Classical Theory
The Classical Approach: If the principle of
supply creating its own demand is made applicable to the labor market,
one would wonder what its effect would be. The number of workers may be
in excess of the available job opportunities and the employer’s demand
for their services. Therefore at the existing or going market rate of
wages all available working force cannot be absorbed. Some workers will
be rendered superfluous and will remain unemployed. The classical
answer to the problem is that like all other goods and their prices workers’
wage rate should be cut or lowered so that the employers will be induced
to employ more number of workers. The condition of full employment
can then be restored if workers are agreed upon the wage cut solution.
Thus flexible rate of wages is a classical approach to solve the problem
of unemployment.
In this equilibrium position original price level is
P and real output or national income level is Y. This is full employment
equilibrium since the long run supply curve LAS passes through this point.
When the consumers reduce their demand for consumption goods the aggregate
demand curve then shifts as AD2. The new
AD2 curve and original SAS1
curve have intersected at point E1 which is a short
run partial equilibrium condition. At E1
the price level falls to P1 and real output
level reduces to Y1. Thus a fall in the
real output causes some unemployment of labor and other resources. But
due to equilibrating forces at work, such as a fall in the rate of interest
and a cut in the wage rates, a fresh demand for investment goods is generated.
A fall in the wage rates reduces cost of production which induces producers
to employ more workers. As a result of these adjustments the economy moves
from E1 to a new equilibrium point E2.
At this point AD2 intersects the new supply
curve SAS2 which has shifted downwards.
Such a shift in the supply curve shows a fall in the cost of production
due to a cut in the wage rates. At point E2
the original equilibrium level of output Y can be produced which is the
full employment level of output. The price level has now fallen to P2.
Thus with a fall in the rate of interest, price level and wage rate, the
restoration of full employment equilibrium level becomes possible.
(A) Introduction: Employment and output analysis
at macro level has become an important part of economic theory only during
and after the Second World War period. It was J. M. Keynes who first analyzed
the frequent problem of unemployment and fluctuating levels of real output
or national income. Before Keynes’ General Theory (1936) there
was hardly any important and serious discussion of the problem of unemployment.
However, some underlying issues were discussed by the classical economists.
The classical school between 1770 to 1870 mainly includes such leading
economists as Adam Smith, David Ricardo, J.B. Say, John Stuart Mill and
Karl Marx. The later neo-classical economists like Alfred Marshall (between
1870 to 1930) had hardly anything to add to the classical theory. Professor
A. C. Pigou, the contemporary of Keynes strongly justified classical approach
and was critical of Keynes’ new theory. Keynes therefore has regarded
all of his predecessors as classical economists in this context. The classical
theory is based on the automatic self equilibrating tendency of
the economic forces.
(B) Say’s Law: The classical theory of employment
rules out the possibility of any general and prolonged unemployment. The
classical employment analysis is based on the Market Law of the
French economist J. B. Say. The law is simply a description of market
exchange activity: "Supply creates its own demand." This apparently
simple statement has serious implications. Usually, for an individual
good of a smaller seller this statement appears to be a truism.
Such a businessman would make suitable adjustments in the price he charges
and would clear the market for the supply that he intends to make. If
on a particular day he observes that his supply is exceeding demand, then
assuming that the good he supplies is extremely perishable (the supply
of which cannot be withdrawn or postponed), he will lower the price somewhat
and thus create sufficient demand for it. So far so good. However, it
is important to remember the classical economists and Say’s Law were
concerned not with a single good and a single supplier of it. The law
is a generalization at the macro-level where all varieties of goods and
services are supplied. This law in particular meets with serious limitations
when an attempt is made to make it applicable to the labor market and
to the conditions of employment level.
It is possible that some workers may resist a cut in
the wage rate and may remain unemployed. But according to the classical
viewpoint such unemployment is only voluntary in nature. Moreover
individual employers face excess supply of labor conditions. Therefore
such unemployment is only temporary and partial in nature. With the acceptance
of the law: "Supply creates its own demand", there cannot be
any prolonged, involuntary and general unemployment situation in the economy.
The classical theory therefore rules out any general or widespread kind
of unemployment. This sort of classical assertion is a result of the typical
approach of the classicists to the capitalist free enterprise system.
They believed in the self-equilibrating nature of such an economy.
Even if there are any disturbances in the initial equilibrium conditions
these are temporary and minor. Moreover, these can be cured automatically
and spontaneously. There is an in-built flexibility in the supply
and demand forces which leads the economy towards restoration of the equilibrium
condition. Therefore general equilibrium in such a private and free economy
is a rule and any disturbance or disequilibrium is only a momentary exception.
(D) Classical Solution Illustrated: The classical
solution to overcome temporary and marginal gaps between demand and supply:
forces is in the form of flexible wage rates and flexible prices.
This can be illustrated. At the macro level of economic operations the
prices include a variety of prices of goods and services, wage rates,
interest rates, rent of land etc. Let’s therefore illustrate it with the
movements in the rate of interest. This should however be treated as of
symbolic importance. What is true about rate of interest is equally true
under the classical system about wage rates of all other prices. Let’s
assume that for some reason the consumers decide not to spend the whole
of their income. This would cause a fall in the demand. With such a shrinking
in the consumers’ aggregate demand all the goods and services offered
for sale in the market cannot be sold. In the market there would exist
the condition of excess supply. The producers would be worried that this
may eventually cause a fall in the price level and thereby a fall in their
profit margin. Therefore the firms would be inclined to restrict their
production and reduce their particular demand for factor services. Hence
an initial fall in the consumer’s demand ultimately results into
the unemployment condition. But in view of self-equilibrating nature of
the economic activities, at this point one can bring in the flexible
price solution of the classical argument. We illustrate this with
the help of a figure which shows the aggregate savings and aggregate investment
curves. In this case with a fall in the aggregate demand for consumption
goods, a compensating increase in investment expenditure takes place,
with appropriate changes in the rate of interest.
In figure 19, SS and II are the initial savings
and investment curves respectively. The point of intersection of
these curves is E which represents the initial equilibrium position.
At point E the rate of interest is r and amount of savings equal
to investment is L. When consumers decide to spend less their unspent
portion of the income results in an increased level of savings. This has
been shown by a shift in the supply curve of savings from SS to S1S1.
With increased amount of savings, the rate of interest starts reducing.
It falls from r to r1. With reduction in the
rate of interest, the price paid for borrowed loanable funds reduces.
This induces producers to invest more to reach a new point of equilibrium
E1. This is a point at which S1S1,
the saving supply curve intersects the investment demand curve. Once again
savings are equal to investment at higher level of loanable funds L1.
Therefore in the new equilibrium position a fall in the rate of interest
causes a rise in the amount of investment of the size L1.
This compensates for the fall in the consumption demand for goods and
services. As a result of such an increase in the investment demand, the
level of aggregate demand is restored. Any danger of large-scale unemployment
has thus been avoided. The classical economists have also depended on
similar adjustments in the level of prices and wage rates. Hence flexible
rates of interest, prices and wage rates together ensure full employment
in the loanable funds, commodity and labor markets. Such a self-equilibrating
process prevents any dangers of prolonged and general unemployment conditions.
The total equilibrium has been shown below in figure 20.
(E) Full Equilibrium: The classical flexible interest,
price, wage rate solution automatically leads the economy back to the
full employment level. Therefore the effect of a fall in consumer demand
on the levels of output and employment is only temporary. In figure 20,
AD1 and SAS1 are original aggregate demand and aggregate
supply curves respectively. The two curves have intersected at point E.
5.2 Keynes’ Employment Theory
(A) Keynesian Revolution: It was in the year
1936 that Lord John Maynard Keynes’ General Theory of Employment,
Income and Rate of Interest was first published. It is the first
ever full account of macroeconomic activities. Keynes’ theory is an
outstanding piece of analysis, which is considered a landmark in
the history of economic science. It contains a variety of novel scientific
ideas. It is a major breakthrough in the classical tradition and an
entry into a modern Keynesian school of economics. His followers Harrod,
Domar, Kaldor, Mrs. Robinson, Solow etc. have ever since widened the
scope of macroeconomic analysis. After the publication of the General
Theory both economic practice and policy making have changed fundamentally.
It is not without reason that the theory has come to be known as 'Keynesian
Revolution'. The revolutionary impact of the theory has been variously
demonstrated. Keynes has introduced a variety of new tools of analysis.
His equations of income and expenditure, consumption function, law of
marginal propensity to consume (MPC), multiplier operations, investment
function and marginal efficiency of capital (MEC), identity between
savings and investment, and his pure monetary liquidity preference theory
of interest accompanied by speculative motive for demand for money are
some of his new contributions.
Keynes denied the classical belief that the free enterprise
system is a self regulating one and asserted that such a system
requires periodic intervention of the public authority to avoid fluctuations
and instability in economic activities. Besides, Keynes replaced the
classical partial equilibrium by a more general equilibrium to
ensure the full employment level of output and employment. Keynes was
building an entirely new structure of economic analysis to study and
redress the problem of unemployment. It was therefore essential
for him to bring out weaknesses and inadequacies of the classical approach
to the problem of unemployment.
(B) Critique of Say’s Law: Keynes’ criticism
of the classical theory in general and Say’s Law in particular is the
first step in the direction of the new theory. Say’s Law of the markets
is a truism only under barter economic system. In that case whatever
goods are produced are either sold in the market or are utilized for
self-consumption. Hence supply and demand are always equated.
There cannot be a general surplus or glut of the goods. Though this
works well under barter conditions it is no more true in a modern economy
where almost every transaction is carried out with money in the form
of currency or credit. In such an economy buyers and producers
or even sellers are not directly collecting together to carry out the
exchange activity but messages are sent through the medium of money.
The classical approach is essentially partial and a
microeconomic piece of analysis. It looks at the problem of employment
and unemployment from the perspective of an individual producer and
employer. Therefore it regards unemployment only as a temporary and
voluntary condition. It rules out any possibility of large-scale involuntary
condition of general unemployment. But in reality one noticed frequent
occasions of economic fluctuations and widespread unemployment conditions
throughout the 19th century and early 20th century. The latest
example of it is in the form of the period of the Great Depression
(1929-33) which rendered 40 percent or more of the labor force unemployed
in western countries and other parts of the world. All these events
make it evident that the classical theory was far from the reality.
This is essentially true because the problem of unemployment is not
partial but general, not voluntary but involuntary and not micro
but macro in its nature. Therefore it needs to be analyzed in its proper
perspective and handled differently. Unemployment, as we understand
today, was not a problem for classics which is unfortunately not true.
Moreover, the classical solution to tackle unemployment,
in whatever form they conceived it, is totally inadequate and unsatisfactory.
They have relied entirely on a cut in the rate of interest and wage
rates. These are self-defeating polices. Any cut in wage rates will
result in widening the gap of unemployment instead of correcting it
in modern times. This is because of the fact that any attempt to cut
wage rates at the bottom of the depression period will cause a considerable
portion of the aggregate or effective demand to reduce further causing
a more severe unemployment situation. This can be illustrated with the
help of a simple example:
Let’s assume that a small fruit seller sells 20kg of
fruit at a market price of $10 on a daily basis. Thus his daily turnover
is $200 (20 ´ 10) of which the only cost
of production is in the form of wage rate. If he employs 10 laborers
at a daily rate of $15, then the total wage payment is $150 (10 ´
15). The fruit seller therefore earns a daily profit of $50 (200 - 150).
If for some reason the demand for fruit that he sells reduces, then
he will have to reduce the price say from $10 to $8. In this new situation
his total daily turnover goes down to $160 and at the old cost of production,
his profit margin declines to $10 (160-150). The fruit seller is not
satisfied with this. Therefore he may reduce the number of his workers
from 10 to 8 and bring down the cost of production from $150 to $120
(8 ´ 15). The two workers are then rendered
unemployed. If the unemployed laborers insist on their re-employment,
the producer will lay down the condition that wage rate of all the workers
will be reduced from $15 to $11. If the workers accept this then the
total wage bill will be $110 (10 ´ 11) which
restores the seller’s profit of $50 (160 - 110) as before. It appears
that even with reduced demand and fall in the price of fruit, unemployment
of workers has been avoided with the help of a cut in the wage rate.
But this in only a momentary and superficial solution. The workers’
total income has
now reduced from $150 to $110 as a result of which
they can spend less and reduce demand for every other commodity that
they consume. Therefore initially the problem of depressed demand and
unemployment which was faced by a single seller will eventually become
a general and wider problem faced by all other dealers. Instead of curbing
it, the wage cut solution will therefore increase the problem
of unemployment. Though this example is oversimplified and hypothetical
yet it helps to bring out gist of the Keynes’ Criticism of Classical
theory.
Keynes further asserts that the classical wage cut
solution is unsatisfactory both in theory as well as practice. In
modern times trade unions and political parties have been strongly
supporting the cause of the working class. Therefore even if wage cut
may make good economic sense, it makes bad political sense.
But Keynes at once proves that it makes bad economic sense as well.
In order that the wage cut solution should be effective, not only is a
cut in the rate of monetary wages required; it is necessary that real
wage rates should also fall. This is in view of the fact that levels of
output and employment are real variables and therefore these can be
altered only when the real cost of production goes down. Hence a fall
in the rate of monetary wages must be accompanied by constant general level of prices (CPI). But this scarcely becomes possible because economic actions are strongly interdependent.
Falling rates of monetary wages are invariably accompanied by a
falling price level. In that case real rates of wages will be
unaltered. Thus Keynes has found faults with the classical analysis in
every respect. He then proceeds to present his own theory of
employment.
(C) Effective Demand: The prospects of
high levels of output and employment depend upon size of the effective
demand and not the rate of wages. Effective demand is the total
monetary expenditure of the community and is therefore a price. It depends upon two other variables, namely, aggregate demand (ADP) and aggregate supply price (ASP). Effective demand (ED) is then an equilibrium value determined at the point of intersection of the ADP and ASP schedules. These have been defined by Keynes as follows:
'ADP is that money value of all goods and services which producers actually receive.'
ASP is that money value of all goods and services which producers expect to realize in the market.’
Thus producers plan their output and employment
decisions on the basis of value of the ASP that they expect. But in
reality what falls in their hand is the total expenditure or ADP that
consumers are prepared to undertake. If ADP value satisfies ASP value
then the producers continue to produce as before and employ as many
workers as before. But if ADP falls short of the ASP then producers’
expectations are not fully satisfied and they are induced to reduce
output and demand for labor. This causes unemployment. Therefore the
cause of unemployment has been detected. It is then deficiency in the effective demand that
is the culprit which results in unemployment. Let’s illustrate this
with the help of a figure. It will also help to draw a distinction
between classical partial equilibrium and Keynes’ general equilibrium analysis.
In figure 21, units of employment have been shown on the horizontal axis and levels of real income have been shown on the vertical axis. AD1, AD2 and AD3 are the levels of aggregate demand.
Note the demand curves in this case are seen as upward functions and
not downward sloping as normal demand curves. This is because demand
curves (AD1, AD2 and AD3) here are functions of the level of income and not of the price level. The relationship between level of income and demand is direct, suggesting that the richer a person gets, the more would be his demand for all goods and services. OZ curve is a continuous upward function representing
ASP and producers’ expectations. Since ASP is related to the cost of
production it behaves in the same manner as a usual aggregate supply
curve. The points of intersection between the two have been marked as E1, E2 and E1 which are all equilibrium points. At every equilibrium position the simultaneous values of real income and level of employment are determined. At points E1, E2 and E3 these are Y1, Y2, Y3 and N1, N2, N3 respectively.
Moreover the points of equilibrium decide effective demand on
different AD curves. Though every point on the individual AD is a point
on the Schedule, only one point on it is effective, in the sense reflecting the willingness of consumers to actually spend a part of their income.
Let’s distinguish between Classical and Keynesian
approaches. As we notice in the figure with a given aggregate supply
curve higher levels of effective demand help to generate more employment
opportunities and lead towards the full employment level. Let’s assume
that the economy is initially at point E2 with employment level as N2 and level of national income as Y2.
At this stage some amount of the workforce is unemployed. If the
classical solution of wage cut is applied then the economy is likely to
move downwards in the direction of point E1.
This will cause a further reduction in the effective demand, level of
employment and real income. Therefore wage cut solution is
self-defeating and intensifies the unemployment condition. What is
needed at point E2 is the organization of the public expenditure program and the boosting the level of effective demand so as to move from E2 to E1.
Such a movement ensures a higher level of employment and leads the
economy closer to the full employment point. This proves that the level
of employment is not a function of the rate of wages but it is a function of effective demand and size of the total expenditure in the economy.
Further, the classical approach is partial in
the sense it favors equilibrium between demand and supply forces
irrespective of whether such an equilibrium can occur at full employment
or less than the full employment level. Since are all E1, E2, E3 equilibrium
conditions, the classical wage cut formula may treat any one of these
positions as equally satisfactory. But what matters is not equilibrium
itself but at what level of effective demand such equilibrium is
attained. Therefore the problem of unemployment demands a continuous
movement in the direction of higher and higher equilibrium levels (such
as E3) to ensure a sufficiently high level of employment. Only then the equilibrium can be said to be general and satisfactory in nature.
(D) Consumption Function: After having
established that the level of employment is a function of the level of
Effective Demand it is necessary to analyze components of effective
demand. If the cause of unemployment is deficiency in effective demand, one might wonder at this point, which component is likely to be deficient. This leads us to Keynes’ income equation :
ED = Y = C + I
In its simplest form total effective demand
equivalent to the size of the real national income is composed of two
types of expenditure. It is partly made up of C, the consumption
expenditure and I the investment expenditure. Let’s begin with the ’C’
component. Keynes at once detects cause of deficiency in the C type of
expenditure itself. Consumption is a function of the level of national
income Y.
This suggests that as income increases consumption
expenditure will increase in (b) proportion where (a) is the initial
amount of consumption even when income is zero. Therefore (b) is the propensity or tendency of consumers to
spend a certain proportion of the income. If we assume the value of
’b’ as 0.8, it would mean that people spend 80 percent of their income
on consumption. If we assume a = 0 then we have :
C = by and where b = 0.8
C = 0.8y
If Y = 100 then :
C = 0.8 (100) = 80
Keynes has further postulated nature of the behavior
of the propensity to consume. It is in the form of the law of marginal
propensity to consume (MPC). It is known as Keynes’ hypothesis of MPC.
It is as follows :
"With every increase in the level of income consumption, expenditure will increase absolutely but will fall relatively."
