Theories of Employment

There are two major theories of employment (Classical and Keynesian Theories) in macroeconomics. This presentation seeks to provide an overview of the two major theories.

1. THEORIES OF EMPLOYMENT Prepared by Atego L. Laurean & Ibrahim A. Swabra

2. INTRODUCTION The following presentation intends to provide a brief overview of the theories of employment in macroeconomics. There are two major theories of employment namely: Classical Theory of Employment Keynes’ Theory of Employment The above listed theories are given brief explanations in the slides that follow.

3. 1. CLASSICAL THEORY OF EMPLOYMENT The classical theory of employment states that in a labor market, employment for labor is determined by the interaction between demand and supply of labor. Workers provide the supply whereas the employer makes the demand for labor. The classical economists believed in the existence of full employment in the economy. This theory is majorly based upon Say’s Law and Pigou’s Theory. Unemployment results from the rigidity of the wage structure and interference with the working of the free market system.

4. Say’s Law Say’s Law is the core of the classical theory. This law was introduced by Jean Baptiste Say who made the proposition that “supply creates its own demand” It is production which creates market for goods. A product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. Nothing is more favorable to the demand of one product than the supply of another. Since supply creates its own demand, there cannot be general overproduction and therefore general unemployment.

5. Pigou’s Theory Also known as the wage cut theory since it advocates the use of wage cut policy to solve the problem of unemployment. This theory was developed by Arthur Cecil Pigou . He stated that the unemployment which exists at any time is because of the fact that changes in demand conditions are continually taking place and that frictional resistances prevent the appropriate wage adjustment from being made instantaneously. This theory makes the volume of employment depend on two fundamental factors: Real rates of wages for which workmen stipulate. The shape of the real demand function for labor. If people were unemployed, wages would fall until all seeking employment were in fact employed. According to him, perfectly elastic wage policy would abolish fluctuations of employment and would ensure full employment.

6. Assumptions of the Classical Theory 1. There is a normal situation of full employment without inflation. 2. Existence of perfect competition in the market. 3. Homogenous labor. 4. Wages and prices are flexible. 5. It is a closed economy without foreign trade. 6. There is laissez faire capitalist economy without government intervention. 7. Money wages and real wages are directly related and proportional. 8. The law of diminishing returns operates in production. 9. There is perfect information amongst market participants. 10. It assumes long run.

7. Criticisms of the Classical Theory 1. Supply may not create its own demand when a part of the income is saved. 2. Employment in a country cannot be increased by cutting general wages. 3. There is no direct relationship between wages and employment. 4. The classical theory has failed to explain the occurrence of trade cycles. 5. Money is not merely a medium of exchange as implied in the classical theory.

8. 2. KEYNES’ THEORY OF EMPLOYMENT This theory is also referred to as the neoclassical theory. The Keynes’ theory of employment is a demand oriented theory developed by John Maynard Keynes in 1936 in his book “The General Theory of Employment, Interest and Money.” It visualizes employment and unemployment from the demand side on the contrary to classical macroeconomic theories. This theory is also based on the short run unlike classical theories. He assumed that in the short run the factors of production remain unchanged while determining the employment level, thereby employment is dependent on income and output. According to him employment is based on the demand for goods and services while unemployment is due to demand deficiency.

9. Principle of Effective Demand Keynes’ theory is based on the principle of effective demand. The level of employment in a capitalist economy depends on the level of effective demand. Unemployment can be attributed to a deficiency of effective demand. Effective demand means the total demand for goods and services in an economy at various levels of employment or total demand of goods and services by the community. Therefore, effective demand can be regarded as the flow of expenditure. Total demand is the sum total of all demand for consumption and investment. According to Keynes, the value of the aggregate demand at the point of aggregate demand function, where it intersects with the aggregate supply function will be called the effective demand.

10. Effective demand is mainly driven by two factors: Aggregate supply Aggregate demand Aggregate Supply. This is the total amount of money that all entrepreneurs in an economy expect to receive from the sale of output produced by a given number of workers employed. For each employment level there is an aggregate supply price. The aggregate supply function is a schedule of the minimum amount of proceeds required to induce varying quantities of employment. The aggregate supply function is an increasing function of the level of employment. The aggregate supply curve slopes upwards from left to right because volume of employment increases with increase in sale proceeds. However there is a limit to this (the full employment level) which output cannot go beyond.

11. Aggregate Demand. This is the expected revenue from the sale of output at a particular level of employment. It signifies the expected sale receipts received by the organization by employing a specific number of workers. The aggregate demand price schedule is a schedule of expected earnings by selling a product at different levels of employment. The higher the level of employment, the greater the output. The slope of the aggregate demand slopes upward towards the right. The aggregate demand curve shows a rapid increase but then flattens, because expected sales increase with an increase in number of workers and thus the organization expects to get more profit and employs more workers. However at some point an increase in employment would not show an increase in sales thus the curve flattens. The equilibrium level of employment is determined at that point where the aggregate supply price is equal to the aggregate demand price, that is, where the aggregate demand curve and the aggregate supply curve intersect. Keynes proposed demand stimulating policies to cure unemployment and according to him the full employment level can never be reached.

12. Criticisms of the Keynes’ Theory of Employment 1. It is a depression theory thereby limiting its application. 2. It has ignored microanalysis and is not helpful in the solution of problems of individual firms and consumers. 3. It has not given any place to the accelerator principle. 4. It pays excessive attention to money in economic analysis

13. THANK YOU Prepared by Atego L. Laurean & Ibrahim A. Swabra