Monday, August 24, 2009

Classical Theory of Employment

The classical theory of employment assumes that there is always full employment of labour and other resources. In fact full employment is considered to be normal. Even if at any time, there is not actual full employment, the classical theory asserts that there is always a tendency towards full employment. The free play of economic forces itself brings about the fuller utilization of economic resources including labour. Any interference with the free play of market forces, says the theory, shall fall to bring about full employment. The classics therefore advocate that the government should keep its hands off the economic field if there is to be full employment of labour and other resources. The assumption that there is always full employment of resources is justified in classical economics by Say’s Law of Market. This law is in fact the core of Classical Economics theory. According to J. B Say “Supply creates its own demand” in say’s words “It is production which creates market for goods, for selling is at the same time buying and more of production more of creating demand for other goods. Every production finds a buyer. In other words, every supply of output creates an equivalent demand for output, so that there can never be a problem of general over production. Say’s Law thus denies the possibility of the deficiency of aggregate demand.

Say’s Law so conceived describes an important fact about the working of the free exchange economy that the main source of demand is the sum of incomes earned by various productive factors from the process of production itself. The employment hither to unutilised labour and other resources pays its own way, because it enlarges the market demand for goods by an amount equivalent to the income created and the value of output produced. A new productive process by paying out income to its employed factors generates demand at the same time that it adds to supply. It is thus production which creates market for goods.

In brief Say’s Law of market is denial of the possibility of general over production, that is, a denial of the possibility of a deficiency of aggregate demand. Therefore employment of more resources will always be profitable and will take place to the point of full employment, subject to the limitation that the contributors of resources are willing to accept rewards no greater than their physical productivity justifies. There can be no general unemployment, according to this view if workers will accept what they are worth.


Keynes in his General Theory made a vigorous attack on the classical theory of employment. As explained above, according to Say’s Law every supply of output creates an equivalent demand for output, so that there can never be a problem of general over production and hence general unemployment. Now it is true that supply does create demand for goods and services because various factors of production earn their incomes in the process of production by helping to create additional supply of output. When factor of production are employed, for instance, to produce cloth they get their reward in the form of wages, rents interest and profits.

But from this it does not follow that entire supply of national output will always is demanded by them. The incomes of the factors of production are necessarily equal to the value added in the productive process, but it does not mean that the entire income will be automatically spent on goods and services created in a given time period. A part of incomes will be saved so that this part of income is not available to create demand for goods and services. Saving this cause or break or leakage in the income stream and obstructs the income expenditure flow. Unless investors are willing to invest to an equivalent extent of intended saving, the total effective demand, which consists of demand for consumers goods and producer’s goods will not be sufficient to absorb to entire available supply of out put. And if it happens like this, there will be overproduction and producers will not be able to sell their entire out put, their profits will fall and they will reduce their production and this will create unemployment. Thus supply does not necessarily create its own demand. In a given time period consumers are planning to spend a given part of their income and save the rest. Similarly entrepreneur are planning to invest in factories, machines etc to a given extent. The total effective demand is the sum of consumption and investment demands. Savers are saving for reasons different from the investors and in a free enterprise economy there is no mechanism to ensure that what savers are planning to save is just equal to what investors are planning to invest. If the planned investment expenditure is not enough to fill up the gap of savings, them the present level of income and employment will not be maintained and therefore there will be a fall in income and employment. Hence the basic weakness of Say’s Law arises because of lack of any agency to ensure the intended savings are just equal to intended investment, and since savings and investments are undertaken by different persons and for different reasons, a discrepancy between the two is bound to arrive and when it arises the necessary mechanism to correct it is through changes in volume of employment and income.

Thus according to Keynes there is no in inherent reason to believe that investment expenditure plus consumption expenditure would always be equal to the cost of any given output, there is thus no assurance that demand would equal any given supply savings are determined primarily by income. But investment demand depends mainly, in the short run, on marginal efficiency of capital and rate of interest and in the long run on factors like changes in technology and population growth. Therefore investment demand so determined will not necessarily fill the savings gap between the income and consumption at the level of full employment and thus unemployment will be the result.

In sharp contrast to the classical view that full employment equilibrium in the normal situation. Keynes in his general theory firmly held the view that in a free private enterprise economy there are more chances for the equilibrium to be established at less than full employment level. Further Keynes strongly opposed the Pigovian view that unemployment would disappear if a general cut in money wages was applied. A general cut in wages according to Keynes will fail to bring about increase in employment, because it will mainly cause a reduction in aggregate demand. No doubt the costs in all industries would be reduced as a result of a general wage cut but that in it would not increase demand for the products, because the purchasing power in the hands of workers would have been reduced by cutting down their wages. A general wage cut by bringing about decline in aggregate demand may actually decrease the volume of employment and thus deepen the depression. Besides worker’s organisations are too strong to permit general wage-cuts. Thus Pigovian theory has no relevance as a guide to policy. Hence the classical theory of employment must be rejected both on theoretical and practical grounds.

The fundamental fallacy in Say’s Law is that partial equilibrium analysis which could apply to particular industry has been extended to the economy as a whole. Lowering of wages rate in a particular industry may increase employment there without decreasing demand. But if wages are reduced all round, it will reduce income and so effective demand and the volume of employment.

The difference between the Pigovian and Keynesian views is fundamental. While Pigou is of the view that employment depends upon the level of money wages and can be increased by lowering wages, Keynes contends that the volume of employment is determined by the level of aggregate demand which may be adversely affected by the cuts in money wages. In Keynes view even if wages rates were perfectly flexible unemployment could still exists if the aggregate demand was deficient. Hence it is wrong to assert, as the classical economists did, that wage adjustment ensures full employment and interest rate adjustment tends to solve the saving investment problem.

By summing up the main points of criticism are as under

(i) Supply may not create its own demand when a part of the income is saved. Aggregate demand is not always equal to aggregate supply.

(ii) Suplyment in the economy as a whole can not be increased by means of a general wage-cut, though it may be possible in a particular industry. It is wrong to apply micro economic principle to macro-economic activities or situations.

(iii) The classical economists looked at wages only from the employers point of view i.e. the cost aspect and ignored the income aspect of wages. There is no direct relationship between wages and employment, nor is the unemployment due to wage rigidities or artificial resistances.

(iv) Interest rate adjustment cannot solve saving-investment problem. Saving and investment are not interest-elastic.

(v) The economic system is not so self-adjusting as it is supposed, hence government interest in the economic sphere becomes necessary. Wages and prices are not so flexible as was supposed.

(vi) Assumption of free and perfect competition is not realistic.

(vii) It is wrong to suppose that money is a mere medium of exchange and has no role in affecting output and employment.

(viii) Say’s Law cannot explain the occurrence of trade cycle.

(ix) The classical theory does not explain how the level of employment is determined. It evades the problem by assuming full employment.


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