Classical Economics: Theory and Assumptions

• Classical theory is economic thought ascribed to Adam Smith, Ricardo, J.S Mill, Marshall, J.B Say, and Pigou
• Classical employment theory assumes full labor employment, even without inflation

Assumptions of Classical Theory

• Full employment, even without inflation
• A free market mechanism exists
• Perfect competition exists in labor and product markets
• Labor is homogenous
• A closed laissez-faire (abstention by governments from interfering in the workings of the free market) capitalist economy exists
• Wages and prices are flexible
• Close coordination between money and real wages
• Supply creates its own demand, eliminating deficiency in demand
• The economy's total output is divided between consumption and investment expenditure
• Capital stock and technological knowledge are given in the short-run
• Classical income and employment theory is outlined through 3 stages

Stage 1: No Saving and Investment

• Without saving and investment, all income is spent on consumer goods
• Quantity demanded equals output produced

Stage 2: With Saving and Investment

• Aggregate demand is not deficient if a part of income is saved
• Classical economists believed producers invested all savings
• Changes in interest rates equalize saving and investment
• Interest rates are determined by the supply of saving and demand for investment
• Equality between saving and investment guarantees aggregate demand equals aggregate supply
• Full employment of labor prevails

Keynes' Criticism of Classical Theory

• Keynes rejected the idea that the economic system is self-adjusting and works automatically without aid
• Classicists believe there is no maladjustment between supply and demand and that overproduction or underproduction are impossible
• Keynes argues that the classicist belief that market is self adjusting is wrong
• State intervention is needed to bring about adjustment between supply and demand
• Keynes opposed money wage cuts arguing they were undesirable and lead to a downfall of a general aggregate demand
  • Keynes believes real wages should be cut by raising prices of wage goods through monetary inflation
• Keynes disagreed with the classical view that laissez-faire policy was essential for employment equilibrium
  • Keynes advocated for state intervention to adjust supply and demand through measures
• Keynes refuted the classical view that saving and investment were equal at the full employment level
  • Keynes believed the level of saving depended upon the level of income, not the interest rate
  • Investment is determined by interest rates and the marginal capital efficiency
• Keynes criticized the classical approach as unrealistic, outdated, and unacceptable in modern conditions
• Keynes attacked the Pigovian formulation that unemployment would disappear if workers accepted voluntary wage cuts
• He opposed wage flexibility as a means of promoting employment during a depression
• He went all out in favor of promoting wage rigidity to promote and expand employment

Say's Law of Market

• As defined by J.B Say, general overproduction and unemployment are impossibilities
• “Supply always creates its own demand.”
• Production creates markets for goods
• Demand's source is factor incomes generated from the main source
• New production initiates a certain output
• Demand for that output is generated through payment to the factors of production
• Every output injects an equivalent amount of purchasing power in circulation
• Leads to its sale, so no surplus output or overproduction
• Manufacturing brings purchasing power through wages, leading to its purchase
• There is no overproduction of any commodity at any time
• Say admitted that excess supply of a commodity may exceed its demand temporarily because of entrepreneur calculations
• General over-production is impossible
• If general over production does not exist, possibility of general unemployment is not possible
• Classicists believed in voluntary unemployment

Implications of Say's Law of Market

• Automatic adjustment of every element within the economy exists
  • If supply increases, so shall demand, and adjustment will occur
  • Gov needs to interefere with the workings of the economic system
• General overproduction is impossible
• The sum of the product never exceeds the sum of the demand
• As production increases, the income of the concerned also increase
  • New demand is created and increased stock is sold
• General unemployment is not possible
• Temporary unemployment would be erased with time
• Employment of unemployed pays its own way
• Unemployed working assists the volume of goods and services increase
• National income increases
• There is no loss of putting the unemployed to work
• Law has policy implications
• According to J.B Say, the economic system is automatic and has built-in flexibility
• If something occurs, the system finds a way
• Gov needs to get involved with the economy

Criticism of Say's Law

• Goods' supply does not create own demand
• Every production has purchasing power to ensure its disposal
  • General overproduction is unachievable
• This assumption is not warranted

Employment perspective

• Labor supply does not automatically adjust to its demand
• Because general overproduction is impossible, general unemployment is not possible
• General unemployment is not possible
• Temporary unemployment will disappear if wages fall & labor demand increases
• Cannot be accepted as unemployment is intense and has prolonged duration in capitalist countries

Aggregate Demand (AD)

• Total money an organization expects from sale of output

• Aggregate demand price means receipts the organization receives by workers

• Economic measurement of the sum of all final goods/services produced in an economy that is exchanged in those goods/services

• AD = C + I + G + (X-M)

  • C = Consumers
  • I = Private Investment
  • G = Government
  • X-M = Exports - Imports

Aggregate Supply (AS)

• Money value of final goods that all producers will supply at a given time
• Represents cost of entrepreneurs
• The total of goods/services produced in an economy at a given price
• AS = National Income (Y)
• Y=AS=C+S

The Principle of Effective Demand

• Effective demand comprises of
  • Consumption (Demand)
  • Consists of demand for consumption goods
  • Investment Function (Demand)
  • Consists of the demand for capital goods
• The term is effective because it emphasizes the distinction of mere desire -Affects volume of employment
  • Effective demand governs that volume Unemplyment due to in sufficient demand
• Remove by increasing demand
• Increase by increasing investment
• ED = Desire + Ability + Willingness
• Effective demand is how much consumers purchase at current market price

Elaboration of Effective Demand

• Determined by Aggregate Demand (AD) and Aggregate Supply (AS)
• Supply function represents cost
• Demand represents receipts of entrepreneurs
• Entrepreneurs finding demand is less than supply shall stop production
• If employment is good
• Employment depends upon effective demand which is governed by AD and AS function Effective demand is the point where AD and AS Function are balanced

Keynes Determination of Income & Employment

• Equilibrium of employment and income is determined at the point of equality between saving and investment
• Which is a function of income
• I.E S=f(Y)
• Defined as excess income over consumption
• S= Y-C

And income is equal to consumptions plus investment

So equilibrium established when saving equals investment

• Keynesian unemployment comes from unemployment

• Employment can be increased by increasing aggregate demand

• Consumption is stable, demand can be increased by increasing investment

• More investment leads to income lead

• Increases consumptions

• All can rise through multiplier process till equilibrium is reached

• Equilibrium of employment = unemployment equilibrium

• When income increase, consumption increases

• Investment in needed to fill income consumption