Classical theory of economics

Assumption of Full Employment

• Labour and other resources were always fully employed: This means that the economy is
assumed to be using all its available resources efficiently. There are no idle workers or unused
capital; everything is being put to productive use.
• General overproduction and hence general unemployment is impossible: The assumption
here is that the market always finds a way to balance supply and demand. Since resources are
fully employed, there's no overproduction, and thus, there's no widespread unemployment.
• The normal situation is stable equilibrium at full employment: In this view, the economy
naturally tends to stabilize at full employment without needing external intervention. Any
disturbances in the market are temporary, and the economy self-corrects to return to full
employment.
• Free competitive capitalist economy that is laissez-faire guaranteed full employment: This
point suggests that a free market economy, without government intervention (laissez-faire),
naturally ensures that resources are fully employed. It relies on the belief that supply and
demand dynamics will always lead to full employment.
• It assumes full employment and tries to explain the allocation of given resources in
production and distribution of income: This point focuses on the idea that economic theories
and models start with the assumption of full employment. They then analyze how resources
are allocated across different sectors of production and how income is distributed among
individuals.

Criticism of this assumption

• The Great Depression:

The prolonged unemployment during the Great Depression (1930s) challenged the classical view.
Despite falling wages, unemployment remained high, suggesting that markets do not always self-
correct quickly.

• Keynesian Economics:

John Maynard Keynes argued that economies can remain in a state of underemployment
equilibrium due to insufficient aggregate demand.

He advocated for government intervention (e.g., fiscal stimulus) to boost demand and reduce
unemployment.

• Wage and Price Rigidities:

In reality, wages and prices are often "sticky" and do not adjust quickly due to factors like contracts,
minimum wage laws, and social norms.

• Involuntary Unemployment:

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Classical economics assumes that unemployment is voluntary (workers choose not to work at lower
wages). However, Keynes argued that involuntary unemployment can persist even when workers are
willing to work at lower wages.

Flexibility of prices and wages

1. Flexibility of Prices and Wages: Classical economists argue that prices and wages are flexible
and can adjust to changes in the economy. This flexibility is crucial for maintaining equilibrium
in the labor market.

2. Automatic Adjustment to Full Employment: If there is overproduction leading to a depression

and unemployment, classical economists believe that prices will eventually fall. Lower prices
would stimulate demand for goods and services, which in turn would increase production and
reduce unemployment.

3. Wage Adjustments: Similarly, if there is unemployment, wages would decrease. Lower wages
would make labor cheaper for employers, increasing the demand for labor and thus reducing
unemployment. This adjustment process is seen as a natural mechanism to restore full
employment.

4. Marginal Revenue Product: The concept of marginal revenue product (MRP) is also relevant
here. MRP is the additional revenue generated by employing an additional unit of labor. If
wages are flexible and adjust to the MRP, it ensures that the labor market clears, meaning that
the quantity of labor supplied equals the quantity demanded.

In summary, classical economists believe that the economy has self-correcting mechanisms through
the flexibility of prices and wages, which help to maintain full employment without the need for
government intervention. This perspective assumes that markets are efficient and that any imbalances
are temporary and will be corrected through natural economic processes.

Say's Law in Classical Economics

Concept:

• Say's Law is a fundamental principle in classical economics, which states that "supply creates
its own demand." In other words, the production of goods generates the income necessary to
purchase those goods.

Key Points:

1. Foundation of Classical Economics: Say's Law supports the classical assumption that full
employment is a normal condition in a free market economy.

2. No General Overproduction or Unemployment: According to classical economists, general

overproduction and widespread unemployment are impossible because the act of producing
goods inherently creates demand for them.

Basic Assumptions of Say’s Law

Free-Exchange Economy:

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 • Say's Law assumes that the economy operates in a free market where buyers and sellers have
complete freedom to exchange goods and services without any restrictions. This freedom
ensures that supply and demand forces can naturally adjust to bring about equilibrium in the
market.

Free Flow of Money Incomes:

• The theory assumes that as people earn incomes, they immediately spend them on goods and
services. This continuous flow of money ensures that all income generated through production
is quickly turned into demand for goods. Even savings are not left idle; they are invested and
used to purchase producer goods, keeping the economic cycle moving.

Savings Equal Investment:

• Say's Law relies on the assumption that any money saved by individuals is eventually invested.
This equilibrium between savings and investment is maintained by the flexibility of interest
rates. When savings increase, interest rates fall, encouraging investment, and when savings
decrease, interest rates rise, discouraging investment, ensuring that total savings always
equals total investment.

Laissez-Faire Government Policy:

• The theory assumes that the government does not interfere with market operations. A laissez-
faire approach means minimal government intervention in economic activities, allowing
market forces to determine prices, wages, and production levels, leading to full employment
and efficient allocation of resources.

Size of the Market Limited by Production Volume:

• Say's Law posits that the market size is determined by the volume of production. The
assumption is that as production increases, it creates its own demand. Therefore, supply will
always equal demand, and there will be no excess supply or insufficient demand.

No General Overproduction:

• Say's Law posits that general overproduction (where the total supply of goods exceeds the
total demand) is impossible. If there is an excess of one good, it means there is a deficiency of
another, and resources will be reallocated accordingly.

Flexibility of Prices and Wages:

• Prices and wages are assumed to be flexible and responsive to changes in supply and demand.
If there is unemployment, wages will fall, making it more attractive for businesses to hire
workers, thereby returning to full employment.

Criticisms
Savings Shortfall: When people save a portion of their income instead of spending it, the overall
demand for goods and services decreases. This shortfall can lead to economic slowdowns and
increased unemployment. Thus, supply may not always create its own demand.

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Wage Cut Limitations: General wage cuts might not lead to increased employment across the
economy. While it could help certain industries, it doesn't guarantee a rise in overall employment.
Reduced wages can also lower aggregate demand.

Employer's Perspective: Classical economists viewed wages primarily as costs to employers. They
overlooked wages' dual role as both a production cost and a source of demand. Lower wages mean
reduced purchasing power for workers.

Interest Rate Issues: Adjusting interest rates alone can't balance savings and investment effectively.
Other factors, such as consumer confidence and economic conditions, significantly influence
investment decisions. Thus, this adjustment may not be sufficient.

Unrealistic Assumptions: Classical theory assumes perfect competition and information in the
markets. In reality, markets often have imperfections, monopolies, and asymmetric information. These
conditions can lead to inefficiencies and unemployment.

Employment Determination: Classical economics assumes full employment without explaining the
mechanisms to achieve it. It doesn't address how variations in aggregate demand impact employment
levels. This oversight weakens the theory's practical application.

Year Questions from this chapter

1. State the assumptions of full employment.
2. Difference between Keynesian and classical theory of employment.
3. What are the basic assumptions of say’s law.
4. Explain say’s law of market. How supply creates demand?
5. Implications of say’s law.
6. Note down the criticism of classical theory and say’s law.

ANSWER

How supply creates demand?

Production Generates Income:

When goods and services are produced, they create income for workers, capital owners,
landowners, and entrepreneurs. This income generates purchasing power.

Income Creates Demand:

The income earned by producing goods and services is used to purchase other goods and
services. Hence, the production process itself creates the demand for the products in the
market.

Market Equilibrium:

The classical theory assumes that all markets are self-regulating. Any excess supply or demand
is balanced through price adjustments, ensuring that the economy moves towards full
employment and equilibrium.

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Difference between Keynesian and classical theory of employment.

Aspect Classical Theory of Employment Keynesian Theory of Employment

Basic Assumption The economy is always at or near The economy can experience
full employment due to flexible persistent unemployment due to
wages and prices. insufficient demand.

Market Self-correcting markets: Wages and Markets may not self-correct; wages
Mechanism prices adjust to restore equilibrium. and prices can be sticky (inflexible).

Role of Demand Supply-side focused (Say’s Law: Demand-driven economy;

& Supply "Supply creates its own demand"). employment depends on aggregate
demand (total spending).

Unemployment Unemployment is voluntary (due to Unemployment can be involuntary,

high wage expectations) or caused by demand deficiencies in the
temporary (due to market economy.
adjustments).

Government Minimal or no intervention is Active government intervention (fiscal

Intervention needed; the economy will naturally & monetary policies) is required to
return to full employment. boost demand and reduce
unemployment.

Savings & Savings automatically turn into Savings can exceed investment,
Investment investment (interest rate causing a demand gap and leading to
adjustments ensure equilibrium). unemployment.

Impact of Wage Lower wages lead to increased Lower wages reduce workers’
Cuts employment. purchasing power, worsening the
recession.

View on Business Business cycles are temporary and Economic fluctuations (booms and
Cycles self-correcting. recessions) require policy intervention.

Best Represented Adam Smith, David Ricardo, J.B. John Maynard Keynes (Keynesian
By Say (Classical economists). economics).

Conclusion

• Classical economists believe in self-regulating markets where full employment is the norm.

• Keynesian economists argue that unemployment can persist due to insufficient demand and
advocate for government policies to stabilize the economy.