In this article we will discuss about:- 1. Propositions of Classical Theory of Employment 2. Assumptions of the Theory 3. Assumptions of Full Employment 4. Explanation of Classical Theory of Employment 5. Classical Model of Employment 6. Criticisms.
The classical economists took full employment for granted, believed in the automatic adjustment of the economy, and, therefore, felt no need to present a proper theory of employment. Keynesian theory of employment was a reaction against the classical economics.
Keynes found that the classical economics provided no solution to the actually prevailing problem of wide-spread unemployment during the Great Depression of 1930s. This led him to develop a systematic theory of employment, explaining the phenomenon of unemployment and suggesting the remedial measures.
By the classical economists, Keynes meant “the followers of Ricardo, those, that is to say, who adopted and perfected the theory of the Ricardian economics, including (for example) J.S. Mill, Marshall, Edgeworth and Prof. Pigou.”
Propositions of Classical Theory of Employment:
The main propositions of the classical theory of employment are given below:
(i) Full employment is a normal feature of a capitalist economy.
(ii) Full employment means absence of involuntary unemployment. Even at full employment, there may exist, voluntary unemployment, frictional unemployment, seasonal unemployment, structural unemployment or technical unemployment.
(iii) The economy attains equilibrium only at full employment.
(iv) General unemployment or general overproduction is not possible.
(v) Under conditions of perfect completion, flexibility of wages tends to establish full employment. Reduction in wages can increase employment.
(vi) The government should not interfere in the automatic working of the economic system and should follow the policy of laissez faire.
(vii) People spend their entire income either on consumption or on investment.
(viii) Interest rate flexibility establishes equality between saving and investment.
Assumptions of the Theory:
The classical theory of employment is based on the following assumptions:
(i) Individuals are rational human beings and are motivated by self-interest.
(ii) Perfect competition exists both in product market and factor market.
(iii) Individuals do not suffer from money illusion.
(iv) Laissez-faire condition prevails, i.e., government does not interfere in the economic activities,
(v) There is closed economy which has no international trade relations,
(vi) Techniques of production and business organisation do not change.
(vii) Money is only a medium of exchange.
Assumption of Full Employment:
Classical theory is based on the assumption of full employment of labour and other resources of the economy. The classical economists believed in the stable equilibrium at full employment level as a normal situation. If there is not full employment in the actual life, then there is always a tendency towards full employment. Less-than-full employment is an abnormal situation which will disappear in the long run through automatic mechanism of the economic system.
The situation of full employment is consistent with the prevalence of certain amount of voluntary unemployment. Voluntary unemployment arises when the workers refuse to accept the going wage rate. Thus, by full employment, the classical economists mean the nonexistence of involuntary unemployment. In the words of Prof. A.P. Lerner, “Full employment is a situation in which all those who want to work at the existing rate of wage get work without any undue difficulty.”
Similarly, the classical economists also considered frictional unemployment as consistent with their assumption of full employment. Frictional unemployment is a temporary phenomenon which arises due to the imperfections in the labour market, such as, ignorance of job opportunities, immobility of labour, seasonal nature of work, shortage of raw materials, breakdowns of machinery, etc.
In short, when the classical economists assume full employment, they mean to say- (a) that involuntary unemployment does not exist; (b) that there is a possibility of some amount of frictional unemployment, and (c) that such frictional unemployment will disappear in the long run i.e., there is always a tendency towards full employment.
Say’s Law of Markets:
Say’s law of markets provides justification to the assumption of full employment. Say’s law in its simplest form means that supply creates its own demand. In a barter economy, a good is produced with a purpose of exchanging it for another good. Thus, additional supply represents additional demand.
In a money economy, money serves as medium of exchange. When a factor of production (say labour) is employed, it results in the production of commodities on the one hand and generates income (in the form of payments of the factor of production) on the other.
The income received is spent in the market on the purchase of goods. Thus, the employment of a factor of production pays its own way because it increases income by an amount equal (in equilibrium conditions) to the amount taken out of the income stream by way of selling its products.
Hence, Say’s law, which rules out the possibility of general over-production and general unemployment, applies both in barter as well as in a money economy.
Faith in Policy of Laissez-Faire:
Full employment is assured through the policy of laissez-faire or government non-intervention. Whenever there exists involuntary unemployment, it is due to the interference with the free working of the competitive system. Such interference can be in the form of action by trade unions to raise wages, unemployment insurance, minimum wage legislation, etc. Remove these obstructions, allow the natural working of the economic system, and the unemployment will automatically end.
Explanation of Classical Theory of Employment:
The classical theory of employment is based on the assumption of flexibility of wages, interest and prices. This means that wage rate, interest rate and price level change in their respective markets according to the forces of demand and supply. Changes in these variables automatically adjust the economic system in such a way as to ensure full employment.
The working of self- regulating mechanism under the classical system can be understood in the three markets of the economy.
1. Labour market,
2. Product market, and
3. Money market.
1. Labour Market:
According to the classical theory of employment, other things being constant, wage rate flexibility assures that, in a competitive market, full employment is provided and full employment output is produced.
Real wage rate is determined by the forces of demand and supply in the labour market. Demand for labour is a negative function of real wage rate; demand for labour increases with a fall in the real wage rate and decreases with a rise in the real wage rate.
Supply of labour is a positive function of real wage rate; supply of labour increases with a rise in the real wage rate and decreases with a fall in the real wage rate. Real wage rate is determined at the level where demand for labour and supply of labour are equal. This level also represents full employment equilibrium level.
If there exists some unemployment, the unemployed will compete for jobs and the real wage rate will fall. A fall in the real wage rate will lead to an increase in the demand for labour and decrease in the supply of labour. This will remove unemployment. Thus, flexibility of real wage rate ensures full employment.
According to the classical theory, unemployment is the result of rigidly of wage structure and interference in the automatic working of the labour market. When government intervenes by recognising trade unions, passing minimum wage legislation, etc., and labour adopts monopolistic behaviour, wages are pushed up which lead to unemployment.
Only flexibility of wages, under the conditions of perfect competition, can ensure full employment. In the words of Pigou, “With perfectly free competition…. there will be at work a strong tendency for wage rates to be related to the demand that everybody is employed.”
In Figure-1 (A), DL is the aggregate demand for labour curve and SL is the aggregate supply of labour curve. Intersection of these two curves at point E determines the equilibrium real wage rate, (W/P), at full employment level ON. If real wage rate is maintained at a higher level, (W/P)1, supply of labour will exceed demand for labour by GH, which indicates the amount of unemployment. Labour market being competitive, unemployment of labour will reduce wage rate to the original equilibrium level, (W/P). This will remove unemployment and once again establishes full employment level ON.
2. Production Function:
At the full employment level, total output of the economy depends upon the nature of the technology, total output (Y) is a function of the number of workers employed (N). The classical economists assume the operation of the law of diminishing returns.
In Figure-1 (B), Y = f (N) curve represents total production function. At the full employment level, ON, the corresponding full employment output is OY.
3. Product Market:
Maintenance of full employment level, according to Say’s law, requires that the whole of the income generated at full employment level must be spent on the purchase of the whole of the output produced at that level. Total output comprises of consumer goods (C) and investment goods (I).
Again, total income is partly spent on consumer goods (C) and partly saved (S). Hence, the part of income which is not consumed (i.e. S) must be spent on investment goods. The logic of this argument can be easily grasped with the help of the following algebric expression.
Thus, saving-investment equality (S = I) gives the market clearing condition in the product market at full employment level. It assures that whole of full employment output in the product market will be purchased.
Or, in other words, if saving plans by the households are equal to investment plans by businesses, neither unemployment (overproduction) nor inflation (underproduction) will result.
According to the classical economists, equality between saving and investment is brought about through interest rate flexibility. Saving is a positive function of rate of interest; saving will be more at higher interest rate and less at lower interest rate.
Investment is a negative function of interest rate; investment increases at low interest rate and decreases at higher interest rate. The equilibrium rate of interest is determined at the level where saving and investment are equal.
At this level whole of the full employment output is purchased. If saving exceeds investment, the rate of interest will fall. This will discourage saving and encourage investment, thus making saving and investment once again equal.
In Figure-2, S curve is the saving curve and I is the investment curve. The two curves intersect at point E. The equilibrium rate of interest is Oi, where saving and investment are equal (i.e., iE). If community decides to increase saving at all levels of rate of interest, the saving curve will shift to the right to S1 curve.
Now at the original interest rate Oi, saving exceeds investment by EE2 which indicates the amount of overproduction. As a result of this excessive saving, the rate of interest will fall, which on the one hand leads to increase in investment and on the other hand tends to reduce saving. Eventually, the rate of interest will fall to Oi1 and once again the equality between saving and investment is established at Point E1.
4. Money Market:
Irving Fisher’s equation of exchange, MV= PY, states that total expenditure on final goods and services (MV) is equal to total value of output (PY). According to the classical economists, the long- run rate of output of final goods and services (Y) remains constant at full employment level.
They also assume that velocity of money (V) is stable because the payment habits of the people change very slowly. Thus, Y and V being constant, the price level (P) is determined by the supply of money (M) and there is a direct relationship between M and P; changes in the money supply lead to proportional changes in the price level.
In Figure-3(A), MV curve is the money supply curve which also represents demand for goods. It is a rectangular hyperbola because the equation MV = PY holds true on all the points of the curve. At full employment level of output, OY, the corresponding price level is OP, which is consistent with the supply of money MV.
When the supply of money (or monetary demand for goods) increases, form MV to M1 V (indicating an increase of money supply by GH amount), total output being given, there will be a proportional increase in the price level from OP to OP1.
Figure-3 (B) explains the determination of money wage consistent with a given real wage. (W/P) is the real wage line. At OP price level, the money wage is OW. When the price level rises to OP1, the money wage also rises to OW1. The price-wage combination OW1 = OP1 is consistent with the full employment real wage level (W/P), as determined in the labour market.
Classical Model of Employment:
The classical theory of employment can be summarises in equation model given below:
1. S = S (i) – Saving Function
The description of the various equations in the model is as follows:
1. Saving (S) is an increasing function of rate of interest (i).
2. Investment (I) is a decreasing function of rate of interest (i).
3. Saving equal to investment (S = I) gives the market clearing condition in the product market.
4. Saving (S) is equal to total income (Y) minus consumption expenditure (C).
5. Total output (Y) is the function of number of workers employed (N). It is subject to the law of diminishing marginal returns.
6. Demand for labour (D1) is a decreasing function of real wage (W/P).
7. Supply of labour (SL) is positive function of real wage (W/P).
8. Demand for labour equal to supply of labour (DL = SL) gives the market clearing condition in the labour market.
9. People demand money (Md) for transactions and precautionary purposes (LI) and demand for these purposes is a function of income (Y).
10. Demand for money equal to supply of money (Md = Ms) gives the market condition in the money market.
11. Wage rate, interest rate and the price level are determined in their respective markets through the equality of demand and supply forces.
12. Flexibility of wages, interest rate and prices ensures full employment equilibrium in the economy in the long run.
Criticisms of Classical Theory of Employment:
The classical theory of employment has been severely criticized by Keynes. According to Keynes, the classical theory was perfectly logical. But the difficulty with this theory is that it is incapable of solving the actual economic problems. It is misleading and disastrous if we attempt to apply it to the facts of experience.
The main points of criticism of the classified theory are as follows:
I. Under-Employment Equilibrium:
Keynes’ foremost attack was on the classical assumption of full employment. According to the classical economists, full employment was a normal feature and involuntary unemployment was an impossibility.
Flexibility of wages always tends to maintain full-employment equilibrium. Keynes, on the other hand has shown that the possibility of under-employment, and not full employment, is a normal phenomenon in the real capitalist world.
II. Repudiation of Say’s Law:
Keynes raises a severe attack on Say’s law of markets. According to Say’s law, an increase in employment increases income, the whole of which is automatically spent either on consumer goods or on investment goods. According to Keynes, a part of the increased income is spent on consumer goods and the other saved.
But, there is no guarantee that the saved part of income will be spent on investment goods. Thus, if investment does not increase when employment increases, there will appear a deficiency of demand. This implies that supply docs not create its own demand.
III. Rejection of Pigou’s View:
Keynes has criticised Pigou’s formulation of Say’s law on both theoretical as well as practical grounds:
(i) On the theoretical side, Keynes rejected the Pigovian wage-adjustment mechanism. According to Pigou, reduction in money wages, through its downward effect on cost of production and prices, tends to increase employment. Keynes, on the other hand pointed out that wages are a double-edged weapon.
They are not only costs of production, but also form the incomes of labourers. A reduction in wages, if on the one hand produces favourable effect on employment through reduction in costs and prices, also, on the other hand, reduces income which, in turn, decreases aggregate demand and hence employment.
(ii) On the practical side, it is difficult to reduce wages because- (a) the workers, due to money illusion, often oppose such a cut; (b) trade unions, which are now an integral part of the modern industrial system, oppose a wage-cut policy; and (c) there is labour legislation regarding minimum wages, unemployment insurance, etc. in a welfare state.
IV. No Automatic Adjustment:
Keynes rejected the classical belief that economic system is automatic and self-adjusting in character.
He mentioned three cases when the economic system does not remain self-adjusting:
(i) When liquidity preference schedule becomes perfectly elastic (i.e., liquidity trap) as a result of the investors’ expectation that the rate of interest cannot fall further.
(ii) When investment function becomes interest inelastic.
(iii) When, due to money illusion, money wages become rigid downwards.
V. Government Intervention:
Keynes analysis leads to the practical conclusions- (a) that the economy does not automatically reach full employment equilibrium; (b) that the policy of laissez-faire is not a reliable policy; and (c) that active government intervention is required if the objective of full employment is to be achieved.
Keynes did not believe in the self- adjusting mechanism of the competitive system and recommended government expenditure in public works in order to save the economy from uncertainties of private investment. He also suggested a number of fiscal and monetary measures to fight unemployment.
VI. Saving-Investment Equality:
Keynes also criticised the classical version of saving-investment equality. According to the classical economists, saving and investment are equal and this equality is maintained by the interest rate adjustment mechanism. According to Keynes, income, and not rate of interest, is the equilibrating force between saving and investment.
Whenever saving exceeds investment, aggregate demand decreases and income level declines. As a result, saving falls and. becomes equal to investment. Similarly, if investment exceeds saving, income level rises, saving increases and becomes equal to investment.
VII. Role of Money:
For the classical economists, money is only a veil and its main function is to act as a medium of exchange. Keynes, on the other hand, emphasised the store of value function of money. According to Keynes, when there is unemployment of resources, an increase in the quantity of money increases output and employment, and prices rise very little and that too only indirectly.
VIII. Long-Run Analysis:
The classical economists provided long-run analysis. According to them, there may be temporary imbalances (e.g. unemployment) in the economy, but these imbalances will disappear in the long run. According to Keynes, actual problems are short-run problems and they must be given greater importance.
IX. Static Analysis:
The classical theory gives a static picture of the economy by assuming a state of full employment. It ignores the empirical facts of changing levels of employment in the real world.
X. Not a General Theory:
The classical theory of employment is not a general theory. It deals with the special case of full employment only. According to Keynes, there may be full employment, over-full employment or under-employment.
XI. Assumption of Perfect Competition:
The theory is also based on the unrealistic assumption of perfect competition. Perfect competition does not exist in the real world.
XII. Not Practical:
The classical theory has little practical significance. It does not provide any solution to the problems of unemployment or trade cycles.
Though the classical theory is perfectly logical in its content, but it has little practical relevance. It cannot be applied to solve the actual problems of the world. As D. Dillard has remarked- “The great fault of the classical theory is its irrelevance to conditions in contemporary capitalistic world.” Again, in the words of Peterson, “The classical theory of employment is no longer widely accepted either by the public or by academic and business economists.”