Theory of income and employment chap 1

Theory of Income and
Employment
 Classical theory of Employment
 Say’s Law of Market
 Pigou’s Wage-cut theory
 Keynesian Theory of Income and
Employment
 Theory of Effective Demand

Classical theory of Income and
Employment
• The entire economic premise of the classical
economists was based on the assumption of
full employment of labour and other economic
resources.
• They were of the opinion that the economy
operates in the stable equilibrium situation in
the long run and any deviation thereto was
regarded as abnormal.

• Along with that, they also made an assumption
of perfect competition, fr4ee capitalist
economy and optimum use of resources in
long run.
• Here full employment does not mean the total
absence of the unemployment but there can be
frictional unemployment of temporary nature,
or seasonal unemployment.

Assumption of the classical theory of
Income and Employment
1. Perfect Competition
2. Wage- Price Flexibility
3. Homogeneous Labour
4. Constant stock of capital and technology
5. Liaises Faire Economy
6. All the units produced are sold in the market

Say’s Law of Market
(Supply creates its own Demand)
• J.B. Say, a French economist of 19th century, arrested that,
“Supply creates its own Demand.” this appears to be
simple proposition but has had many different meanings,
and many sets of reasoning.
• According to this concept: Whenever any product is
produced, the demand of that product is also
simultaneously generated on account of or through the
process of payment of remuneration to the factors of
production.
• In other words every output produced, results in an
equivalent demand being generated which leads to its sale
so that there is no surplus output or over production.
• Say’s law is applicable both in barter economy and in
money economy.

Assumptions under Say’s Law
1. Optimum Allocation of Resources
2. Perfect Equilibrium
3. Perfect Competition
4. Market Economy
5. Laissez Faire Policy of the government
6. Elastic market
7. Market Automatism
8. Circular Flow
9. Saving-Investment Equality
10. Long term concept

A. Say’s Law in Barter Economy:
• In barter economy, the producers undertake to produce
the goods either to consume or to exchange them for
other goods which they need for consumption.
• In any case they create a demand for goods which is
equal to the supply of goods they have produced. “It is
production which creates market for goods: no sooner
a product is created, from that instant i8t affords a
market for other product to the full extent of its value.
Thus, a producer himself becomes a consumer for his
own product or somebody else’s product.
• In the words of J.S. Mill “all sellers are inevitably
and by meaning of the word buyer.”

B. Say’s Law in Money Economy:
• In money economy, people receive money in exchange of the
goods that they have produced. This implies that the supply
of product, through the process of production, generates
necessary income- occurring to the factors of production in
the form of rent, wages, interest, profits, etc. to demand the
goods produced so that an equivalent demand is created in
accordance with the supply. So we can say that the main
source of demand is the flow of incomes generated from the
process of production itself.
• However, in money economy, people may not spent all the
money income that they have received. They may decide to
save a part of their income.

• According to classical writers, the interest rate
mechanism would ensure the conversion of saving
into investment to ensure full employment.
• If people decide to save more than before, total
savings in the economy would increase leading to fall
in interest rates, which would encourage
entrepreneurs to invest more.
• The investments will increase till it becomes equal to
total savings.
• So the income not spent for consumption goods
would be spent for investment by entrepreneurs.

Criticisms of Say’s Law:
1. The assumption of perfect competition is
unrealistic.
2. Savings and investments are not continuous
process.
3. Investment is mainly influenced by the Marginal
Efficiency of Capital and not solely on the
changes in the rate of interest.
4. According to Keynes, equilibrium can be attained
at any level below the full employment situation
also.

Wage Flexibility and Full Employment
(Pigou’s Wage –Cut Theory)
• The classicists have advocated “the money wage cut
policy” to solve the problem of unemployment.
• The classical economists believed that involuntary
unemployment, if it exists in an economy, was a
consequence of the rigid wage structure. If wages are
lowered sufficiently , all involuntary unemployment
would disappear.
• It is assumed that the self adjusting system of wage
rates would push the economy towards full
employment stage.

Continue……..
• The involuntary unemployment comes into existence
due to the interference to the free play of market
mechanism in a capitalist economy.
• Such interference is the result of collective bargaining
of trade unions to push wages or governmental
interventions through passing of law of minimum
wages.
• This disturbs the smooth functioning of the market
mechanism in determining the equilibrium wage rates
which clear off the labour market.

Explanation:
On OY axis, wage rate is taken
and on OX axis Rate of
Employment is taken.
S is the labour supply curve and
D is the demand curve of labour in
the economy.
If the wage rate is WP1, the MT
is the amount of Unemployment in
the economy.
To remove this level of
unemployment, Pigou suggests that
the wage rates should be reduced
to WP2, where the demand and
supply curve of the labour
intersects each other and ON level
of Employment is maintained.
Therefore, the wage cut theory of
Pigou can help in eliminating the
problem of unemployment.

Criticisms of the Wage cut theory
1. Unrealistic Assumption of Full Employment
condition.
2. Undue importance of the Long Period.
3. Keynes’ Denial of Say’s Law of Market.
4. Attack on Money Wage cut policy.
5. Keynes’ attack on Interest Rate to be strategic
variable.
6. Keynes’ attack on Laissez faire policy.

The Theory Of Effective Demand
• The principle of effective demand lies at the
heart of Keynes’ General theory of
Employment.
• The dictum of the theory is that the volume of
employment depends on the level of effective
demand in the economy.
• Unemployment is due to deficiency of
effective demand.

• Broadly speaking, Keynes designated the term
“effective demand” to denote the total demand of
goods and services (consumption and investment) by
the community.
• Here we can say that the effective demand is the flow
of expenditure.
• As the expenditure of one becomes source of income
for the others.
• It means the consumption expenditure and the
investment expenditure by the community expresses
the total demand for goods and services.

• According to Keynes, as Income increases,
consumption expenditure also increases, but after a
certain point it does not increases in the same
proportion as increase in income. It means,
Expenditure increases along with the level of income
but at the diminishing rate.
• Here there is a gap between income and expenditure
which may be bridged by investment expenditure.
• If Investment expenditure does not increases to this
extent, the total expenditure in the economy will be
less and the effective demand will be low leading to
unemployment in the economy.

• Effective demand is determined by two factors:
A. Aggregate Demand Price:
• In the Keynesian terminology, the Aggregate demand
function refers to the schedule of maximum sale proceeds
which the entrepreneurial community actually does expect to
be received from the sale of different quantities of output,
resulting at various level of employment. The quantum of
maximum sales revenue expected from the output produced
is described as the demand price of a particular level of
employment.
• There is a positive correlation between level of employment
and the demand price.

• The aggregate demand price depends upon the total
expenditure flow of the economy, which is
determined by the spending decision of the
community as a whole.
• In a free capitalist economy, households and the firms
are the two major economic sectors which spent for
consumption and investment.
• Now, what these sectors are expected to spend in next
period is viewed as the aggregate demand price.
• This can be more simply presented with the help of a
schedule and a diagram.

ADF = f (N)
ADF= Expected sales receipt by
entrepreneurs
N= the volume of employment
f= the functional relationship

• The ADF curve drawn in the diagram is linear but it
can also be non linear.
• Its shape and slope depends on the assumptions and
nature of data relating to the aggregate demand
schedule.
B. Aggregate Supply price:
• The ”supply price” for a given quantity of commodity
refers to that price at which the seller is willing or
induced to supply that amount in the market. Hence
the supply schedule of that commodity shows the
varying level of quantities of the commodity the
seller offers for sale at the alternative prices.

• Similarly, the aggregate supply schedule for the economy
as a whole, refers to, the response of all entrepreneurs in
supplying the whole of output of the economy.
• Keynes was of the opinion that the level of output varies
with the level of employment.
• Each level of employment necessitates certain quantities
of other factors of production like land, capital, raw
materials, etc., to assist the labour employed.
• The reward paid to all factors of production will be
considered to be cost of production.
• Thus each level of employment will involve certain
amount of money cost including normal amount of profit.

• Therefore, the entrepreneur must get some minimum amount
of sales revenue to cover the total cost incurred at a given level
of employment.
• Only if the sales proceeds are high enough to cover the total
costs of production at a given level of employment and output,
the entrepreneur will be induced to provide that particular level
of employment.
• The minimum price of revenue proceeds the entrepreneur must
get from the sales of output, associated with different levels of
employments is defined as “aggregate supply price” or
“aggregate supply function”
• So, it is a schedule of various minimum amount of revenues
which must be expected to be received by the entrepreneur
class from the sale of output resulting at various levels of
employment.

In the above figure, OX represents
level of employment and OY
represents minimum sales proceeds.
AS curve represents the aggregate
supply function.
It is linear as because we have
assumed constant wage rate.
However, after the level of full
employment, the ASF will be
perfectly inelastic.
In the figure the level of full
employment is being represented by
QZ dotted line. i.e. 6 lakhs workers.
However, there are uncertainty
prevails regarding the shape of ASF as
it is depended on the Marginal
productivity of the labours.

• The intersection of aggregate demand function with the
aggregate supply function determines the level of income and
employment.
• The aggregate supply schedule represents the cost involved at
each possible level of employment.
• The Aggregate demand schedule represents expectation of
maximum receipts of the entrepreneur at each possible level of
employment.
• Thus, it shows that, as long as the receipts exceeds costs, the
level of employment will go on increasing.
• The process will continue till revenues becomes equal to costs.
Equilibrium Level of Employment – The Point of Effective
Demand

• In tabular terms shown above the point of effective demand
and equilibrium of t6he economy is at point 4 where ADP and
ASP both are 400 crores.
• In diagram, the point of effective demand of the economy is
represented at point E where ADF and ASF are intersecting
each other.
• In long run, if Aggregate Demand increases, it can be said that
the level of employment or the Point of Effective demand will
also increase.
• This can be seen in the following diagram:

• If ADF increases from ADF2 to ADF1, the point of
Effective Demand will also increase from E1 to E2 and
the level of employment will also increase from N1 to N2

• Gist of Keynesian Theory of Income and
Employment:

Theory of income and employment chap 1

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Theory of income and employment chap 1