full employment and flexibility of price and wages. Let us study these two broad features in detail.
Assumption of full employment
According to classical economists, full equilibrium is the characteristics of every economic system and a normal situation of the economy. In simpler terms, full employment refers the situation when every individual are employed. There will always be full employment in the economy due to price mechanism in the capitalist society in the long run. If there is any unemployment in the economy, it does not last longer and there is a tendency towards full employment without any government interference.
Full employment means the absence of involuntary unemployment and it was further assumed , even at full employment, there may exists voluntary unemployment, involuntary unemployment, frictional unemployment, seasonal and situational or technical unemployment.
Frictional unemployment: It exists as a result of lack of necessary skills and workers are located in the wrong place or unsuitable jobs.
Technological unemployment: The technological advancement results in changes in techniques of production causing technological unemployment.
Seasonal unemployment: It arises on particular industries as a result of seasonal variation brought about by climatic condition or change in fashion.
Structural unemployment: It arises when the factors of production are not sufficiently available. There may be a scarcity of land, capital or skill in the country cause structural disequilibrium.
Voluntary unemployment: It is the condition where the workers refuse to work at the current wage rate or wants to remain unemployed.
The classical economists do not consider frictional, seasonal, technological and structural unemployment as unemployment because they are of short-run nature. Similarly, the voluntary unemployment is not regarded as unemployment at all. Only the involuntary unemployment is considered as unemployment. According to classic economists, the laissez-faire capitalism is self-adjusting which guarantees full employment.
Flexibility of prices and wages
The classical economists also advocated that the prices, wages and interest are flexible in nature. The self-adjusting nature of prices and wages creates the condition of full employment. The prices and wages are balanced by the forces of demand and supply.
For example, when there is overpopulation resulting depression and unemployment, the prices will fall which further increases demand and consumption. As a result, employment opportunities will increase and unemployment will be eliminated.
Apart from above mentioned postulates, another important theory of classical economy is say’s law.
Say’s Law
Often called the “foundation of classical macroeconomics”, Say’s law was propounded by the French economist J.B. Say during the 18th century. Say’s law is regarded as the ‘beginning of sound thinking in macroeconomics.’ The main idea of this theory is that “supply creates its own demand” or “supply calls forth its own demand”. In simpler form, the supply of goods itself generates sufficient income to generate a demand equal to that supply. Whatever is produced in the market is automatically absorbed by the consumers for consumption purpose. There can’t be general overproduction because whenever additional production takes place the income is also generated at the same time to absorb the additional supply. Hence there won’t be the chance of excess supply and unemployment.
Propositions of Say’s Law
- Supply creates its own demand
- Money is viewed as the medium of exchange
- Existence of free-market adjustment in the economy
- Saving is equal to investment
- Involuntary unemployment does not exist
- Closed economy
This law can be explained in both the barter system and monetized economy.
Say’s Law in Barter Economy
In a barter economy, there is the absence of money and people tend to specialize in the production of goods and services which they can produce more efficiently. They get other goods and services for their consumption in exchange for their goods. Primarily, the people produce for their consumption and the surplus amount is exchanged to acquire other necessary goods. For example, a maize farmer exchanges his surplus product to the waiver in exchange for cloth. Thus the farmer creates demand for cloth and waiver supply his surplus product in exchange for maize. Hence, whatever is produced is consumed automatically.
In this economy, there cannot be overproduction or underproduction. People produce what they consume and if they produce surplus goods they exchange it for other necessary goods. Similarly, they do not produce excessive goods.
Say’s Law in Money Economy
Say’s law is also equally applicable in money economy. This theory considers money only a medium of exchange i.e. goods are bought and sold with the help of money. In a money economy the law applies differently. In the market economy the productions are meant for sell. For the production of goods the factors of production are employed and the employment of factors of production generates income in the form of rent, wages, interest and profits. By spending the income generated the demand for goods is created. Hence, if there is production, there is income and if there is income, there is demand for goods. The demand for goods requires the supply. In this way, supply creates its own demand.
Quantity theory of Money
The classical quantity theory of money was first propounded by French economist Jean Bodian in the 16th century in order to explain the price rise in contemporary society. However, Fisher’s quantity theory of money is most famous and represents characteristics of the classic economy.
The basic idea of this theory is that no rational people hold money for the ideal purpose. Instead, they use all the money they receive for buying and selling of goods. Hence, money is only the medium of exchange of goods.
The quantity theory of money can be explained by the help of equation of exchange developed by Fisher.
MV = PT
Where, M = quantity of money in circulation
V = velocity of money
P = price level
T = transaction volume
Here, MV represents money supply and PT represents money demand. The theory assumes that the velocity of money and transaction volume is constant. Hence, P = f (M) f’ > 0
Product market, Labor market and money market in classical economy
Product market
In this market, equilibrium is guided by the equality of saving and investment. According to classical theory, saving and investment are a function of the rate of interest.
Saving is the positive function of rate of interest i.e. S = f (r), f’>0
Investment is the negative function of rate of interest i.e. I = f(r), f’<0
Labor Market
The labor market is another important part of this theory. In this market, equilibrium is guided by the equality of demand for labor and supply of labor. Both of them are the function of real wage rate (W/P).
D = f (W/P), f’<0
S = f (W/P), f’>0
Money Market
Money market equilibrium is represented by the equation MV = PT i.e. money supply is equal to money demand.
Criticisms of classical theory of output and employment
Wrong assumption of full employment: The classical theory assumes full employment of resources and general overproduction and underproduction are impossible. But we are facing the problem of high unemployment and the condition of overproduction. These assumptions in the present world are unrealistic.
The flexibility of wages and prices: In reality, there is the intervention of trade unions and the central bank in the determination of wage rate and interest rates. Hence the flexibility of price and self-adjusting property of price is invalid.
Long-run and static analysis: According to classical economists the adjustment process operate in the long run, but Keynes view that short run is more important than long run because, in the long run, we all are dead.
Not practical: Classical theory is not practical because this theory does not provide any solution to solve the problems of unemployment and other economic problems.
Unrealistic assumption of perfect competition: The classical theory is based on the existence of perfect competition. But it is found that monopolistic competition is found in the economy.
Government intervention is essential :The great depression of the 1930s made us realize the importance of government intervention in regulating prices and demand of goods. The economy without government intervention is unreal in today’s world.
References
Dwivedi, D. N. (2010). Macroeconomics theory and policy. New Delhi: Tata McGraw-Hill Education.
Kharel, K. R., Ghimire, Y., Bhattarai, D., Jnawali, S., & Paudel, K. (2010). Business Economics. Kathmandu: Sukunda Pustak Bhawan.
Lesson
Theories of National Income Determination
Subject
Macroeconomics
Grade
Bachelor of Business Administration
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