In this article we will discuss about Keynes Principle of Effective Demand:- 1. Meaning of Effective Demand 2. Determinants of Effective Demand 3. Equilibrium Level of Employment or Point of Effective Demand 4. Less-than-Full Employment Equilibrium 5. Relative Importance of ADF and ASF 6. Role of Government 7. Importance 8. Criticisms.
The principle of effective demand is basic to Keynes’ general theory of employment. Effective demand, which is the sole determinant of employment, is the logical starting point of Keynes’ theory of employment.
Employment depends upon effective demand and unemployment is the result of deficiency of effective demand. As employment increases, output and real income also increases.
A fundamental principle is that as the real income increases, consumption also increases, but by less than the increase in income. Therefore, in order to have sufficient demand to sustain an increase in employment, there must be an increase in investment equal to the gap between income and consumption demand out of that income.
In other words, employment cannot increase unless investment increases. This is the core of the principle of effective demand.
Effective demand refers to the total demand of the community which is met by corresponding supply.
Keynes uses the term ‘effective’ for two reasons:
(a) It shows that the demand is effective in determining the level of employment,
(b) It emphasises the distinction between a mere desire to buy and the desire plus ability and willingness to buy.
It is not mere desire to buy but effective demand that affects the volume of employment. At various levels of income, there are corresponding levels of demand, but all the levels of demand are not effective. Only that level of demand is effective which is fully met by the corresponding supply.
According to Stonier and Hague, effective demand “is the aggregate demand price which becomes effective, because it is equal to aggregate supply price and thus represents a position of short run equilibrium.” In the words of D. Dillard, “The adjective ‘effective’ is used to designate the point on aggregate demand curve where it is intersected by the aggregate supply curve.”
Effective demand manifests itself in spending of income or the flow of total expenditure in the economy. The flow of expenditure determines the flow of income because one man’s expenditure is another man’s income. The flow of expenditure also represents the value of total output because total price of national output is just the same thing as the total expenditure made and the total income received by the community.
Total expenditure, which represents total demand for goods and services, comprises of consumption expenditure and investment expenditure. To meet this demand, workers are employed to produce the required consumer goods and investment goods.
Thus, Effective demand (ED)
= total expenditure
= Expenditure on consumption goods (C) + Expenditure on investment goods (I)
= National income (Y)
= Value of national output (O)
= Total employment (N)
or ED = N = O = Y = C + I
In this way, effective demand represents the economy’s general equilibrium level at which
(i) aggregate supply (total income) = aggregate demand (total expenditure)
Y = C + I … (1)
(ii) total saving = total investment
S = I … (2)
(Since total saving is equal to total income minus total consumption (S = Y – C), therefore Y = C + I can be written as Y – C = I or S = I)
To sum up, effective demand determines the equilibrium level of employment (or output or income) in a capitalist economy. At this level, aggregate demand is equal to aggregate supply. The entrepreneurs earn maximum profits and have no incentive to offer more or less employment.
Effective demand depends upon aggregate demand and aggregate supply. It refers to the point of intersection between aggregate demand function and aggregate supply function. This point also determines the volume of employment.
Just as in the Marshallian analysis, price is determined by the forces of market demand and supply, similarly in the Keynesian analysis, effective demand is determined by the forces of aggregate demand and aggregate supply.
Thus, there are two determinants of effective demand:
(i) Aggregate demand function
(ii) Aggregate supply function
Keynes relates demand for goods with demand for labour and expected sale proceeds with the volume of employment. The aggregate proceeds expected from a given amount of employment is called aggregate demand price of the output of that amount of employment.
Aggregate demand price refers to the amount of maximum sales revenue expected from the total output produced at a particular level of employment in the economy. According to D. Dillard, “The aggregate demand price for the output of any given amount of employment is the total sum of money, or proceeds, which is expected from the sale of the output produced when the amount of labour is employed”.
In the words of S tonier and Hague, “The aggregate demand price at any level of employment is the amount of money which all the entrepreneurs in an economy taken together really do expect that they will receive if they sell the output produced by this given amount of men.”
Aggregate demand function (ADF) is a schedule of the various amounts of money which the entrepreneurs in an economy expect from the sale of their output at varying levels of employment. Aggregate demand function relates various volumes of employment in the economy with the sale proceeds expected from their output.
Or, to put it differently, aggregate demand function reveals planned or intended expenditure at different levels of income. In the words of D. Dillard, aggregate demand function “is a schedule of the proceeds expected from the sale of the output resulting from varying amounts of employment.”
Aggregate demand price, or the maximum sale proceeds expected from a given level of output and employment, depends upon total expenditure flow of the economy, which, in turn, is determined by the spending decisions of the community as a whole.
In a capitalist economy, total expenditure of the economy comprises of total consumption expenditure (C) and total investment expenditure (I). Thus, aggregate demand is equal to total consumption expenditure plus total investment expenditure.
Aggregate demand function is illustrated through an example given in Table-1. Column (2), which represents aggregate demand function, gives different aggregate demand prices (or maximum expected receipts) at different levels of employment. It is clear from the table that aggregate demand price increases with the increase in employment.
In Figure-10, AD curve represents aggregate demand function. It shows that aggregate demand price is an increasing function of the volume of employment. AD curve goes up towards right reflecting that there is a direct relation between aggregate demand price and the level of employment; aggregate demand price increases as the amount of employment increases and vice versa.
Shape of AD Curve:
AD curve first rises quite steeply, but this rapidity tends to slacken at higher levels of employment. This shape of AD curve implies that expected receipts increase rapidly in the initial stages of rise in employment.
But gradually this increase slows down when employment reaches higher levels. It follows from the fact that with income and employment at low levels, the community will be too poor to save much of its earnings.
There is a certain amount of proceeds which is necessary to induce employers as a whole to offer any given aggregate amount of employment. This minimum price or proceeds which will just include employment on a given scale is called the aggregate supply price of that amount of employment.
In other words, aggregate supply price refers to the minimum expected proceeds which are necessary to induce entrepreneurs to provide a certain amount of employment.
According to Stonier and Hague, “At any given level of employment of labour, aggregate supply price is the total amount of money which all the entrepreneurs in the economy, taken together, must expect to receive from the sale of the output produced by that given number of men, if it is to be worthwhile employing them.”
Aggregate supply function represents different amounts of money which the entrepreneurs must get from the sale of output at varying levels of employment with the corresponding minimum amounts of sale proceeds of output resulting from those volumes of employments.
Or, stated in a different way, aggregate supply function represents different levels of income (and thus output and employment) which the entrepreneurs will supply at different levels of expenditure.
In the words of D. Dillard, “The aggregate supply function is a schedule of the minimum amount of proceeds required to induce various quantities of employment.” Thus, while aggregate demand function refers to the maximum expected sale proceeds, aggregate supply function considers the minimum sale proceeds necessary.
In Table-1, Column (3) shows the aggregate supply function which is an increasing function of employment. As the minimum amount of proceeds increases, a greater amount of employment will be offered. In order to employ one lakh workers, the employers must expect to get a minimum of Rs. 4 crores from the sale of the resulting output.
Similarly, the minimum sale proceeds for two lakh workers is Rs 9 crores, and so on. AS curve in Figure-10 represents aggregate supply function. AS curve also goes up towards right, showing that the aggregate supply price (or the minimum expected sale proceeds) increases with the increase in employment.
Shape of AS Curve:
The shape of AS curve depends upon the relationship between employment and marginal productivity. The AS curve rises slowly to begin with implying that employment would increase fairly rapidly at first as amount received from selling output of the economy rose from zero.
This is because the cost of production would not initially rise rapidly. Later on, AS curves rises progressively as employment increases because at higher levels of employment cost of production rises more rapidly.
At full employment level (i.e., after point F), AS curve becomes a vertical straight line, indicating that no increase in receipts would increase employment further.
The equilibrium level of employment and income in an economy is determined by the point of intersection between aggregate demand function and aggregate supply function. This is also the point of effective demand.
Aggregate supply function represents costs, while aggregate demand function represents the expected receipts of all entrepreneurs taken together in the economy. So long as the receipts of all entrepreneurs taken together in the economy.
So long as the receipts are greater than the costs, the employment in an economy will go on increasing. This process will continue till receipts become equal to costs. In no case the entrepreneurs would offer employment to workers if the costs are greater than the receipts. The determinants of equilibrium level of employment or the point of effective demand can be explained with the help of Table-1 and Figure-10.
In Table-1, the equilibrium level of employment is 4 lakh workers. At this level, both the aggregate supply price (i.e., the expected minimum costs) and aggregate demand price (i.e. expected maximum receipts) are equal to Rs. 34 crores. At employment level less than 4 lakh workers, aggregate demand price is greater than aggregate supply price.
Hence employment will tend to increase. On the other hand, at an employment level more than 4 lakh workers, aggregate supply price exceeds aggregate demand price. Therefore employment will tend to decrease.
In Figure-10, the aggregate demand schedule (AD) and aggregate supply schedule (AS) intersect at point E, which represents the point of effective demand. The equilibrium level of employment is ON, at which receipts and costs are equal to EN. At ON employment level, entrepreneurs maximise their expected profits.
Any other level of employment will reduce the profits and the economy will not be in equilibrium. For example, at ON, level of employment the expected receipts are greater than the expected costs (AN1 > BN1).
This will induce the entrepreneurs to employ more workers. On the other hand, at ON2 level of employment, expected costs are greater than expected receipts (FN2 > GN2). Therefore this level of employment will not be offered by the producers.
Thus, the equilibrium level of employment or the point of effective demand is determined at point E where aggregate demand price (expected receipts) equals aggregate supply price (expected costs), offering employment to ON workers.
The economy in equilibrium does not mean the economy in full employment equilibrium. The point of effective demand, which represents the equilibrium level of employment does not necessarily indicate a full employment level.
Keynes’s, main contribution is to show that less-than-full employment equilibrium is possible and, in a capitalist economy, this is a normal feature. In such an economy investment is generally inadequate to fill the gap between income and consumption.
In Figure-11, point E is the point of effective demand, but the employment level consistent with this point (i. e. ON) is less- than full employment level, because there exists NNf amount of unemployment. In order to attain full employment level, aggregate demand must rise from AD to AD1.
The new point of effective demand (point F) will represent the full employment equilibrium level ONf, Further increase in aggregate demand (i.e. AD2) will take the economy to point F1, which indicates over-full employment equilibrium. In this situation, output and employment does not increase, but, due to increase in demand, only prices tend to rise.
In Keynes’ theory, aggregate supply function (ASF) is not of so much importance because of two reasons:
(i) Keynesian economics is short-term economics. In the short period, aggregate supply cannot be manipulated.
(ii) Keynes’ theory primarily deals with an economy facing unemployment. In such a situation, it is not desirable to manipulate ASF through relationalisation (i.e., mechanisation). If costs are sought to be reduced through mechanisation then, instead of reducing, it will increase unemployment further.
This, however, does not mean that ASF is not at all important. In an inflationary situation, when there is over-full employment, manipulation of aggregate supply function by reducing costs and increasing productive efficiency becomes indispensable.
Thus, Keynes gave exclusive attention to aggregate demand in his analysis. That is why, his theory of employment may be more properly called the theory of aggregate demand.
In the original Keynesian theory, government expenditure is not considered. But, the post-Keynesians give due recognition to government expenditure as a source of effective demand. Government expenditure has become an important determinant of effective demand in modern capitalist economies.
The special significance of government expenditure is that it is autonomous in nature, i.e., it is influenced more by social and political factors rather than economic factors. Foreign sector also provides another source of effective demand.
Thus, to be realistic, the components of effective demand or aggregate demand are:
(i) Consumption expenditure (C);
(ii) Investment expenditure (I);
(iii) Government expenditure (G) and
(iv) Foreign expenditure on domestic goods and services over and above domestic expenditure on foreign goods and services (X-M).
Thus, ED = AD = C + I + G + (X-M)
The importance of Keynes’ concept of effective demand is clear from the following points:
I. Main Determinant of Employment:
Effective demand occupies an important place in the Keynesian theory of employment. Effective demand is the sole determinant of employment and unemployment is result of deficiency of effective demand. Effective demand expresses itself in the spending of income. Thus, it is the level of spending on which employment depends.
II. Repudiation of Say’s Law:
The principle of effective demand has repudiated Say’s law of markets according to which supply creates its own demand. If Say’s law were true then aggregate demand would be equal to aggregate supply at all levels of employment. But, the principle of effective demand has shown that aggregate demand and aggregate supply are not always in equilibrium and normally this equilibrium is achieved at less- than-full employment. The concept of effective demand has made it clear that what is produced is not automatically consumed or invested at the rate which will keep the factors of production fully employed.
III. Contradiction in Pigou’s Argument:
The theory of effective demand has revealed the inherent contradiction in Pigou’s argument that wage cuts will remove unemployment. According to Keynes, employment will increase by increasing effective demand. But, a cut in wages will cause a reduction in effective demand.
IV. Emphasis on Demand Side:
In contrast to the classical emphasis on supply side, Keynes laid more emphasis on demand side and traced fluctuations in output and employment to changes in aggregate demand. Aggregate supply is assumed to be given in the short period.
V. Importance of Investment:
The theory of effective demand also shows that in order to maintain effective demand (or the level of employment) at the original level, real investment, equal to the gap between income and consumption, must be made. Employment cannot expand unless investment expands.
VI. Paradox of Poverty:
Keynes’ principle of effective demand provides an explanation of the paradox of poverty amidst plenty. In the words of D. Dillard, “Keynes’ principle of effective demand furnishes an explanation of the paradox of poverty in the midst of potential plenty, one of the gravest contradictions of capitalism.”
The advanced capitalist economies are always under constant fear of unemployment and panic of depression. The reason is that as income increases, consumption also increases, but by less than the increase in income.
This gap between income and consumption widens at higher levels of employment (as experienced by rich economies), and is not removed automatically without an active participation of the government. Thus, the deficiency of aggregate demand leads to large-scale unemployment and becomes the cause of poverty in an otherwise affluent economy.
Such a problem exists only for rich economies. A poor country on, the other hand, has no difficulty in employing all its resources because it will tend to spend on consumption a large proportion of its total income.
Only a small gap needs to be filled by investment and, the stock of capital being small, good opportunities exist to fill the gap by additional investment. Thus, according to Keynes, “The richer the community, the more obvious and outrageous the defects of the economic system.”
Criticisms of Keynes’ principle of effective Demand:
Keynes’ principle of effective demand has been criticised on the following grounds:
(i) Hazlitt feels that the use of the term ‘effective’ before demand is superfluous and misleading. Demand in economics is always effective, otherwise it is merely a desire or wish.
(ii) Keynes’s theory is concerned only with involuntary unemployment. Other types of unemployment, such as frictional, seasonal, disguised, voluntary, have been ignored.
(iii) According to Hutt, the very notion of effective demand, as propounded by Keynes, is objectionable because he has reversed the cause and effect relationship. There are circumstances (e.g., in case of underdeveloped countries) where employment is not determined by demand, but rather affects demand itself.
(iv) Keynes has established a direct relationship between income, demand and employment. But the critics feel that no such relationship exists in reality. Employment, besides effective demand, also depends upon skill formation, inventions, techniques of production, etc.
(v) The principle of effective demand is not applicable in underdeveloped countries where the problem is not of deficiency of effective demand, but of inelastic supplies.
Despite this criticism, the principle of effective demand continues to remain the vitally important part of the modern macro-economic analysis. Without relating aggregate demand and aggregate supply functions, all discussions concerning the determination of income and employment are futile.