Classical Theory of Employment
The classical theory of employment states that in a labor market, employment for labors is determined by the interaction between demand and supply of labor, where the workers provide a constant supply of labor, while the employer makes demand for them.
Classical economists believed that full employment prevailed in the economy through wage and price adjustments, and any deviation from the phenomena was considered to be an abnormal event. In order to understand the classical view of employment, Say’s law of market should be analyzed.
Say’s Law of Market
Say’s law of market, named after the proprietor Jean Baptiste Say, is a classical economic idea which states that supply creates its own demand. The law views that aggregate output produced generates aggregate demand at the same level, and argues that prices and wages are flexible and maintain an equilibrium state in a self-regulating economy.
The basic assumption of the law is that no demand is created without supply. This means in order to create a demand in the economy, there must be supply of any goods and services. It overruled the possibility that full employment level of output produced by full employment of labor force will not find a market assuming that aggregate demand will be generated. For any excess of supply of goods in a market, there will be a corresponding excess demand on another. So, at macroeconomic level, oversupply is not possible with inadequate demand for products.
Say’s law of market holds following assumptions about the economy:
Free market economy
The law assumes free market economy where perfect competition prevails in the economy and the interaction between demand and supply determine the factor prices and price of products.
There is no government intervention in the functioning of the economy besides minimum interference to ease the free operation of enterprises (business firms).
Flexibility in internal prices
The prices of products, wages of labors and interest rates are assumed to be flexible. This maintains equilibrium in the labor market, money market, and product market.
Expandable market size
The size of the market is considered flexible that are easily expandable with the increase in the volume of products that are being produced and offered for sale in the market.
Role of money
I order to ease and simplify the transaction of goods and services within the economy, money is used a medium of exchange.
No leakages in money use
The money that flows within the economy are utilized without leakages. It is assumed that the money that flows into the economy is not hoarded by any economic units as it is used either for consumption or investment.
Long run time
Classical economists are more concerned with the long run equilibrium in an economy. The main interest of these economists lie in analyzing and determining the long run relation between profit, income distribution, and the level of output.
Say’s Law in a Barter Economy
Say’s law hold true for most of the cases in a barter system. In a traditional barter system, goods and commodities are consumed either for consumption or for exchange with some other goods. Supply of a commodity is possible only if there is a demand for it. For instance, a person producing goods in excess should find another person in the market who is searching for that good. This applies to all the other producers and consumers in the economy. So, in a barter economy, products are exchanged for products, and supply creates in own demand.
Moreover, people in a barter economy are self-employed which means that involuntary unemployment doesn’t exist. Production is carried out in small scale and any earnings made from the sale of the produced goods are invested in the business itself.
Say’s Law in a Money Economy
Say’s law remains valid even in the money economy because classical economists view money only as a medium of exchange with no active role in influencing the real sector of the economy.
In a money economy, the purchase and sale of goods and services is made possible by money. People use money only as an easy and reliable source of exchange. The earnings made after selling a product are used for the purchase of other necessary goods rather than for hoarding or saving. However, not all money earned is spent as soon as it is earned. It is only a medium that bridges the gap between receipts and payments.
Further, classical economists did not consider saving as bad thing. Rather, they saw it as a way through which investment could be increased in the economy. They believed that the disequilibrium between saving and investment will lead to a decline in the interest rates. This will discourage saving and encourage investment. The interest rates would continue to fall till the level where equilibrium is gained and there are no un-invested savings among households.
The validity of Says’ law depend on two conditions. They include:
- The amount of money generated from the aggregate goods and services produced, will be equal to the aggregate cost incurred for the production of those goods and services. Thus, aggregate income earned is equal to aggregate cost.
- Aggregate income is spent on the purchase of other goods and services to satisfy the needs. So, aggregate income is equal to aggregate expenditure.
Say’s law of market in the money economy is expressed in terms of aggregate demand and aggregate supply, which is illustrated in the figure below:
The figure shows that aggregate demand and aggregate supply at all points of the 450 line is equal. For instance, at point A, aggregate supply OQ1 is equal to aggregate demand OE1. When the aggregate supply increases to OQ2, aggregate demand also moves to OE2. This shows that aggregate demand is equal to aggregate supply and thus, there is no possibility of general over-production or general unemployment in the classical system.
Criticisms of Say’s Law
Say’s law has been criticized by many economists, among which, J.M. Keynes was a major critic. He refused to accept the law in any form, especially due to the following shortcoming:
Deficiency of aggregate demand
Say’s law is based on the assumption that for every unit of output produced, there will be sufficient demand. Keynes denied this by classifying demand as consumption demand and investment demand. He pointed out the factors that determine consumption demand and investment demand. According to him, consumption demand is affected by psychological factors and income levels, whereas, investment is determined by technological factors and marginal efficiency of capital (MEC).
Since, consumption increases in less proportion in comparison to income, a gap is created between income and consumption. The proportion of income not spent is saved but it doesn’t always lead to investment during the times of downturns in the business, even when the interest rates are low. Thus, deficiency of demand arises.
Although Say’s law claims existence of full employment, unemployment occurs in the economy since it cannot self-adjust to the deficiency of aggregate demand of labor in the market. Therefore, certain level of government intervention is needed to maintain a balance in the economy.
Possibility of general over-production
According to Say’s law, the income generated from the sale of produced goods is spent on consumption and investment. The income spent on consumption will be sufficient to keep all the productive resources fully employed in the economy and general over-production does not occur. But Keynes pointed out that all the income earned is not spent on consumption or investment. Consequently, a shortage in demand arises, leading to a problem of over-production.
Role of money
Keynes rejects the idea that money is only a medium of exchange and states that money has a greater role in the economy such as determination of income, output, and employment.
Say’s law implies that equilibrium is maintained at full employment level in the economy. But, Keynes believed that even when aggregate demand and aggregate supply are in equilibrium, it may not always be attained at full employment level.
Lack of automatic adjustments
Keynes and other critics argued that the economy is not always self-regulating. Say’s law was based on the belief that prices and interest rates are flexible to maintain equilibrium in the economy. However, the difficulty in determining the level of wages, prices and interest rates drag the economy into a state of disequilibrium.