Classical Model

By Shikha Singh
 Introduction
• Refers to theory and ideas about the determinants of employment propounded by
the classical writers who lived between 1776-1930.
• Imp. ones are: Adam Smith, David Ricardo,John Stuart Mill,JB Say,Thomas
Robert Malthus, Alfred Marshall and AC Pigou
• 2 features of classical analysis arose as part of attack on mercantilists:
a. Classical economics stressed the role of real as opposed to monetary factors in
determining real variables such as output and employment. Money had a role in
the economy only as a means of exchange.
b. Classical economics stressed the self adjusting tendencies of the economy.
Government policies to ensure an adequate demand fro output were considered
by classical economists to be unnecessary and generally harmful.
• The general opinion among the classical economists was that an economy will
always operate at full employment without inflation.
• Given Wage price flexibility there are automatic forces in the economics system
that tend to maintain full employment and produce output at that level.
• They were mainly concerned with:-
a. Determination of prices of different goods and services
b. Distribution of income
c. Allocation of economy’s given resources
 Say’s Law :classical theory
Say’s Law is one of the most important conclusions which have been provided by the classical economists.
It is named after the famous economist J.B. Say.
J.B. Say refused to believe that general overproduction and unemployment are common occurrences.
There are some assumptions which are implicit in the Say’s Law.
The average propensity to consume is one. Y=C, S=0 Thus savings will be zero.
Government does not perform any economic functions, Laissez Faire Economy (no taxes or subsidies or
govt.borrowing)
The economy is a closed economy, there is no foreign trade and market automatically clears due to
equilibrium between forces of DD and SS
Prices, Wages and rate of interest are flexible. (FOP and Commodities are flexible) Free Market
economy.Prices can adjust upwards or downwards.
There are only two sectors in the economy, the firms and households who are engaged in production and
consumption respectively.
The most famous tenet of the classical theory is the Say’s law ‘supply creates its own demand’.
 Output (supply)= Employment of factors of production=increase in income = increase in purchasing
power (demand)
Thus, the production of the goods itself creates a demand for them.
Say’s Law :classical theory…contd
 In a barter economy, Say’s law will function because the production or supply of the goods creates a direct demand for the
goods.
 The only function of money is to act as a medium of exchange.
 It is obvious that in any economy, the supply of any commodity implies a demand for the other commodities in the economy.
 The aggregate of the demand in all the markets will be always equal to the aggregate of the supply. AD=AS
 There is perfect competition in the factor market (homogenous) and product market (Normal profits)
Output and Employment in the Classical Model
The production function describes the input-output relationship.
A short-run aggregate production function can be represented as Y = f (L, K) in Figure 4.1.
Stock of Capital and technology is constant

Figure 4.1: The Short-Run Aggregate Production Function

It can be divided into three parts—showing proportional, diminishing returns and finally
constant returns.
It is obvious that a profit maximizing firm will operate in the stage of diminishing returns.
Upto L1:linear production function: proportional returns,L1 to L2: increasing units of labour are applied to
fixed amount of plant and equipment. stage of diminishing returns, beyond L2 output may decrease if more
labour is hired,so firm will not employ beyond L2 units of labour.
The Labour Market in the Classical Theory
 It is assumed that the workers and the firms have complete knowledge about the prices which are prevailing in the market.
 There exists wage price flexibility. :money wages adjust and thus the market clears.
 A perfectly competitive profit maximizing firm will go on hiring labour till the MPL is equal to the real wage.
 The marginal product schedule is the firm’s demand curve for labour.
 The individual firms demand curve for labour can be summed up horizontally to arrive at the downward sloping aggregate
demand curve for labour, Ld = Ld (W/P) as in Figure 4.2.

Figure 4.2: Aggregate Demand Curve for Labour

The Labour Market in the Classical Theory

 As far as the supply of labour is concerned there appears to be a trade-off between leisure and income.
 The individual’s supply curve of labour can be derived diagrammatically through indifference curves and budget lines.
 The individual aims at maximizing his utility for any given real wage.
 He will do so by choosing that particular point on the indifference curve that is tangential to the budget line which corresponds to that particular wage rate as in Figure
4.3.
The Labour Market in the Classical
Theory
 The aggregate supply curve for labour can be arrived at by summing up horizontally the individual supply
curves of labour, Ls = Ls (W/P) as in Figure 4.4.

Figure 4.4: The Individual’s Supply Curve of Labour 

The Determination of Employment, Real Wage Rate and Output 

The Labour Market in the Classical
Theory
The intersection of the aggregate demand and aggregate supply curves
of labour determines the equilibrium level of output, employment and
the real wage rate as depicted in Figure 4.5.
Given the conditions in the short run, the classical economists had
proposed that this will be the full employment level.
Given the equilibrium level of employment, the corresponding
equilibrium level of output can be determined from the production
function.
In the classical theory, the main role in the determination of output,
employment and the real wage rate is played by the supply side in the
labour market.
The Labour Market in the Classical Theory

Figure 4.5: The Determination of Employment, Real Wage Rate and Output  
A Criticism of the Classical Model
The classical theory had opposed any government interference with the
market.
They had propagated a free market economy which they believed would
automatically lead to full employment.
Many criticisms have been put forward against the classical theory.
1.Keynes had argued that the classical assumption of wage price flexibility
is totally unrealistic.
 Keynes argued : real world markets :monopolistic and oligopoly
firms,labour unions,govt.support programmes,min.wage legislations are
responsible for erecting barriers in the functioning of wage price
mechanism)
A Criticism of the Classical Model..contd
2.He had criticized the Say’s Law as to be a truism only under the barter system.
 In such a market whatever goods are produced are sold in the market or used for self
consumption. Thus,ss=dd. Hence there cannot be a surplus or a deficit. This is not true for a
modern economy where every transaction involves or is carried out with money.
3. Keynes had no faith in the classical belief that the free enterprise system could be self
regulating. He asserted that it required periodic interventions by the authorities to evade
fluctuations and instabilities involved in economic activities.
The Great Depression was a crucial time when the classical theory was put to test and it failed.
This was responsible for the loss of faith in the classical economics and paved the way for the
Keynesian economics.