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.