Classical Theory of Employment

Classical Theory of Employment

• The classical theory posits that a free-enterprise economy inherently tends toward full employment.
• It advocates for laissez-faire economic policies (minimal government intervention).
• The theory hinges on the concept of Say's Law, which posits that supply creates its own demand.
• The theory assumes wage and price flexibility allowing the market to adjust to equilibrium.
• Classical theorists believe there is no involuntary unemployment in capitalist economies.

Key Concepts

• Say's Law of Market: Supply generates its own demand; thus, overproduction and underconsumption are unlikely.
• Full Employment: All who wish to work find employment; frictional or structural unemployment are considered temporary issues.
• Laissez-faire Policy: The economy operates best with minimal government intervention.
• Labour Market Equilibrium: The equilibrium of labor supply and demand determines employment and wage rates.
• Capital Market Equilibrium: Equilibrium between savings and investment.
• Money Market Equilibrium: The quantity of money in circulation, in relation to aggregate output, determines the price level.

Introduction

• Classical economists hypothesize that free enterprise economies tend naturally towards full employment.
• This implies an economy should adopt laissez-faire policies, avoiding government interference.
• Central to the classical view is Adam Smith's concept of the "invisible hand."

Two Basic Concepts

• Say's Law of Market: Any increase in production leads to increased income and thus more demand, removing any possibility of excess supply or under consumption.
• Wage-Price Flexibility and Full Employment: The classical economists assume that wages and prices adjust to clear markets, eliminating involuntary unemployment. Anyone willing to work at the going wage will find employment.

Full Employment

• Definition (Spencer): A situation in which every person willing to work and capable of doing so is employed (excluding those who are frictionally or structurally unemployed).
• Frictional Unemployment: Temporary unemployment occurring due to factors such as worker mobility, lack of suitable jobs, or limited information. This is viewed as a normal aspect of a dynamic economy.
• Structural Unemployment: Mismatch between job skills and available jobs. Potentially a longer-term issue stemming from technological or industrial changes.

Assumptions of the Theory

• Capitalist Closed Economy: The theory assumes an economy without significant external factors impacting employment or economic activity.
• Long-Run Period with No Inflation: The theory primarily applies to long-term conditions.
• Perfect Competition: Perfect competition exists in all markets (labor, money, product).
• Homogeneous Labor: All workers are equally qualified and capable of performing any given job.
• Investment as Part of Spending: The entire production is allocated to either consumption or investment.
• Money as Medium of Exchange: Money facilitates transactions without interfering with overall supply and demand dynamics.
• No Technological Change: The theory involves conditions where technology does not play a significant role in changing the dynamics of the economy.
• Flexible Prices and Wages: The system adjusts freely to maintain equilibrium.
• Saving Equals Investment: Savings automatically equate to investment in the market.
• Diminishing Returns: The law of diminishing marginal returns applies to most sectors, including agriculture.

Output Determination

• Full employment is a key characteristic of a capitalist economy.
• Employment levels are determined by the equilibrium between demand and supply for labor.
• Aggregate supply and aggregate demand are equal at the full employment level.

Money Market Equilibrium

• The supply of money determines the aggregate price level (Fisher Quantity Theory).
• The classical approach assumes that output remains relatively stable in the short term when there are changes in the money supply.

Implications

• Involuntary unemployment doesn't exist in the classical model.
• Wage and price flexibility, dictated by supply and demand, eliminate unemployment.
• The system's inherent self-adjustment ensures overall equilibrium.

Criticisms

• Keynes argued that Say's Law doesn't hold during economic downturns (depressions).
• Keynesian theory emphasizes the role of aggregate demand in influencing employment.
• Keynes argues that involuntary unemployment can exist, especially due to a deficiency of demand in the economy.
• He believed the classical theory neglected short-run problems, and that the classical model did not account for the existence of involuntary unemployment.

Conclusion

• The classical theory of employment offers a powerful framework for understanding the principles of a fully functioning economy. However, it has been subject to criticism by economists like Keynes, particularly during periods of economic downturn.