Theory of income and employment chap 1

Theory of income and employment, classical theory of employment, say's law of market, supply creates its own demand, theory of effective demand

1. Theory of Income and
Employment
Classical theory of Employment
Say’s Law of Market
Pigou’sWage-cut theory
Keynesian Theory of Income and
Employment
Theory of Effective Demand

2. Classical theory of Income and
Employment
•Theentireeconomicpremiseoftheclassical
economistswasbasedontheassumptionof
fullemploymentoflabourandothereconomic
resources.
•Theywereoftheopinionthattheeconomy
operatesinthestableequilibriumsituationin
thelongrunandanydeviationtheretowas
regardedasabnormal.

3. •Alongwiththat,theyalsomadeanassumption
ofperfectcompetition,fr4eecapitalist
economyandoptimumuseofresourcesin
longrun.
•Herefullemploymentdoesnotmeanthetotal
absenceoftheunemploymentbuttherecanbe
frictionalunemploymentoftemporarynature,
orseasonalunemployment.

4. Assumption of the classical theory of
Income and Employment
1.Perfect Competition
2.Wage-Price Flexibility
3.Homogeneous Labour
4.Constant stock of capital and technology
5.Liaises Faire Economy
6.All the units produced are sold in the market

5. Say’s Law of Market
(Supply creates its own Demand)
•J.B.Say,aFrencheconomistof19
th
century,arrestedthat,
“SupplycreatesitsownDemand.”thisappearstobe
simplepropositionbuthashadmanydifferentmeanings,
andmanysetsofreasoning.
•Accordingtothisconcept:Wheneveranyproductis
produced,thedemandofthatproductisalso
simultaneouslygeneratedonaccountoforthroughthe
processofpaymentofremunerationtothefactorsof
production.
•Inotherwordseveryoutputproduced,resultsinan
equivalentdemandbeinggeneratedwhichleadstoitssale
sothatthereisnosurplusoutputoroverproduction.
•Say’slawisapplicablebothinbartereconomyandin
moneyeconomy.

6. Assumptions under Say’s Law
1.Optimum Allocation of Resources
2.Perfect Equilibrium
3.Perfect Competition
4.Market Economy
5.Laissez Faire Policy of the government
6.Elastic market
7.Market Automatism
8.Circular Flow
9.Saving-Investment Equality
10.Long term concept

7. A.Say’s Law in Barter Economy:
•Inbartereconomy,theproducersundertaketoproduce
thegoodseithertoconsumeortoexchangethemfor
othergoodswhichtheyneedforconsumption.
•Inanycasetheycreateademandforgoodswhichis
equaltothesupplyofgoodstheyhaveproduced.“Itis
productionwhichcreatesmarketforgoods:nosooner
aproductiscreated,fromthatinstanti8taffordsa
marketforotherproducttothefullextentofitsvalue.
Thus,aproducerhimselfbecomesaconsumerforhis
ownproductorsomebodyelse’sproduct.
•InthewordsofJ.S.Mill“allsellersareinevitably
andbymeaningofthewordbuyer.”

8. B.Say’sLawinMoneyEconomy:
•Inmoneyeconomy,peoplereceivemoneyinexchangeofthe
goodsthattheyhaveproduced.Thisimpliesthatthesupply
ofproduct,throughtheprocessofproduction,generates
necessaryincome-occurringtothefactorsofproductionin
theformofrent,wages,interest,profits,etc.todemandthe
goodsproducedsothatanequivalentdemandiscreatedin
accordancewiththesupply.Sowecansaythatthemain
sourceofdemandistheflowofincomesgeneratedfromthe
processofproductionitself.
•However,inmoneyeconomy,peoplemaynotspentallthe
moneyincomethattheyhavereceived.Theymaydecideto
saveapartoftheirincome.

9. •Accordingtoclassicalwriters,theinterestrate
mechanismwouldensuretheconversionofsaving
intoinvestmenttoensurefullemployment.
•Ifpeopledecidetosavemorethanbefore,total
savingsintheeconomywouldincreaseleadingtofall
ininterestrates,whichwouldencourage
entrepreneurstoinvestmore.
•Theinvestmentswillincreasetillitbecomesequalto
totalsavings.
•Sotheincomenotspentforconsumptiongoods
wouldbespentforinvestmentbyentrepreneurs.

10. Criticisms of Say’s Law:
1.Theassumptionofperfectcompetitionis
unrealistic.
2.Savingsandinvestmentsarenotcontinuous
process.
3.InvestmentismainlyinfluencedbytheMarginal
EfficiencyofCapitalandnotsolelyonthe
changesintherateofinterest.
4.AccordingtoKeynes,equilibriumcanbeattained
atanylevelbelowthefullemploymentsituation
also.

11. Wage Flexibility and Full Employment
(Pigou’s Wage –Cut Theory)
•Theclassicistshaveadvocated“themoneywagecut
policy”tosolvetheproblemofunemployment.
•Theclassicaleconomistsbelievedthatinvoluntary
unemployment,ifitexistsinaneconomy,wasa
consequenceoftherigidwagestructure.Ifwagesare
loweredsufficiently,allinvoluntaryunemployment
woulddisappear.
•Itisassumedthattheselfadjustingsystemofwage
rateswouldpushtheeconomytowardsfull
employmentstage.

12. Continue……..
•Theinvoluntaryunemploymentcomesintoexistence
duetotheinterferencetothefreeplayofmarket
mechanisminacapitalisteconomy.
•Suchinterferenceistheresultofcollectivebargaining
oftradeunionstopushwagesorgovernmental
interventionsthroughpassingoflawofminimum
wages.
•Thisdisturbsthesmoothfunctioningofthemarket
mechanismindeterminingtheequilibriumwagerates
whichclearoffthelabourmarket.

13. Explanation:
OnOYaxis,wagerateistaken
andonOXaxisRateof
Employmentistaken.
Sisthelaboursupplycurveand
Disthedemandcurveoflabourin
theeconomy.
IfthewagerateisWP1,theMT
istheamountofUnemploymentin
theeconomy.
Toremovethislevelof
unemployment,Pigousuggeststhat
thewageratesshouldbereduced
toWP2,wherethedemandand
supplycurveofthelabour
intersectseachotherandONlevel
ofEmploymentismaintained.
Therefore,thewagecuttheoryof
Pigoucanhelpineliminatingthe
problemofunemployment.

14. Criticisms of the Wage cut theory
1.Unrealistic Assumption of Full Employment
condition.
2.Undue importance of the Long Period.
3.Keynes’ Denial of Say’s Law of Market.
4.Attack on Money Wage cut policy.
5.Keynes’ attack on Interest Rate to be strategic
variable.
6.Keynes’ attack on Laissez faire policy.

15. The Theory Of Effective Demand
•Theprincipleofeffectivedemandliesatthe
heartofKeynes’Generaltheoryof
Employment.
•Thedictumofthetheoryisthatthevolumeof
employmentdependsonthelevelofeffective
demandintheeconomy.
•Unemploymentisduetodeficiencyof
effectivedemand.

16. •Broadlyspeaking,Keynesdesignatedtheterm
“effectivedemand”todenotethetotaldemandof
goodsandservices(consumptionandinvestment)by
thecommunity.
•Herewecansaythattheeffectivedemandistheflow
ofexpenditure.
•Astheexpenditureofonebecomessourceofincome
fortheothers.
•Itmeanstheconsumptionexpenditureandthe
investmentexpenditurebythecommunityexpresses
thetotaldemandforgoodsandservices.

17. •AccordingtoKeynes,asIncomeincreases,
consumptionexpenditurealsoincreases,butaftera
certainpointitdoesnotincreasesinthesame
proportionasincreaseinincome.Itmeans,
Expenditureincreasesalongwiththelevelofincome
butatthediminishingrate.
•Herethereisagapbetweenincomeandexpenditure
whichmaybebridgedbyinvestmentexpenditure.
•IfInvestmentexpendituredoesnotincreasestothis
extent,thetotalexpenditureintheeconomywillbe
lessandtheeffectivedemandwillbelowleadingto
unemploymentintheeconomy.

18. •Effective demand is determined by two factors:
A.Aggregate Demand Price:
•IntheKeynesianterminology,theAggregatedemand
functionreferstothescheduleofmaximumsaleproceeds
whichtheentrepreneurialcommunityactuallydoesexpectto
bereceivedfromthesaleofdifferentquantitiesofoutput,
resultingatvariouslevelofemployment.Thequantumof
maximumsalesrevenueexpectedfromtheoutputproduced
isdescribedasthedemandpriceofaparticularlevelof
employment.
•Thereisapositivecorrelationbetweenlevelofemployment
andthedemandprice.

19. •Theaggregatedemandpricedependsuponthetotal
expenditureflowoftheeconomy,whichis
determinedbythespendingdecisionofthe
communityasawhole.
•Inafreecapitalisteconomy,householdsandthefirms
arethetwomajoreconomicsectorswhichspentfor
consumptionandinvestment.
•Now,whatthesesectorsareexpectedtospendinnext
periodisviewedastheaggregatedemandprice.
•Thiscanbemoresimplypresentedwiththehelpofa
scheduleandadiagram.

21. ADF = f (N)
ADF= Expected sales receipt by
entrepreneurs
N= the volume of employment
f= the functional relationship

22. •The ADF curve drawn in the diagram is linear but it
can also be non linear.
•Its shape and slope depends on the assumptions and
nature of data relating to the aggregate demand
schedule.
B. Aggregate Supply price:
•The ”supply price” for a given quantity of commodity
refers to that price at which the seller is willing or
induced to supply that amount in the market. Hence
the supply schedule of that commodity shows the
varying level of quantities of the commodity the
seller offers for sale at the alternative prices.

23. •Similarly,theaggregatesupplyschedulefortheeconomy
asawhole,refersto,theresponseofallentrepreneursin
supplyingthewholeofoutputoftheeconomy.
•Keyneswasoftheopinionthatthelevelofoutputvaries
withthelevelofemployment.
•Eachlevelofemploymentnecessitatescertainquantities
ofotherfactorsofproductionlikeland,capital,raw
materials,etc.,toassistthelabouremployed.
•Therewardpaidtoallfactorsofproductionwillbe
consideredtobecostofproduction.
•Thuseachlevelofemploymentwillinvolvecertain
amountofmoneycostincludingnormalamountofprofit.

24. •Therefore,theentrepreneurmustgetsomeminimumamount
ofsalesrevenuetocoverthetotalcostincurredatagivenlevel
ofemployment.
•Onlyifthesalesproceedsarehighenoughtocoverthetotal
costsofproductionatagivenlevelofemploymentandoutput,
theentrepreneurwillbeinducedtoprovidethatparticularlevel
ofemployment.
•Theminimumpriceofrevenueproceedstheentrepreneurmust
getfromthesalesofoutput,associatedwithdifferentlevelsof
employmentsisdefinedas“aggregatesupplyprice”or
“aggregatesupplyfunction”
•So,itisascheduleofvariousminimumamountofrevenues
whichmustbeexpectedtobereceivedbytheentrepreneur
classfromthesaleofoutputresultingatvariouslevelsof
employment.

26. Intheabovefigure,OXrepresents
levelofemploymentandOY
representsminimumsalesproceeds.
AScurverepresentstheaggregate
supplyfunction.
Itislinearasbecausewehave
assumedconstantwagerate.
However,aftertheleveloffull
employment,theASFwillbe
perfectlyinelastic.
Inthefiguretheleveloffull
employmentisbeingrepresentedby
QZdottedline.i.e.6lakhsworkers.
However,thereareuncertainty
prevailsregardingtheshapeofASFas
itisdependedontheMarginal
productivityofthelabours.

27. •The intersection of aggregate demand function with the
aggregate supply function determines the level of income and
employment.
•The aggregate supply schedule represents the cost involved at
each possible level of employment.
•The Aggregate demand schedule represents expectation of
maximum receipts of the entrepreneur at each possible level of
employment.
•Thus, it shows that, as long as the receipts exceeds costs, the
level of employment will go on increasing.
•The process will continue till revenues becomes equal to costs.
Equilibrium Level of Employment –The Point of Effective
Demand

29. •In tabular terms shown above the point of effective demand
and equilibrium of t6he economy is at point 4 where ADP and
ASP both are 400 crores.
•In diagram, the point of effective demand of the economy is
represented at point E where ADF and ASF are intersecting
each other.
•In long run, if Aggregate Demand increases, it can be said that
the level of employment or the Point of Effective demand will
also increase.
•This can be seen in the following diagram:

30. •If ADF increases from ADF2 to ADF1, the point of
Effective Demand will also increase from E1 to E2 and
the level of employment will also increase from N1 to N2

31. •Gist of Keynesian Theory of Income and
Employment: