Classical Theory of Employment

Prof. Mahendra Kumar Ghadoliya

Classical economists believed that market economy is self equilibrating and unemployment could not exist in the long run as such the general over production cannot be a long rum phenomenon. Their belief in Say’s Law of Market was the basis of the classical thinking. This law in its simplest form can be summarised as saying that ‘supply creates its own demand’. This view provided the basis for the assumption of market clearing. Labour market was thought to be competitive and automatic, that is where individual workers and employers behave separately as individuals rather than combining in trade unions or employers’ association.

The equilibrium level of aggregate output and employment in the classical theory of labour market is determined by the aggregate production function and the demand and supply schedules of labour. Now, let us discuss the theory in detail:

The Demand for Labour:

The demand for labour is assumed to depend inversely on the real wage. In a purely competitive market a firm is a price taker and not a price maker. Price is determined by the industry’s demand and supply. The short run profit maximising level of output is the point at which the marginal input cost of money wage is equal to the price (p) i.e.MC= P or MRP (Marginal Revenue Produce) MRP is the marginal physical product of labour times the marginal revenue from the firm’s output. The demand for labour can be derived from summing the demands of each firm based on the above mentioned assumption of profit maximisation. The profit maximising output can be expressed as that output at which:

P= W/MPP_L   ---- (1)

Where; P= Price. W= Wage rate of Labour,  MPP_L = Marginal Physical Product of Labour

Labour is employed up to the point where the MC=MR

In competitive market each individual firm is the industry and can sell the entire output at a going market price, so that MR=P. Under imperfect competition additional output can be sold only by cutting P, so that MR is always less than P. From eq. 1 the profit maximising output level will be the level at which

W=P* MPP_L ---------- (2)

This identifies the point that labour is employed by the firm at which the Marginal revenue Product i.e. the additional receipt from the sale of the additional output produced by an additional unit of labour (MRP= P* MPP_L) just equals the wage rate of labour. 
If the receipt from the sale of output exceeds the wage rates per unit of labour the expansion of output will add to profits. On the other hand if the receipts from the sale of the output produced by an additional unit of labour is less than the wage rate i.e. (MC

L

and the wage rate of the labour W  is also the firm’s supply curve. It shows the various quantities of output that the firm will supply to the market at each price in order to maximise profits. Once the demand for labour for a single firm is found on the basis of the total product curve the total demand curve for labour can now be derived from the aggregate production function.

 The aggregate production function relates the total output of goods and services to total labour employed. The total production curve drawn for a fixed capital stock and given technology follows the Law of variable proportions. Its slope changes after a point. In the beginning the output rises at a fast rate but after point N’  it slows down the employment growth is slow after this point.

Figure: 1 The total production curve

Due to diminishing returns the MPP_L decreases as we employ more and more labour to increase output. In eq. (2) it has already been mentioned that profit maximising firms employ labour up to the point at which marginal revenue product is equal to the wage rate. For any given wage rate more labour will be employed only at a higher price conversely at any given p more labour will be hired only at a lower wage rate W. This can also be put in real terms:

W/P = MPP_L  ------- (3)

This says that the level of employment will be the point where real wage is equal to the marginal physical product of labour ( MPP_L  )  Figure (2) below presents a hypothetical Demand Curve for labour.

Figure: 2 Demand Curve for labour

In figure (2) DD_L is demand for labour plotted against the real wage. This is firm’s marginal physical product of labour curve. A real wage such as W/P₁ the firm will employ N₁ units of labour. At a level of employment such as N₂ marginal physical product of labour MPP_L exceeds the real wage (W/P₁). This also implies that payment to worker in real terms is less than the real product he produces. Profits could be increased by employing additional labour. Alternatively, at N₃ level of employment real wage (W/P₁) will be above the marginal physical product of labour (MPP_L). The payment to worker exceeds the real product of the marginal worker and the marginal cost exceeds the product price. The firm therefore will reduce labour input to increase profit. Thud the employment will be at W/P1 at which MPP_L is equal to real wage.

In short demand for labour depends inversely on the level of real wage. The demand for labour curve is a negatively slopped curve. The aggregate labour demand curve is:

D= f (W/P) Where in the aggregate, an increase in the real wage lowers the labour demand.

Supply of Labour:

As in the case of demand for labour function, real wages play key role in the supply of labour function for determining employment and hence output in the classical system. Supply of labour is assumed to be positively related to real wage. The supply of labour can be best explained by first studying an individual’s supply function and them by summing them up for determining the total supply function. The classical economists believe in the unpleasantness of more work, a larger real wage will induce labour to substitute the more work effort in place of leisure. Firms also wish to maximise their profits and demand for labour is a derived demand. Firms will hire more labour at a lower money wage rate if the prices of output falls proportionately with the money wage rate because for firms the real wage rate (W/P)is relevant. At a higher real wage rate the substitution effect of an increase in the wage outweighs the income effect[1].

To maximise utility an individual will supply more labour at a higher real wage. The supply curve of labour shows the number of people willing to work at a given real wage. At a higher real wage rate people wish to work longer hours, or more people e.g. housewives, students, wish to join job. Thus utility maximising labourers supply more labour at higher real wage making the supply of labour an upward slopping function of real wage S_L=f(W/P).

Figure (3) Supply of Labour curve

Figure -3 portrays the supply curve of labour in which units of labour(N) is measured on the horizontal axis and the real wage (W/P)on vertical axis. At real wage W/P₁ N₁ units of labour are supplied, at a higher real wage W/P₂ more labour N₂ is supplied.

Two features of the classical labour supply function require further comment. First, note that the wage variable is real wage. The worker receives utility from the consumption of goods and services. He will be induced to supply more labour only when he believes that from increased money wage he will get command over more goods and services. Second, supply curve is positively slopped.

Equilibrium Output and Employment in the Classical Model

The equilibrium is determined by the intersection of demand and supply curves for labour. We have already explained that both demand for labour and supply of labour depend on a new endogenous variable the real wage (W/P). The equilibrium condition D_L=S_L determines output, employment, and the real wage in the classical production function as shown in the figure (4a).

Figure-4  depicts the equilibrium in the labour market at a point where D_L = S_L at real wage rate (W/P^e) and the equilibrium level of employment is N^e. The model can be represented by the following set of equations:

Y = f (͞K,N)

MPPL = WP,

D_L=f(W/P) , S_L=f (W/P)

D_L=S_L                      

                                                                                        

Figure-4a: Equilibrium in the Classical Model

Figure 4-b: Production function and the equilibrium level of income and output

The important point to note for classical model is that there is no involuntary unemployment. Once the equilibrium level of employment is determined we can project this down in Figure4b of the figure to determine equilibrium level of income or output Ye along the production function curve.

In classical model the variables affecting supply and demand for labour are assumed to be constant in the short run, the production function will be shifted by technical change and change in capital stock. Both these are long run variables. The demand for labour curve is marginal physical product of labour –the slope of production function. As the production function does not shift the labour demand function will also be stable. The supply of labour varies with individual’s preferences with work-leisure trade-off. Changes in these variables can take place in the long run but not in the short run.

Another important feature of the classical model is that all variables affect the supply side of the relationship. Increase in the price level shift the labour supply and demand schedules up ward proportionately. The money wage rises with the price level keeping real wage unchanged and therefore the level of employment remains unchanged.

This information is useful in constructing the classical aggregate supply function which is vertical and does not affect equilibrium output. The labour market is in equilibrium with employment N^e and real wage (W/P)^e. The flexibility and self adjusting properties of the classical model ensures the proportional increase in money wage in response to the rise in prices keeping real wage at its original level. Thus whatever the price level, employment is N^e and output is Y^e and the AS curve is vertical. The level of aggregate demand has no effect on output. The aggregate demand function will be a negatively slopped function. The aggregate demand curve slopes downward from left to right showing that demand is higher when prices are lower (with other things being equal); it can be thought of as derived from the classical quantity theory of money, but with the money supply held constant and only P and Y allowed to vary. Higher price levels are compatible only with lower levels of transactions or income. In terms of equation:

M̅ =  K̅PY

Y= M̅/ K̅. 1/P

Therefore is there is an inverse relationship between Y and P. The equilibrium level of output or income Y^e is determined at the intersection of aggregate demand and aggregate supply curve. To sum up, the striking feature of the classical model is supply determined nature of real output and employment. Wages and prices are perfectly flexible and the markets are competitive. 

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[1] The classical economists assumed that an individual attempts to maximise utility. The level of utility or satisfaction depends positively on both real income and leisure. Higher real wage induce more workers to work and /or induce existing workers to work more hours since there is a continuous trade-off between work and leisure. Leisure also gives utility but reduces income because income is increased by work.

What are the basic features and assumptions of Classical Economics or Classical Doctrines?

Classical Economics and its Assumptions

Prof. Mahendra Kumar Ghadoliya

In Macroeconomics Income and Employment are interchangeable terms, since in the short-run National income depends on the total volume of employment or economic activity in the country. As income and employment are synonymous the employment theory is also called income theory.

It should be clear to readers that the classical economists did not formulate any specific theory of employment as such. They only laid down certain postulates which subsequently developed as a theory.

Classical Economists

The term classical economist was first used by Karl Marx to describe economic thought of David Ricardo and his predecessors including Adam Smith. Classical economists viewed labour as a significant measure of value than money. Later, classical economists gave more importance to marginal productivity for determination of value. Keynes regarded Ricardo and his followers like John Stuart Mill, Alfred Marshall and A.C. Pigou as classical economists. According to Keynes classical economists refer to traditional or orthodox principles of economics which had come to be accepted by and large by the well known english economists since the time of David Ricardo. They were so widely accepted and well established for over more than a century that they were labelled ‘Classical’.

Basic Features or Assumptions of Classical Economics:

There are two broad features of classical economics; (a) The assumption of full employment of labour and other productive resources in the economy, and (b) the flexibility of prices and wages to bring about full employment.

1.      Assumption of full Employment: The classical economists had a great faith in the equilibrating forces of the economy at full employment. According to them, the situation of general over production and hence general unemployment cannot be a long run phenomenon. The disturbance or deviation from this point of full employment if any was temporary and that the normal situation is only of full employment. If at any time unemployment persists for a long time, according to classical economists, it is because of interference by the government or private monopoly with the free play of market forces, or wrong calculations of businessmen or artificial resistance in the economic system. Thus, the disequilibrium or disturbance is a temporary phenomenon and that there is a full employment or a tendency towards equilibrium at full employment in an economy.

2.      Labour is homogeneous: The quality of labour does not differ it is homogeneous.

3.      Policy of ‘laissez faire’: The classical economists had a great faith in the free functioning of market forces known as ‘laissez faire’. The classical economists believed that only this policy guarantees stable equilibrium at full employment. The perfect competition and profit motive are the forces that are automatic and capable enough to cure any ills in the economic system.

4.      Perfect Competition in the labour market and commodity market.

5.      Price mechanism: The free functioning of price mechanism through the forces of demand and supply ensures full employment equilibrium. The price mechanism does the work of allocation of resources and determination of their reward. They do not answer the question regarding the level of employment but only say there will be full employment.

6.      Perfect knowledge and market information to all the participants.

7.      Price wage flexibility: The most important feature of the classical theory was the assumption of price wage flexibility which automatically brings about full employment. In times of depression and unemployment resulting from general over production in the market the prices would go down as a result of which demand would go up. This rise in demand would automatically cure the depression. Similarly, unemployment would be cured by cutting down wages. As a result of wage cut the demand for labour would go up stimulating economic activities in the economy.

8.      Money wages and real wages are directly related and proportional.

9.      The theory applies only in the long run.

10.  Savings and Investment are always equal. The rate of interest is the linking variable. If at any point of time there is mismatch between the two the changes in the rate of interest guarantees the equilibrium between the two.

11.  Capital stock and technical knowledge remain fixed in the short run.

12.  They had full faith in the Say’s law of market. Supply creates its own demand. The economy may not face the conditions of over production.

Full employment so assumed by classical economists is consistent with a certain amount of voluntary unemployment and frictional unemployment. In the Classical theory of full employment there is no place for involuntary unemployment. Classical economists were not ready to believe that work would not be available to the workers if they were willing to work. But, there is unemployment in the society and it is not difficult to find people without job. According to classical economists this was due to interference with the free working of economic forces. Thus, the cure of unemployment is to remove all interference whether by collective action of trade unions or by the government. The free and unrestricted working of economy would guarantee full employment equilibrium in the economy.

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Critically examine the statement, "Supply creates its own Demand".

Introduction:

Prof. Mahendra Kumer Ghadoliya

This has been named after J.B. Say (1767-1832) a French classical economist. In 1803 his famous book “A Treatise of Political Economy” was published. In this book he presented the ‘Law of market’ which became famous as Say’s Law of Market or simply Say’s Law. The law is the dictum ‘Supply creates its own Demand’ states that aggregate production necessarily creates an equal quantity of aggregate demand. 

Say further argued that there can never be a problem of  general overproduction or glut in the market.  If there is a surplus for one good there must be unmet demand for another. If certain goods remain unsold it is because other goods are not produced. According to this law the owners of factors of production receives income in various forms e.g. rent, wages, interest and profit or loss in the production process.  The sum total of this output produced by these factors of production generates sufficient income in the society to purchase the produced output assuming that there are no leakages in the income stream. 

Assumptions of Say’s Law:

The say’s law takes the following assumptions of the classical school:

1.      All markets are perfectly competitive so that agents decide how much to buy and sell on the basis of a given set of prices which are perfectly flexible. The required amount of labour and capital can be raised from the market on prevailing prices.

2.      Firms are free to enter or exist without affecting the equilibrium output and prices in the market.

3.      The market is capable of expansion. It expands with the increase in the volume offered for sale in the market.

4.      All economic agents (like firms and households) are rational and aim to maximise their profits or utility; further more they do not suffer from money illusion.

5.      All savings are automatically invested and this equality is brought about by the changes in the rate of interest.

6.      Full employment is considered to be normal situation and any lapses from full employment are considered to be abnormal.

7.      Full employment is guaranteed because of free play of market forces. The government does not interfere in the automatic functioning of the economy. As any interference with the free play of market forces   shall fail to bring about full employment.

Keynes’ Criticism of the Say’s Law of Market:

Keynes criticised the Say’s Law of Markets and the classical theory of employment on the following grounds:

1.      Supply does not create its own demand: According to the Say’s Law every supply creates its own demand, e.g. if in an economy goods and services of Rs. 1000 crore are produced it implies that this much of value has already been transferred to various factors of production. This Law is based on the assumption that entire income is spent and nothing is saved. Thus, whatever is produced is sold off in the market. This assumption has failed on the criterion of time. In fact, it is a proven fact on the criterion of time that people do not spend their entire income on purchase of goods and services but also save. This savings in effect is a leakage in the income stream. This reduces aggregate demand and some production remains unsold and condition of over-production.

2.      Based on unrealistic assumptions:  Say’s Law is based on unrealistic assumption of perfect factor mobility, perfect competition and wage price flexibility.  Time has proved that these assumptions does not hold good and therefore the Law is not applicable.

3.      Keynes’s critique: Keynes criticised the Law and rejected the assumption of self-equilibrating and automatic achievement of  full employment in the economic system. He said that unemployment is the common phenomenon in almost all capitalist countries. The wage- price flexibility is absent and in fact they are rigid.

4.      Economy is at equilibrium at less than full employment level: In sharp contrast to the classical view that full employment equilibrium is the normal situation, Keynes in his Famous book, ‘General Theory’ firmly held the view that in a free private enterprise economy there are more chances for equilibrium to be established at less than full-employment level. The simple argument advanced by Keynes was that in an economy savings (S) and Investment (I) are done by two different groups. The motives of Savers are different from the motives of investors.

In a free enterprise economy there is no mechanism to ensure that what savers are planning to save is just equal to what investors are planning to invest. If the planned investment expenditure is not equal to planned savings then the present level of income and employment will not be maintained and therefore there will be fluctuations in the level of income and employment.

Keynes sais that there was no inherent reason to believe that S+I would always be equal to output Y. Therefore there is no assurance that demand would always be equal to supply. Savings are determined primarily by income. But investment depends mainly in the short- run, on marginal efficiency of capital (MEC)and the rate of interest (r), and in the long run on factors like changes in technology and population growth. Thus, investment demand, so determined will not necessarily fill the savings gap between income and consumption. It will result in equilibrium at less than full employment level quite in contrast with what the Say’s Law of market ensures.

5.      General cut in wages cause a reduction in aggregate demand: Further Keynes strongly opposed Pigouvian view that unemployment would disappear, if a general cut in wages was applied. A general cut in wages according to Keynes will fail to bring about increase in employment, because it will mainly cause reduction in aggregate demand (AD). It is true that a general cut in money wages would reduce the cost in all industries but this in it self would not increase employment because a cut in wages would reduce the income of workers resulting in fall in aggregate demand. This will deepen depression. Besides trade unions will resist such a general wage cut. The fundamental fallacy in Say’s Law is that partial equilibrium analysis which could apply to a particular industry has been extended to the economy as a whole. Lowering a wage rare in a particular industry may increase employment there without decreasing demand but if there is a general cut in wages it will reduce income and so effective demand and volume of employment.

6.      Great Depression of 1930: Say’s Law of Market proved wrong during the great economic depression during 1929-34 when there was over production in the market. Supply failed to create its own demand. About 15 million workers were unemployed in early 1930s that were prepared to accept any wage. Producers could not sell their production. There was a general glut in the economy.  Say’s law of market was not supported by facts and the practical experience.

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Discuss the say's Law of Markets. Examine the statement, "Demand creates its own Supply".

Say’s Law

Prof. Mahendra Kumar Ghadoliya

This has been named after J.B. Say (1767-1832) a French classical economist. In 1803 his famous book “A Treatise of Political Economy” was published. In this book he presented the ‘Law of market’ which became famous as Say’s Law of Market or simply Say’s Law. The law is the dictum ‘Supply creates its own Demand’ states that aggregate production necessarily creates an equal quantity of aggregate demand. This characterizes the essential feature of exchange in an economy. Every product that is offered in the market for sale creates an equivalent demand for output to the full extent of its own value. Say further argued that there can never be a problem of  general overproduction or glut in the market.  If there is a surplus for one good there must be unmet demand for another. If certain goods remain unsold it is because other goods are not produced. According to this law the owners of factors of production receives income in various forms e.g. rent, wages, interest and profit or loss in the production process.  The sum total of this output produced by these factors of production generates sufficient income in the society to purchase the produced output assuming that there are no leakages in the income stream.

Demand is created through supply:

Say’s Law describes an important fact that the main source of demand is the sum of incomes earned by the various productive factors from the process  of   production itself. The employment to unemployed labour enlarges the market demand for goods by an amount equivalent to the income created and the value of output produced. A new productive process, by paying out incomes to its employed factors generates demand at the same time that it adds to supply. It is thus production which creates market for goods. The supply creates its own demand not at the same time but to an equal extent. Demand is created simultaneously through the act of supply because supply creates income in the form of wages, interest and profits.  Suppose 1000 meters of cloth is produced. The value of cloth has been distributed in the form of wages, rent, interest and profit as reward to the participating factors of production. The purchasing power so generated will be spent either on purchasing of cloth or some other commodity. The factors of production producing other commodity will receive purchasing power as reward which may be spent on purchase of cloth or again some other commodity. Thus, the circle of production and purchase goes on widening till the market clears. Thus, the total aggregate supply in the economy will be equal to total aggregate demand. This can be illustrated with the circular flow diagram. Money flows between firms and households in an economy. Firms pay for hiring factors of production in the form of factor income to the households for production and supply of goods. The income is spent by the households on purchase of goods supplied by these firms. Thus, completing the circular flow of money from firms to households and households to firms in a two sector economy with the assumption that all income is spent on consumption and nothing is saved. This assumption seems to be quite unrealistic. However, it does not make any difference with the working of Say’s law even if we assume some part of income is not spent but saved.

The real question then is what happens to the unspent balance or savings. Suppose we have an economy with an equilibrium income of Rs, 1000Cr. Households now decide to save 10% of their income. The result will be fall in consumer expenditure. Profits will fall as only Rs. 900 Cr. will be received back. But the savings of Rs 100 Cr. Will be spent on investment i.e. purchase of new equipment and machinery. The savings of the household will ultimately reach to firms via commercial banks this completes the circular flow. Thus it follows from the Say’s Law that it always pay to employ unemployed factors of production. The increase in supply facilitates an expansion of market for the products. Thus, according to say’s law, it would be unwise to let resource remain idle they can be profitable to their employers.

Since supply creates its own demand there is no limit to productive activity in the economy.  In other words economic development can be carried out to any extent for there can be no deficiency of aggregate demand.

Say’s Law was originally set forth in the context of a barter economy where, goods are exchanged for goods and the supplier of one good demands some other good. In general, classical economists notably Ricardo, Mill gave support to the Say’s Law, which they believed also true for a money economy. Money was nothing more than a convenient medium of exchange, a veil covering the underlying real forces in the economy which enabled market participants to avoid difficulties of barter economy. If Say’s Law applies to a money economy then the logic holds true that whatever is produced in an economy finds its market.

Assumptions of Say’s Law:

The say’s law takes the following assumptions of the classical school:

1.      All markets are perfectly competitive so that agents decide how much to buy and sell on the basis of a given set of prices which are perfectly flexible. The required amount of labour and capital can be raised from the market on prevailing prices.

2.      Firms are free to enter or exist without affecting the equilibrium output and prices in the market.

3.      The market is capable of expansion. It expands with the increase in the volume offered for sale in the market.

4.      All economic agents (like firms and households) are rational and aim to maximise their profits or utility; further more they do not suffer from money illusion.

5.      All savings are automatically invested and this equality is brought about by the changes in the rate of interest.

6.      Full employment is considered to be normal situation and any lapses from full employment are considered to be abnormal.

7.      Full employment is guaranteed because of free play of market forces. The government does not interfere in the automatic functioning of the economy. As any interference with the free play of market forces   shall fail to bring about full employment.

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What are the implications of the Say's Law

                

        Implications of the Say’s Law:

Prof. Mahendra Kumar Ghadoliya

1.      Over Production and Unemployment: According to Say’s law general over-production and general unemployment are logical impossibilities. As production increases, incomes of the concerned factors increase. As a result new demand is created and the increased stocks sold off in the market.

2.      Automatic Adjustment: Supply creates its own demand and therefore the sufficient purchasing power arrives in  the market before the product comes in. In other words every output brought into existence injects an equivalent amount of purchasing power in circulation which is sufficient for its sale. Thus, there is no need for any external force to jump in or intervene in the automatic functioning to price mechanism.

3.      Employment to Unemployed Resources: It is always profitable to employ the unemployed labour force (resources) because they help in increase in production in the economy. As such, the size of national income increases and it becomes possible to pay the unemployed factors out of it.

4.      Interest and wage rate flexibility: As per the law savings and investment equality is guaranteed through changes in the rate of interest. In fact the mechanism of flexibility brings about the desired equality. Similarly, the flexibility in wages guarantees the full employment in the economy.

5.      Absence of any Role of Government: In the Say’s Law no role is envisaged for the government. Economic system is automatic and self-equilibrating. As such according to this law government should leave the economic forces free to adjust and government should not interfere in the free functioning of the market forces.

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What are the important assumptions of say's Law?

 Assumptions of Say’s Law:

Prof. Mahendra Kumar Ghadoliya

The say’s law takes the following assumptions of the classical school:

1.      All markets are perfectly competitive so that agents decide how much to buy and sell on the basis of a given set of prices which are perfectly flexible. The required amount of labour and capital can be raised from the market on prevailing prices.

2.      Firms are free to enter or exist without affecting the equilibrium output and prices in the market.

3.      The market is capable of expansion. It expands with the increase in the volume offered for sale in the market.

4.      All economic agents (like firms and households) are rational and aim to maximise their profits or utility; further more they do not suffer from money illusion.

5.      All savings are automatically invested and this equality is brought about by the changes in the rate of interest.

6.      Full employment is considered to be normal situation and any lapses from full employment are considered to be abnormal.

7.      Full employment is guaranteed because of free play of market forces. The government does not interfere in the automatic functioning of the economy. As any interference with the free play of market forces   shall fail to bring about full employment.

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What are the Weak and Strong versions of Say’s Law?

Prof. Mahendra Kumar Ghadoliya

Weak and Strong versions of Say’s Law:

At this point there is important to distinguish between two versions of Say’s Law.

Weak Version of say’s Law:

According to Trevithick[1] (1992) the weak version is taken to imply that each act of production and supply necessarily involves the creation of an equivalent demand for output in general. This version of Say’s Law is a weak version. This version does not guarantee that output produced will be consistent with full employment.  It may be any amount of production below or full employment level. This weak version of says law applies to both depressed or buoyant level of output.

Strong Version of say’s Law:

The strong version of Say’s Law states that in a competitive market economy there will be an automatic tendency for full employment to be established. Since the strong version o say’s law implies an equality of aggregate demand and supply which is consistent with labour market equilibrium, it is equivalent to the proposition that there is no obstacle to the achievement of full employment in terms of a deficiency of aggregate demand.

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[1]  Trivithick, J.A. (1992) Involuntary unemployment: Macroeconomics from Keynes perspectives, London Harvester- Wheat-sheaf quoted from a modern guide to macroeconomics, ‘An Introduction to Competing Schools of Thought’ by Snowdon,B. and et.al. (1998)

Write a short note on Green Accounting. what are the problems of Green Accounting? Is it superior to conventional accounting?

A note on Green Accounting:

Prof. Mahendra Kumar Ghadoliya

Meaning:

“Green accounting is a type of accounting that attempts to factor environmentalcosts into the financial results of operations. It has been argued that gross domestic product ignores the environment and therefore policymakers need a revised model that incorporates green accounting.”Wikipedia, (https://en.wikipedia.org)

Why Green Accounting:

Measures of the economic activity in the system of National Income Accounting can be misleading because of the following:

(a)   Environmental quality is not reflected in the conventional data.

(b)  Depletion of natural resources is not considered.

(c)   Earlier economists believed that natural resources were gift of nature. This was wrong in fact their quality has an impact on the quality of life.

(d)  The expenditure made on maintenance of the environmental hazards is mistakenly considered as investment in the System of National Income Accounting (SNA)

We have already studied the concept of national income where we have defined the Net Domestic product as;

NDP= C+I+G+(X-M)

To arrive at Green NDP the concept of net capital formation (I) is replaced to include non-produced capital assets and account for its depletion by subtracting the used non- produced assets from the initial stock.

Green NDP or EDP=EDP = + C + NAp. ec + (NAnp.ec - NAnp.n) +Net Exports(X-M)

Where;

Green NDP = Environmentally adjusted domestic product.

С = Final Consumption

NAp.ec = Net accumulation of produced economic assets.

NAnp.ec = Net accumulation of non-produced economic assets

NAnp.n = Net accumulation of non-produced natural 

Net Export(X-M) = Exports-imports

Problems of Green Accounting:

The SEEA method of calculating Green NDP hasseveral problems discussed below:

1.  comprehensive natural resource accounting is difficult to introduce.

2.   Regional natural resource accounts are not reflected in the main accounts.

3.  The stock of natural resources cannot be estimated in advance. New discoveries always changes the availability

4. It focuses on the use of natural resource for economic activities and ignores the flows and transformations within the natural resources.

5. Lack of Data and methodology: The types of data needed for SEEA are not available in the necessary format. Thus, lack of data has been one of the main problems in the SEEA.

6. Causes of environmental degradation not known:  The costs of preventing pollution can only be determined if the causes of pollution are identifiable. But the causes of many types of environmental pollution are not clear. If there are several pollution factors which cause environmental damage, the assignment of this damage will be highly arbitrary.

7. Visible after a long time: Some problems are visible after very long time. Estimating only the immediate consequences will lead to wrong policy decisions.

8. There is no simple justifiable valuation system for the SEEA. For different aspects of environmental problems, different valuation problems are used such as prevention and restoration costs and contingent evaluations based on surveys. There are mainly theoretical and arbitrary constructions in SEEA.

9. The pricing of all environmental variables in monetary terms in the SEEA has consequences:

(i) The accounting system is restricted to those variables which are easily monetized thereby reducing the range of the accounting system,

(ii) Monetization of environmental variables and their concentration of only a few aggregates results in a drastic reduction of the SEEA system.

It’s Superiority over Conventional Accounting System:

Conventional national income accounting does not fully consider pollution preventive expenditure. Green accounting considers pollution preventive expenditure and environment impact studies.

Conventional national income accounting does not measure the depletion of natural resources and the degradation of the environment. Green accounting considers the costs of depletion of natural resources and changes in environmental quality.

Conventional national income accounting does not fully report different types of resource expenditure:

(i) Consumption of environmental goods such as exhaustible resources; and

(ii) Conflicting uses of environmental services such as the atmosphere used by producers as an input into production and by household as a consumption good.

On the other hand, green accounting expands and complements the conventional system of national accounts about costing:

(a) The use (depletion) of natural resources in production and final demand; and

(b) The changes in environmental quality, resulting from pollution and other impacts of production, consumption and natural events.

Incorporating more information on natural resources and environment into the accounts requires much conceptual framework and data gathering. The most challenging problems are: 

Determining the most appropriate way of measuring physical changes in environmental quality and natural resource reserves.

Developing reliable and consistent methods of these assets accounting. The united Nations efforts concentrated on determining monetary value of depletion of non-renewable resources and identifying abatement expenditure designed to reduce pollution damages. These efforts are not enough; substituting market value for non-market services generates controversy. Nevertheless, it may be feasible to expand the information on natural resources and environment beyond that provided by the market, especially for imputing the value of factor services such as environmental waste disposable and certain final services. There is a long way to go on the methodology of green accounting. The beginning has been made and the continuous refinement will make these data more useful and reliable than the data for conventional national income accounting.

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