Classical Theory Of Income And Employment Case Study

Classical economists such as Adam Smith and Ricardo maintained that the growth of income and employment depends on the growth of the stock of fixed capital and inventories of wage goods. But, in the short ran, the stock of fixed capital and wage goods inventories are given and constant. According to them, even in the short run full-employment of labour force would tend to prevail as the economy would not experience any problem of deficiency of demand.

On the basis of their theory they denied the possibility of the existence of involuntary unemployment in the economy.

The short- run classical theory of income and employment can be explained through the following three stages:

1. Determination of income and employment when there is no saving

At a lower real wage rate, more labour will be demanded or employed by the firms and vice versa. Thus, the demand curve for labour is derived from the marginal product curve of labour. In fact, the former coincides with the latter. Thus demand function for labour can be written as

Nd=f (W/P)

Consider Fig. 3.1 where MP curve depicts the diminishing marginal product of labour with a given stock of fixed capital and a given state of technology. As explained just above, marginal product (MP) curve of labour also represents the demand curve of labour (Nd).

On the other hand, the supply of labour by the households in the economy depends on their pattern of preference between income and leisure. The classical theory assumes that in the short run when population does not vary, supply curve of labour slopes upward. Now, what is the rational behind the upward-sloping supply curve of labour.

This is based on the assumption that households or individual workers maximise their utility or satisfaction in their choice of work (which yields them income) and leisure. When real wage rate rises, two effects work in opposite

When real wage rate rises leisure becomes relatively more expensive, that is, opportunity cost or price of leisure in terms of income forgone by not working goes up. This induces the individual to work more (i.e. supply more labour hours) and thereby substitutes income for leisure. This is the substitution effect.

On the other hand, with a rise in real wage rate individuals become relatively richer than before, and this induces them to consume more of all commodities (including leisure which is regarded as a normal commodity). This is income effect of the rise in real wage rate which tends to increase leisure and reduce labour-hours supplied.

The classical economists believed that substitution effect is larger than income effect of the rise in real wage rate and as a result supply of labour increases with the rise in wage rate. Thus the supply function of labour can be written as

Ns=g (W/P)

This implies that at a higher wage rate, more labour would be supplied and vice versa. It will be seen from Fig. 3.1 that supply and demand for labour are in equilibrium at the real wage rate