THEORY OF EMPLOYMENT

CLASSICAL THEORY OF EMPLOYMENT

For this theory, French economist J. B. Say formulated a law which is known as the “Say's Law of Market”.

Classical economists such as, J.S. Mill, Marshall, Pigou etc. have supported this law of J.B. Say.

The theory of employment developed by classical economists is called classical theory of employment.

Classical economists assumed full employment in the free market economic system.

According to their views, under perfect competition, unemployment will be temporary and after sometime, it will disappear.

Even at times, if full employment is not realized, then this will gradually move towards full employment.

SAY’S LAW OF MARKETSay’s law of market is the foundation of classical economics. This law has been named for the French economist J.B. Say, a famous economist of 19th century.

The theory of full employment of classical economists is based on J.B. Say’s law of market.

According to him, “Supply creates its own demand”. It means that production of goods will create demand for them also.

Assumptions:1. There is existence of free market economy.

2. There is absence of government intervention in the automatic working of the economy.

3. The size of market is flexible enough for expansion.

4. Money is only a medium exchange.

5. There is closed economy which has no international trade relations..

5. Perfect competition exists in both factor and product market.

6. Individuals are rational human beings and are motivated by self-interest.

7. There is no leakage in the circular flow of income between different economic units.

8. Wages and prices are flexible.

9. Saving equals to investment

CRITICISMS3. Supply does not create its own

demand.2. Money is also demanded for other

purposes. 3.Economy is not self-adjusting.

DETERMINATION OF EMPLOYMENT AND OUTPUT IN THE CLASSICAL MODEL

AssumptionsThe classical theory of employment is

based on the following assumptions: Individuals are rational human beings

and are motivated by self-interest.Perfect competition exists in both

product market and factor market. Individuals do not suffer from money

illusion.Laissez-faire condition prevails, i.e.

government does not interfere in the economic activities.

There is closed economy which has no international trade relations.

Technique of production and business organizations do not change.

Money is only a medium of exchange. Wage and prices are flexible both upward

and downward. The labour force is homogeneous. There is full employment in the economy.

Y

E

JI

K L

O XDL

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N2 N N1

Fig (a)UnemploymentReal

Wage Rate

1

2

Y Fig (b)

Y = f (N)

EmploymentNO

Output

Y

Saving and Investment

Rate of Interest

S

I

ER

R2

R1

Y

MO

Excess

Saving

Excess

Investment

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S

CRITICISMS OF CLASSICAL THEORY OF EMPLOYMENT1. Under-employment Equilibrium:2. Supply does not create its own

Demand.3. No automatic Adjustment:4. Government Intervention:5. Role of Money:6. Saving-Investment Equality:7. Long-run Analysis:8. Assumption of Perfect Competition:9. Not a General Theory:10. Not a Practical Theory

KEYNESIAN THEORY OF EMPLOYMENTJ.M. Keynes "The General Theory of employment, Interest and Money" published in 1936. The classical and the neoclassical economists almost neglected the problem of unemployment. They regarded unemployment as a temporary phenomenon and assumed that there is always a tendency towards full employment. It was Keynes who led vigorous and systematic attack on the classical theory of employment and replaced it with more general and more realistic theory.

Assumptions:1. Keynes confines his analysis to the short-period.2. He assumes that there is perfect competition in the market.3. He assumes closed economy ignoring effect of foreign trade.4. His analysis is a macroeconomic analysis, i.e., it deals only with aggregate facts.5. He assumes operation of the law of diminishing returns or increasing cost.6. He assumes that labour has money illusion.

Principle of Effective DemandThe origin of Keynesian theory of employment is based on the principle of effective demand. Effective demand is that point where aggregate demand curve intersects the aggregate supply curve

Determinants of Effective Demand. 1. Aggregate Demand Functions (ADF) 2. Aggregate supply function (ASF)

1. Aggregate Demand Functions (ADF)Aggregate demand function is the relationship between the level of employment and the expected income from the sale of output resulting from the varying level of employment. The expected income from the sale of output resulting from such different level of employment is called aggregate demand price (ADP) for the output.

AD

EmploymentX O

Cost and Revenue

Y

2.Aggregate supply function (ASF)

Aggregate supply function is defined as the amounts of money which the entrepreneur must get from the sale of output at varying levels of employment. In other words, it represents different levels of income which the entrepreneur will supply at different levels of employment.

AS

EmploymentXO

Cost and Revenue

Y

Determination of Equilibrium Level of Employment by the Principle of effective Demand

According to Keynesian theory, the equilibrium level of employment is determined at the point of intersection between aggregate demand function and aggregate supply function. This has been shown in the following diagram:

O N1 NN2

R2

R3 AD

XEmploymen

t

Cost and revenue

Y

E

AS

R

R1

Criticism1.Not a complete theory:2.Based on the unrealistic Assumption of perfect Competition:3.No direct relationship between unemployment level and effective demand:4.Short-run analysis:5.Ignores microeconomic problems:6.Static in Nature:7.Assumption of closed economy:8.A depression economics:9.Capitalistic theory:10.Not applicable in the developing countries