The classical economists held the view that the economic system automatically adjusted itself at the level of full employment through wage-price flexibility. According to this view, there was a strong tendency towards full employment via wage adjustments. For example, if during depression, money wages were reduced all around, it would be possible not only to reduce unemployment but eventually to create a situation of full employment. A cut in money wages will lower marginal production costs and as a result, lead to increase in output and employment. The output will increase, because reduction in production costs will enable the producers to lower prices and stimulate demand. Unemployment if any will be temporary phase.
Keynes severely eroticised the classical view. He made a comprehensive analysis of he problem and pointed out serious flaws in the classical argument. The main flow is that classical economists have ignored the demand aspect. They hold the reduction in wages will leave the aggregate effective demand unaffected. There is no doubt that reduction in wages will lead to increase in output. But, unless the increased output is purchased and consumed, investment will be discouraged and output and employment reduced.
The classical economists simply saw that when wages in a particular industry were reduced, profits there increased resulting in larger output and employment. Cut in wages in a particular industry or by particular firm does not reduce the demand for the products of that industry. This is so because their particular labour is a small fraction of the total labour force. Their purchasing power may be reduced by a cut in their wages, but the purchasing power of the rest of the labour is not reduced. Hence the demand for goods will not be reduced. On the contrary the cheapening of the goods produced by them will increase demand for them. Their output will increase and so employment in that particular will increase. But what is true of a particular industry cannot be true of the economic system as a whole. If there is a great wage cut i.e. cutting of wages in all industries, then the incomes and so the purchasing power of all workers will decrease. Reduction in aggregate effective demand will result in reduction of output and curtail the volume of employment. It is to be remembered that so far as the economy is concerned wages are not only cost but also source of demand.
It is not necessary that a cut in money wage may lead to a reduction in real wage. If prices fall to that same extent as wages fall, real wages remain the same. Real wages will be reduced only when prices do not fall to the same extent as fall in wages. It is reduction in real wages which is going to provide incentive to the producers to invest and increase output and employment.
Thus the fatal flaw in the classical analysis is that it suffers from the lack of a theory of effective demand and it arises from the classical economists attempt to apply to the economy as a whole, the logic of a theory designed to apply to a particular industry. They ignored the fact that on all around reduction in wages or general or over all cut in wages would reduced effective demand or aggregate demand which will reduce employment rather than increase it.
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