The classical theory of employment is based on the following assumptions: (i) Individuals are rational human beings and are motivated by self-interest. Keynes’s Criticism of Classical Theory. 4. The classical theory of employment is criticized on the following grounds: (1) Equilibrium Level need not be Full Employment Level. Content Filtration 6. The intersection of the two curves at E shows the level of full employment NF and the real wage W/P0. Where DN = demand for labour, W = wage rate and P = price level. When there is a general wage-cut, the income of the workers is reduced. If there is any divergence between the two, the equality is maintained through the mechanism of the rate of interest. Given K and T, the production function becomes Q = f (AO which shows that output is a function of the number of workers. Keynes rejected the classical belief that economic system is automatic and self-adjusting in character. Keynes, therefore, advocated state intervention for adjusting supply and demand within the economy through fiscal and monetary measures. He pointed out that the capitalist system was not automatic and self-adjusting because of the non-egalitarian structure of its society. Figure-3 (B) explains the determination of money wage consistent with a given real wage. The Grounds are: 1. Report a Violation 11. The fixed income of level. He developed a new economics which brought about a revolution in economic thought and policy. The basis of the classical theory is Say’s Law of Markets which was carried forward by classical economists like Marshall and Pigou. Real wage rate is determined at the level where demand for labour and supply of labour are equal. Assumption of full employment. Keynes begins the General Theory with a summary of the classical theory of employment, which he encapsulates in his formulation of Say's Law as the dictum "Supply creates its own demand". Keynes’ main criticism of the classical theory was on the following two grounds: (a) The classical prediction that full- employment equilibrium will be achieved in the long-run was not acceptable to Keynes, who wanted to solve the short run problem of unemployment. Wages and prices are perfectly flexible. This, in fact, led to the Great Depression. 3. In the classical theory, output and employment are determined by the production function and the demand for labour and the supply of labour in the economy. B. As a result, the price level would rise from OP to OP1 given the same level of output OQ. Now at the original interest rate Oi, saving exceeds investment by EE2 which indicates the amount of overproduction. Criticism of Classical Theory Assumption of full employment (long-run analysis) Assumption of perfect competition Wage-price flexibility Say’s Law of Market Money functions not only as the medium of exchange Working of invisible hands (i.e. N can be increased by a reduction in W. Thus the key to full employment is a reduction in money wage. Whenever saving exceeds investment, aggregate demand decreases and income level declines. J.B. Say (1764-1832), a French economist, introduced a law of markets in his book Traite d’economic politique. Competition by employers for workers will raise the wage rate from W/ P2 to W/P0 and the equilibrium point E will be restored along with the full employment level NF. If the quantity of money increases, the MV curve will shift to the right as M1V curve. The logic of this argument can be easily grasped with the help of the following algebric expression. Prohibited Content 3. Before uploading and sharing your knowledge on this site, please read the following pages: 1. Or, in other words, if saving plans by the households are equal to investment plans by businesses, neither unemployment (overproduction) nor inflation (underproduction) will result. He integrated the value theory and the monetary theory through the theory of output. As we know that the seeds of scientific management were sown long before Taylor brought together several strands of thinking into a single methodology for applying scientific principles to the design and organization of work. Thus the price level is a function of the money supply: P = f (M). Employment-Output Determination: Labour Market: Let us first consider the labour market where […] This framework is composed of an aggregate production function, the labour market, the money market, and the goods market. In modern times, workers have formed strong trade unions which resist a cut in money wage. Image Guidelines 4. Keynes opposes this remedy. The Keynes’ Critique of Classical Theory . The equation is MV= PT, where M = supply of money, V= velocity of circulation of M, P = Price level, and T = volume of transaction or total output. This leads to general overproduction because all that is produced is not sold. Classical organization theory - key criticisms. According to the classicists, what is not spent is automatically invested. General Theory: Evolutionary or Revolutionary:. Unemployment results from the rigidity in the wage structure and interference in the working of free market system in the form of trade union legislation, minimum wage legislation etc. It is by increasing the real wage rate that more workers can be employed. Terms of Service 7. //]]>, In the labour market, the demand for labour and the supply of labour determine the level of output and employment. Saving equal to investment (S = I) gives the market clearing condition in the product market. The quantity of money is given and money is only the medium of exchange. Thus Keynes rejected Say’s Law that supply created its own demand. The Classical Theory of Employment: Assumption and Criticism! For instance, when the quantity of money increases, the rate of interest falls, investment increases, income and output increase, demand increases, factor costs and wages increase, relative prices increase, and ultimately the general price level rises. (v) Under conditions of perfect completion, flexibility of wages tends to establish full employment. Eventually, the rate of interest will fall to Oi1 and once again the equality between saving and investment is established at Point E1. Thus there is general deficiency of aggregate demand in relation to aggregate supply which leads to overproduction and unemployment in the economy. This will remove unemployment. Keynes refuted the Pigovian formulation that a cut in money wage could achieve full employment in the economy. 3. Criticisms. Contrariwise, with the fall in the wage from W/P0 to W/P2, the demand for labour increases more than its supply by s1d1, the workers demand higher wage. The theory of employment developed by classical economists is called classical theory of employment. The money market is in equilibrium when the demand for money equals the supply of money. It is a closed economy without foreign trade. Then the real wage corresponding with the money wage is determined by the (W/P) curve, as shown in Panel (D). (ii) On the practical side, it is difficult to reduce wages because- (a) the workers, due to money illusion, often oppose such a cut; (b) trade unions, which are now an integral part of the modern industrial system, oppose a wage-cut policy; and (c) there is labour legislation regarding minimum wages, unemployment insurance, etc. 2. Report a Violation, Determination of Income and Employment: Complete Classical Model, Classical Model of Employment (Useful Notes), The Principle of Acceleration and Super Multiplier in Business Economics. From the practical view point also Keynes never favoured a wage cut policy. Total output comprises of consumer goods (C) and investment goods (I). Full employment exists “when everybody who at the running rate of wages wishes to be employed.”. According to Keynes, a part of the increased income is spent on consumer goods and the other saved. THEORY OF EMPLOYMENT 2. If saving exceeds investment, it means people are spending less on consumption. Given K and T, total output (Q) is an increasing function of the number of workers (N): Q=f (N) as shown in Panel (B). In this article we will discuss about:- 1. The supply of labour depends on the wage rate, SL = f (W/P), and is an increasing function of the wage rate. At point E, ONF workers produce OQ output. The classical theory of employment has been severely criticized by Keynes. The classical theory of employment is based on the assumption of flexibility of wages, interest and prices. He also suggested a number of fiscal and monetary measures to fight unemployment. The equation tells that the total money supply MV equals the total value of output PT in the economy. Plagiarism Prevention 5. The main points of criticism of classical theories are as follows: a. This is because saving is regarded as an increasing function of the interest rate and investment as a decreasing function of the rate of interest. According to Say’s law, an increase in employment increases income, the whole of which is automatically spent either on consumer goods or on investment goods. They did not recognise the speculative demand for money because money held for speculative purposes related to idle balances. The classical theory has failed to explain the occurrence of trade cycles. As a result of this excessive saving, the rate of interest will fall, which on the one hand leads to increase in investment and on the other hand tends to reduce saving. 13. According to Pigou, the tendency of the economic system is to automatically provide full employment in the labour market when the demand and supply of labour are equal. They would resort to strikes. The equilibrium in the money market is shown by the equation MV = PT where MV is the supply of money and PT is the demand for money. In Figure-1 (B), Y = f (N) curve represents total production function. The working of self- regulating mechanism under the classical system can be understood in the three markets of the economy. Keynes did not believe in the self- adjusting mechanism of the competitive system and recommended government expenditure in public works in order to save the economy from uncertainties of private investment. They are not only costs of production, but also form the incomes of labourers. Say’s law of markets provides justification to the assumption of full employment. In the words of Prof. A.P. Keynes Rejected the Fundamental Classical Assumption of Normal, Automatic Full Employment Equilibrium in the Economy 2. 6. But beyond point E, as more workers are employed, diminishing marginal returns start. window.__mirage2 = {petok:"e66f552e4ce46864d26052b2e208f6391ad2e2f8-1607022658-3600"}; When prices fall with the reduction of money wage, real wage is also reduced in the same proportion. If saving exceeds investment, the rate of interest will fall. If there is not full employment in the actual life, then there is always a tendency towards full employment. Say’s law of markets is the core of the classical theory of employment. The following points highlight the nine grounds on which Keynes criticized the Classical Theory of Employment. MV is the/money supply curve which is a rectangular hyperbola. They also assume that velocity of money (V) is stable because the payment habits of the people change very slowly. According to classical economic theory, a market economy: is self-regulating, will automatically adjust to the natural unemployment rate, and will automatically adjust to Natural Real GDP According to Marx's criticism of classical theory: He regarded full employment as a special situation. This is because the money wage cut will reduce cost of production and prices by more than the former. The demand for labour, in turn, depends on the marginal productivity (MP) of labour which declines as more workers are employed. Thus, Y and V being constant, the price level (P) is determined by the supply of money (M) and there is a direct relationship between M and P; changes in the money supply lead to proportional changes in the price level. When money wages fall, real wages rise and vice versa. Say's Law of Market. The scientific approach the use of work study techniques to the systematic investigation of work and the subsequent matching of worker to the job requirements. This is because the equation MV = PT holds on all points of this curve. Remove these obstructions, allow the natural working of the economic system, and the unemployment will automatically end. Supply of labour (SL) is positive function of real wage (W/P). To them, both saving and investment are the functions of the interest rate. His theory of employment is widely accepted by modern economists. The Classical Vs.Keynesian Models of Income and Employment! (vii) People spend their entire income either on consumption or on investment. Given the capital stock, technical knowledge and other factors, a precise relation exists between total output and amount of employment, i.e., number of workers. Whenever there exists involuntary unemployment, it is due to the interference with the free working of the competitive system. The basis of this perspective had existed for many centuries in one form or another. Total output of the economy is divided between consumption and investment expenditures. Increased sales will necessitate the employment of more labour and ultimately full employment will be attained. It does not provide any solution to the problems of unemployment or trade cycles. Classical Model of Employment 6. Maintenance of full employment level, according to Say’s law, requires that the whole of the income generated at full employment level must be spent on the purchase of the whole of the output produced at that level. Equality between saving and investment. This will discourage saving and encourage investment, thus making saving and investment once again equal. Keynes also criticised the classical version of saving-investment equality. Real wage rate is determined by the forces of demand and supply in the labour market. But the equilibrium level so reached is one of underemployment rather than of full employment. Mill, Marshall, Edgeworth and Prof. Pigou.”. People demand money (Md) for transactions and precautionary purposes (LI) and demand for these purposes is a function of income (Y). Given the output level OQ, there would be only one price level OP consistent with the quantity of money, as shown by point M on the MV curve. Similarly investment is determined not only by rate of interest but by the marginal efficiency of capital. 2. In the long run, the economy will automatically tend toward full employment when the demand and supply of goods become equal. Intersection of these two curves at point E determines the equilibrium real wage rate, (W/P), at full employment level ON. In order to maximize their profit, firms employ factors of production to the point where margi… It is subject to the law of diminishing marginal returns. 10. According to this law, “Supply creates its own demand.” As a result, saving falls and. Explanation of Classical Theory of Employment 5. Keynes, on the other hand, emphasised the store of value function of money. Introduction: John Maynard Keynes in his General Theory of Employment, Interest and Money published in 1936, made a frontal attack on the classical postulates. The consequent unrest in the economy would bring a decline in output and income. For the classical economists, money is only a veil and its main function is to act as a medium of exchange. The classical theory of employment was based on the assumption of full employment where full employment was a normal situation and any deviation from this was regarded as an abnormal situation. Capital stock and technical knowledge are given. 7. 12. It follows that the money wage should be reduced in order to attain the full employment level in the economy. Mill, Marshall and Pigou. He considered it as unrealistic. The classical economists believed in the existence of full employment in the economy. Savings are automatically invested and equality between the two is brought about by the rate of interest. The equilibrium of the money market explains the price level corresponding to the full employment level of output which relates Panel (E) and Panel (B) with MQ line. He maintained that all income earned by the factor owners would not be spent in buying products which they helped to produce. Changes in the general price level are proportional to the quantity of money. It also depends on the extra unit of output that an additional worker can produce if added to the current workforce. When the DN and SN curves intersect at point E, the full employment level NF is determined at the equilibrium real wage rate W/P0. This means that wage rate, interest rate and price level change in their respective markets according to the forces of demand and supply. 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