Classical Theory of Employment

Introduction:

Classical economics is an English school of economic thought that originated during the late 18th century with Adam Smith and that reached maturity in the works of David Ricardo and John Stuart Mill.
Classical economists believed in the existence of full employment in the economy. Full employment was a normal situation, and any deviation from this was regarded as something abnormal. According to Pigou, the tendency of the economic systems is to automatically provide full employment in the labour market when the demand and supply of labour are equal. Unemployment results from the rigidity in the wage structure and interference in the working of the free-market system in the form of trade union legislation, minimum wage legislation etc.

Assumptions:

1. There is the existence of full employment without inflation.
2. There is a laissez-faire capitalist economy without government interference.
3. It is a closed economy without foreign trade.
4. There is perfect competition in labour and product markets.
5. Labour is homogenous.
6. Wages and Prices are perfectly flexible.
7. The law of diminishing returns operates in production.
8. It assumes the long run.
9. It is based on Say’s law of markets which says that “supply creates its own demand.

Determination of Output and Employment:

In classical theory, output and employment are determined by the production function, the demand for labour, and the supply of labour in the economy. Given the capital stock, technical knowledge and other factors, a precise relation exists between total output and employment, i.e., number of workers. This is shown in the following production function: Q = f (K, T, N). Where total output (Q) is a function (f) of capital stock (K), technical knowledge (T), and the number of workers (N).

Given K and T, the production function becomes Q = f (N) which shows that output is a function of the number of workers. Thus, the output is an increasing function of the number of workers, output increases as the employment of labour rises. But, after a point when more workers are employed, diminishing marginal returns to labour start. This is shown in figure 1, where the curve Q = f (N) is the production function, and the total output  corresponds to the full employment level . But when more workers  are employed beyond the full employment level of output , the increase in output  is less than the increase in employment .

Labour Market Equilibrium:

In the labour market, the demand for labour and the supply of labour determines the level of output and employment. Classical economists regard the demand for labour as the function of the real wage rate: . Where = demand for labour, W = wage rate and P = price level. Dividing wage rate (W) by price level (P), we get the real wage rate (W/P).
The demand for labour is a decreasing function of the real wage rate. The supply of labour also depends on the real wage rate: , where  is the supply of labour. But it is an increasing function of the real wage rate.

When the  and  curves intersect at point E, the full employment level  is determined at the equilibrium real wage rate . If the wage rate rises from  to  the supply of labour will be more than its demand by ds. On the contrary, if the wage rate falls from  to  the demand for labour will be more than its supply. This is because competition by employers for workers will raise the wage rate from   to  and the equilibrium point E will be restored along with the full employment level .

Wage Price Flexibility:

The demand for labour is a decreasing function of the real wage rate. Thus, if W is the money wage rate, P is the product's price and  is the marginal product of labour, we have  or .

Since  declines as employment increases, it follows that the level of employment increases as the real wage (W/P) declines. This is explained in the figure. In Panel (A),  is the supply curve of labour and  is the demand curve for labour. The intersection of the two curves at E shows the level of full employment  and the real wage .
If the real wage rises to , supply exceeds the demand for labour by sd and workers are unemployed. It is only when the wage is reduced to  that unemployment disappears and the level of full employment is attained.
This is shown in Panel (B), where  is the marginal product of the labour curve slopes downward as more labour is employed. Since every worker is paid wages equal to his marginal product, therefore the full employment level  is reached when the wage rate falls from  to . Contrariwise, with the fall in the wage from  to , the demand for labour increases more than its supply by , the workers demand higher wages. This leads to the rise in the wage from  to  and the full employment level  is attained.

Limitations/Criticisms:

i) Underemployment Equilibrium: Keynes rejected the fundamental classical assumption of full-employment equilibrium in the economy. He considered it unrealistic.
ii) Refutation of Say’s Law: Keynes refuted Say’s Law of markets that supply always created its own demand. Instead, he maintained that all income earned by the factor owners would not be spent on buying products they helped produce.
iii) Self-adjustment not Possible: Keynes disagreed with the classical view that the laissez-faire policy was essential for an automatic and self-adjusting process of full employment equilibrium.
iv) Equality of Saving and Investment through Income Changes: The classicists believed saving and investment were equal at the full employment level. In case of any divergence, equality was brought about by the mechanism of interest. Keynes held that the level of saving depended upon the level of income and not on the interest rate.
v) Long-Run Analysis Unrealistic: The classicists believed in the long-run full employment equilibrium through a self-adjusting process. However, Keynes had no patience to wait for a long period, for he believed that “In the long run we are all dead”.

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