Classical Economics its Assumptions, and

Classical Theory of Employment

Prof. (Dr.)M. K. Ghadoliya
Vice Chancellor,
Shri Khushal das University,
Hanumangarh (Rajasthan) 335801

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 were
subsequently developed as a theory.

Classical Economics

The term classical economics was first used by Karl Marx to describe economic thought
of David Ricardo and his predecessors including Adam Smith. Classical economics
viewed labour as a significant measure of value. Later, classical economists gave more
importance to marginal productivity of a factor 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 economics 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 of Classical Economics:

There are two basic features of classical economics viz;

(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.

Assumptions of Classical Economics:

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 homogenous: The quality, efficiency, productivity of labour does not
differ it is homogenous.
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: There are large number of buyers and sellers in the in
the labour market and commodity market. It is therefore not possible to affect or
change the wages and prices in the markets.
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: The players in the market are well aware and have full
market information it is therefore possible to buy and sell at competitive prices
in the market..
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. The classical economics did not
provide any short term solution. Criticising this Keynes said in the long run we
all are dead therefore a theory explaining short term fluctuations was necessary.
10. Savings and Investment are always equal. In the long run 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 interferences with the free working of
economic forces. Thus, the cure of unemployment is to remove all interferences
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.

Classical Theory of Employment

Classical economists believed based on their assumptions 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/MPPL ---- (1)

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

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

In a perfectly 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* MPPL ---------- (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* MPPL) 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>P) the contraction would increase profit.

The marginal cost curve which is derived from the MPPL 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 (Y=f (K,N) 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 Total Production Curve

Due to diminishing returns the MPPL 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 (MRP) 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 = MPPL ------- (3)

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

Figure: 2 Demand Curve for labour

In figure (2) D=f W/P) 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 MPPL 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 (MPPL). 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. Thus the employment will be at
W/P1 at which MPPL 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.

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 SL=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
DL=SL determines output, employment, and the real wage in the classical production
function as shown in the figure 4 (a) below.

It depicts the equilibrium in the labour market at a point where DL = SL at real wage rate
(W/Pe) and the equilibrium level of employment is Ne. The model can be represented by
the following set of equations:
Y = f (͞K,N)
MPPL = WP,
DL=f(W/P) , SL=f (W/P)
DL=SL

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 Figure4 (b) 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 Ne 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 Ne and output is Ye 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 = K̅ PY

Y= M̅/ K̅ . 1/P

Therefore is there is an inverse relationship between Y and P. The equilibrium level of

output or income Ye 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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Prof. (Dr.) M.K.Ghadoliya, served V.M. Open University, Kota (Raj) for 24 years
and have contributed extensively in the area of Economics. He also writes for the
benefit of the students of economics regularly his blog
http://ghadoliyaseconomics-mahendra.blogspot.in