Unit 3.1 Classical Theory of Employment.pdf

This a precise note meant for BBA students.

1. Classical Theory of Employment
By
KhemRaj Subedi
Associate Professor
Far Western University

2. Classical Theory of Employment
•The Classical Theory of Employment, developed by economists such as
Adam Smith, David Ricardo, J.B. Say, and later refined by Alfred Marshall
and A.C. Pigou, emphasizes the self-adjusting nature of the economy.
•According to this theory, full employment is the normal condition in a free-
market economy due to the flexibility of wages and prices.
•Say’s Law, “supply creates its own demand,” plays a central role, suggesting
that production automatically generates income sufficient to purchase goods.
•Unemployment is considered temporary and caused by wage rigidities or
frictions. Thus, classical economists advocated minimal government
intervention in economic activities.

3. Assumptions
1. There is a normal situation of full employment without inflation.
2. There is a laissez-faire capitalist economy without foreign trade.
3. There is perfect competition in the labourmarket, money market, and product
markets.
4. Labouris homogeneous.
5. Total output of the economy is divided between consumption and investment
expenditures.
6. The quantity of money is given, and money is only a medium of exchange.
7. There is wage and price flexibility.
8. Money wages and real wages are directly related, and this relationship is
proportional.
9. Saving equals investment in the economy.
10. Capital stock and technological knowledge are given in the short run.

4. •The classical theory of employment can be discussed with the help of
three market equilibria:
•Labour Market equilibrium
•Product Market equilibrium
•Money Market equilibrium

5. LabourMarket Equilibrium
•In the classical framework, the labormarket reaches equilibrium through
wage-price flexibility.
•The demand for labordepends on the marginal productivity of labor, while
the supply of laboris determined by real wages.
•If unemployment arises, wages adjust downward, encouraging firms to hire
more workers until full employment is restored. Conversely, if laboris
scarce, wages rise, reducing demand and restoring balance.
•Classical economists argue that involuntary unemployment cannot persist in
the long run, as wage adjustments always clear the labormarket. Thus,
equilibrium ensures full utilization of the laborforce at the prevailing real
wage.

6. Labour Market Equilibrium
The adjoining figure explains the Classical Theory of
Employment through labormarket and output
determination.
In Panel A, the vertical axis shows the real wage rate
(W/P)and the horizontal axis shows employment. The
laborsupply curve (SL) is upward sloping, while the
labordemand curve (DL) slopes downward. Their
intersection at point E determines the equilibrium real
wage and employment level N. If the wage is fixed
above the equilibrium (W/P)1, laborsupply exceeds
demand, creating unemployment (N2). If wages fall to
(W/P)2, labordemand rises to N1, again moving toward
equilibrium. This shows that wage flexibility eliminates
unemployment in the classical view.
In Panel B, employment (N) determines output Y
through the production function Y=f(N). As
employment increases, output also rises but at a
diminishing rate due to the law of diminishing returns.
Thus, classical economists argue that full employment
ensures maximum possible output, with labormarket
equilibrium driving overall economic activity.

7. Product Market Equilibrium
•Product market equilibrium in the classical theory is governed by Say’s Law,
which states that supply creates its own demand.
•Whatever is produced generates income equal to its value, which is spent on
goods and services.
•Hence, general overproduction is impossible, and aggregate supply equals
aggregate demand. Prices are flexible, adjusting to eliminate any excess
demand or supply in the market.
•Producers allocate resources efficiently, guided by competition and profit
motives. T
•hus, equilibrium in the product market ensures that the economy operates at
full capacity, with all output purchased and no persistent shortages or
surpluses in the long run.

8. Product Market Equilibrium
The Classical Theory of Employment states that other
things being same, full employment is maintained only
when whole income generated at the full employment
level is spent on the purchase of whole of the output.
Total output comprises of consumer goods (C) and the
investment goods(I). Again, the total income is partly
spent on consumer goods (C) and partly saved (S).
This can be presented as follows:
Total Income = Total Output
Or, C+S = C+I
Or S = I
Where, C= Consumption
S = Saving
I = Investment
Likewise, the theory also postulates that investment(I)
is the inverse function of interest rate(r) and saving(S)
is the positive function of interest rate. The equilibrium
interest is determined at the point where saving equals
investment. Thus, saving-investment equality gives the
market clearing in the product market at the full
employment level.

9. Money Market Equilibrium
In the classical model, money is neutral and serves only as a medium of
exchange.
The quantity theory of money explains money market equilibrium: MV=PY,
where M is money supply, V velocity, P price level, and Y output.
Since output is fixed at full employment, changes in money supply only affect
prices, not real variables.
????????????,??????=
????????????
Y
Money demand is purely for transactions, determined by the level of income.
Equilibrium occurs when money supply equals money demand.
Thus, monetary factors cannot influence employment or output in the long run,
reinforcing the classical belief in real-sector dominance.

10. Money Market Equilibrium
The classical economists believed on quantity theory of money.
According to quantity theory of money, the supply of money
determines the price level in the economy. Irving Fisher’s
equation of exchange states that total expenditure on final goods
and services (MV) is equal to the total value of output (PY). It
can be presented as follows:
????????????=????????????
Or,????????????=????????????
????????????,??????=
????????????
Y
Where,P=PriceLevel
M=QuantityofMoney
Y=Levelofaggregateoutput/totalvolumeoftransactions
V=Incomevelocityofcirculationofmoney
Accordingtoclassicaleconomists,levelofaggregateoutput(Y)
remainsconstantatfullemploymentlevel.Theyalsoassumed
thatincomevelocityofcirculationofmoney(V)remains
constantorstable.Thus,YandVbeingconstant,thelevelof
priceisdeterminedbythequantityofmoney(M)andthereisa
directrelationshipbetweenMandP.Itimpliesthatthechanges
inthemoneysupplyleadtoproportionalchangesintheprice
level.

11. Criticism of the Classical Theory of Employment
•Unrealistic full employmentassumption ignores widespread involuntary
unemployment.
•Supply does not create its own demand, ratherdemand creates its own
supply.
•Wage-price flexibilityis impractical due to contracts, unions, and social
resistance.
•Neglect of aggregate demand, which Keynes highlighted as key to
employment.
•Neutrality of moneyoverlooks its real short-run effects on output and jobs.
•Perfect competition assumptionis unrealistic in modern economies with
monopolies and oligopolies.
•No role for government policy, which proved ineffective during the Great
Depression.