The Principle of Effective Demand

Introduction:

Keynes’ theory of employment is based on the principle of effective demand. In other words, the level of employment in a capitalist economy depends on the level of effective demand. Thus, unemployment is attributed to the deficiency of effective demand and to cure it requires increasing the level of effective demand.

By "effective demand", Keynes meant the total demand for goods and services in an economy at various employment levels. The people's total demand for goods and services is the sum total of all demand meant for consumption and investment. In other words, the sum of consumption expenditures and investment expenditures constitute effective demand in a two-sector economy. Another component of effective demand is the component of government expenditure. Thus, effective demand may be defined as the total of all expenditures.

According to Keynes, the level of employment is determined by the effective demand, which, in turn, is determined by aggregate demand function or aggregate demand price and aggregate supply function or aggregate supply price. In Keynes words, “The value of D (Aggregate Demand) at the point of Aggregate Demand function, where it is intersected by the Aggregate Supply function, will be called the effective demand.”

Aggregate Demand Function: Aggregate demand refers to the total amount that different sectors in the economy willingly spend in a given period. Aggregate demand (often written AD) equals total spending on goods and services. It depends on the level of prices and monetary policy, fiscal policy, and other factors. The components of aggregate demand include consumption, investment, government purchases and net exports. Aggregate demand is affected by the prices at which the goods are offered, exogenous forces like wars and weather, and government policies. Thus the aggregate demand price is the amount of money the entrepreneurs expect to get by selling the output produced by the number of men employed. In other words, it refers to the expected revenue from the sale of output produced at a particular level of employment. Thus, different aggregate demand prices relate to different levels of employment in the economy.

Aggregate Supply Function: Aggregate supply refers to the total quantity of goods and services that the nation’s businesses willingly produce and sell in a given period. Aggregate supply (often written AS) depends upon the price level, the productive capacity of the economy, and the level of costs. For example, when an entrepreneur gives employment to a certain amount of labour, it requires certain quantities of co-operant factors like land, capital, raw materials, etc. These will be paid remuneration along with labour. Thus each level of employment involves certain money costs of production, including normal profits, which the entrepreneur must cover. 

Determination of Effective demand:

Figure 1 illustrates the determination of effective demand where AD is the aggregate demand function and AS is the aggregate supply function. The horizontal axis measures the level of employment in the economy, and the vertical axis the proceeds expected (revenue) and the proceeds necessary (costs). The two curves, AD and AS, intersect each other at point E. This is effective demand where ON workers are employed. At this point, the entrepreneurs‟ expectations of profits are maximised. At any point other than this, the entrepreneurs will either incur losses or earn subnormal profits.

At the  level of employment, the proceeds expected (revenue) are more than the proceeds necessary (costs), i.e., . This indicates that it is profitable for the entrepreneurs to provide increased employment to workers till the ON level is reached where the proceeds expected and necessary equal at point E.

It would not be, however, profitable for the entrepreneurs to increase employment beyond this to level because the proceeds necessary (costs) exceed the proceeds expected (revenue), i.e.,  and they incur losses. Thus E, the point of effective demand, determines the actual level of employment in the economy, which is of underemployment equilibrium. Of the two determinants of effective demand, Keynes regards the aggregate supply function to be given because it depends on the technical conditions of production, the availability of raw materials, machines etc. which do not change in the short run.

Additional Notes:

Effective demand: Ex ante spending that is plans to purchase by people with the means to pay. Effective demand is contrasted with notional demand, the demand that would exist if all markets were in equilibrium. Effective demand thus excludes the extra goods that unemployed workers would buy if they could get jobs or that credit-constrained entrepreneurs would buy if they could obtain finance.

Aggregate Demand: The total of intended or ex-ante attempts to spend on final goods and services produced in a country. In a closed economy, aggregate demand is the sum of consumption, investment, and government spending on goods and services. In an open economy, in addition to this, it includes export demand and excludes imports. A rise in aggregate demand is a necessary condition for an increase in real output. However, it is not a sufficient condition unless an economy has spare capacity to produce the goods and services demanded. If the goods demanded are available only as imports, these rises; if the extra goods are not available at all, inflationary pressure is created.

Aggregate Supply: The total amount of real goods and services that the enterprises in an economy are willing to provide at any given ratio of prices to wages. This can be increased by greater productivity due to increases in the volume of productive equipment, improvements in technical knowledge, or the quality of the labour force. Whether actual output equals aggregate supply depends on two conditions. First, there must be sufficient aggregate demand to match the supply: if there is not, the output is demand-constrained. Second, there must be a sufficient supply of labour to satisfy firms' demand for it. If real wages are low, aggregate supply by firms may require more employment than the labour supply forthcoming at these wages, in which case output is constrained by labour shortages. In an economy where firms do not act competitively, the concept of aggregate supply is not applicable: firms in markets characterized by imperfect competition do not have supply curves. See also demand-determined output.

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