Theory of Income and Employment

Classical theory of Employment Say’s Law of Market Pigou’s Wage-cut theory Keynesian Theory of Income and

Employment Theory of Effective Demand

Classical theory of Income and Employment

• The entire economic premise of the classical economists was based on the assumption of full employment of labour and other economic resources.

• They were of the opinion that the economy operates in the stable equilibrium situation in the long run and any deviation thereto was regarded as abnormal.

• Along with that, they also made an assumption of perfect competition, fr4ee capitalist economy and optimum use of resources in long run.

• Here full employment does not mean the total absence of the unemployment but there can be frictional unemployment of temporary nature, or seasonal unemployment.

Assumption of the classical theory of Income and Employment

1. Perfect Competition2. Wage- Price Flexibility3. Homogeneous Labour4. Constant stock of capital and technology5. Liaises Faire Economy6. All the units produced are sold in the market

Say’s Law of Market(Supply creates its own Demand)

• J.B. Say, a French economist of 19th century, arrested that, “Supply creates its own Demand.” this appears to be simple proposition but has had many different meanings, and many sets of reasoning.

• According to this concept: Whenever any product is produced, the demand of that product is also simultaneously generated on account of or through the process of payment of remuneration to the factors of production.

• In other words every output produced, results in an equivalent demand being generated which leads to its sale so that there is no surplus output or over production.

• Say’s law is applicable both in barter economy and in money economy.

Assumptions under Say’s Law1. Optimum Allocation of Resources2. Perfect Equilibrium3. Perfect Competition4. Market Economy5. Laissez Faire Policy of the government6. Elastic market7. Market Automatism8. Circular Flow9. Saving-Investment Equality10. Long term concept

A. Say’s Law in Barter Economy:• In barter economy, the producers undertake to produce

the goods either to consume or to exchange them for other goods which they need for consumption.

• In any case they create a demand for goods which is equal to the supply of goods they have produced. “It is production which creates market for goods: no sooner a product is created, from that instant i8t affords a market for other product to the full extent of its value. Thus, a producer himself becomes a consumer for his own product or somebody else’s product.

• In the words of J.S. Mill “all sellers are inevitably and by meaning of the word buyer.”

B. Say’s Law in Money Economy:• In money economy, people receive money in exchange of the

goods that they have produced. This implies that the supply of product, through the process of production, generates necessary income- occurring to the factors of production in the form of rent, wages, interest, profits, etc. to demand the goods produced so that an equivalent demand is created in accordance with the supply. So we can say that the main source of demand is the flow of incomes generated from the process of production itself.

• However, in money economy, people may not spent all the money income that they have received. They may decide to save a part of their income.

• According to classical writers, the interest rate mechanism would ensure the conversion of saving into investment to ensure full employment.

• If people decide to save more than before, total savings in the economy would increase leading to fall in interest rates, which would encourage entrepreneurs to invest more.

• The investments will increase till it becomes equal to total savings.

• So the income not spent for consumption goods would be spent for investment by entrepreneurs.

Criticisms of Say’s Law:1. The assumption of perfect competition is

unrealistic.2. Savings and investments are not continuous

process.3. Investment is mainly influenced by the Marginal

Efficiency of Capital and not solely on the changes in the rate of interest.

4. According to Keynes, equilibrium can be attained at any level below the full employment situation also.

Wage Flexibility and Full Employment(Pigou’s Wage –Cut Theory)

• The classicists have advocated “the money wage cut policy” to solve the problem of unemployment.

• The classical economists believed that involuntary unemployment, if it exists in an economy, was a consequence of the rigid wage structure. If wages are lowered sufficiently , all involuntary unemployment would disappear.

• It is assumed that the self adjusting system of wage rates would push the economy towards full employment stage.

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• The involuntary unemployment comes into existence due to the interference to the free play of market mechanism in a capitalist economy.

• Such interference is the result of collective bargaining of trade unions to push wages or governmental interventions through passing of law of minimum wages.

• This disturbs the smooth functioning of the market mechanism in determining the equilibrium wage rates which clear off the labour market.

Explanation:

On OY axis, wage rate is taken and on OX axis Rate of Employment is taken.

S is the labour supply curve and D is the demand curve of labour in the economy.

If the wage rate is WP1, the MT is the amount of Unemployment in the economy.

To remove this level of unemployment, Pigou suggests that the wage rates should be reduced to WP2, where the demand and supply curve of the labour intersects each other and ON level of Employment is maintained.

Therefore, the wage cut theory of Pigou can help in eliminating the problem of unemployment.

Criticisms of the Wage cut theory

1. Unrealistic Assumption of Full Employment condition.

2. Undue importance of the Long Period.3. Keynes’ Denial of Say’s Law of Market.4. Attack on Money Wage cut policy.5. Keynes’ attack on Interest Rate to be strategic

variable.6. Keynes’ attack on Laissez faire policy.

The Theory Of Effective Demand

• The principle of effective demand lies at the heart of Keynes’ General theory of Employment.

• The dictum of the theory is that the volume of employment depends on the level of effective demand in the economy.

• Unemployment is due to deficiency of effective demand.

• Broadly speaking, Keynes designated the term “effective demand” to denote the total demand of goods and services (consumption and investment) by the community.

• Here we can say that the effective demand is the flow of expenditure.

• As the expenditure of one becomes source of income for the others.

• It means the consumption expenditure and the investment expenditure by the community expresses the total demand for goods and services.

• According to Keynes, as Income increases, consumption expenditure also increases, but after a certain point it does not increases in the same proportion as increase in income. It means, Expenditure increases along with the level of income but at the diminishing rate.

• Here there is a gap between income and expenditure which may be bridged by investment expenditure.

• If Investment expenditure does not increases to this extent, the total expenditure in the economy will be less and the effective demand will be low leading to unemployment in the economy.

• Effective demand is determined by two factors:A. Aggregate Demand Price:• In the Keynesian terminology, the Aggregate demand

function refers to the schedule of maximum sale proceeds which the entrepreneurial community actually does expect to be received from the sale of different quantities of output, resulting at various level of employment. The quantum of maximum sales revenue expected from the output produced is described as the demand price of a particular level of employment.

• There is a positive correlation between level of employment and the demand price.

• The aggregate demand price depends upon the total expenditure flow of the economy, which is determined by the spending decision of the community as a whole.

• In a free capitalist economy, households and the firms are the two major economic sectors which spent for consumption and investment.

• Now, what these sectors are expected to spend in next period is viewed as the aggregate demand price.

• This can be more simply presented with the help of a schedule and a diagram.

ADF = f (N)

ADF= Expected sales receipt by entrepreneurs N= the volume of employment f= the functional relationship

• The ADF curve drawn in the diagram is linear but it can also be non linear.

• Its shape and slope depends on the assumptions and nature of data relating to the aggregate demand schedule.

B. Aggregate Supply price:• The ”supply price” for a given quantity of commodity

refers to that price at which the seller is willing or induced to supply that amount in the market. Hence the supply schedule of that commodity shows the varying level of quantities of the commodity the seller offers for sale at the alternative prices.

• Similarly, the aggregate supply schedule for the economy as a whole, refers to, the response of all entrepreneurs in supplying the whole of output of the economy.

• Keynes was of the opinion that the level of output varies with the level of employment.

• Each level of employment necessitates certain quantities of other factors of production like land, capital, raw materials, etc., to assist the labour employed.

• The reward paid to all factors of production will be considered to be cost of production.

• Thus each level of employment will involve certain amount of money cost including normal amount of profit.

• Therefore, the entrepreneur must get some minimum amount of sales revenue to cover the total cost incurred at a given level of employment.

• Only if the sales proceeds are high enough to cover the total costs of production at a given level of employment and output, the entrepreneur will be induced to provide that particular level of employment.

• The minimum price of revenue proceeds the entrepreneur must get from the sales of output, associated with different levels of employments is defined as “aggregate supply price” or “aggregate supply function”

• So, it is a schedule of various minimum amount of revenues which must be expected to be received by the entrepreneur class from the sale of output resulting at various levels of employment.

In the above figure, OX represents level of employment and OY represents minimum sales proceeds.AS curve represents the aggregate supply function.It is linear as because we have assumed constant wage rate.However, after the level of full employment, the ASF will be perfectly inelastic.In the figure the level of full employment is being represented by QZ dotted line. i.e. 6 lakhs workers.However, there are uncertainty prevails regarding the shape of ASF as it is depended on the Marginal productivity of the labours.

• The intersection of aggregate demand function with the aggregate supply function determines the level of income and employment.

• The aggregate supply schedule represents the cost involved at each possible level of employment.

• The Aggregate demand schedule represents expectation of maximum receipts of the entrepreneur at each possible level of employment.

• Thus, it shows that, as long as the receipts exceeds costs, the level of employment will go on increasing.

• The process will continue till revenues becomes equal to costs.

Equilibrium Level of Employment – The Point of Effective Demand

• In tabular terms shown above the point of effective demand and equilibrium of t6he economy is at point 4 where ADP and ASP both are 400 crores.

• In diagram, the point of effective demand of the economy is represented at point E where ADF and ASF are intersecting each other.

• In long run, if Aggregate Demand increases, it can be said that the level of employment or the Point of Effective demand will also increase.

• This can be seen in the following diagram:

• If ADF increases from ADF2 to ADF1, the point of Effective Demand will also increase from E1 to E2 and the level of employment will also increase from N1 to N2

• Gist of Keynesian Theory of Income and Employment: