Question

Name the three pillars of classical theory of income and employment .

Answer 1

The classical theory of income, output and employment is based on the following assumptions:

1. There is a normal situation of full employment without inflation.

2. There is a laissez faire capitalist economy without foregin trade.

3. There is perfect competition in labour, money and product markets.

4. Labour is homogeneous.

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Answer 2

 the three pillars of classical theory.

Say’s Law of Markets:

Say’s Law of Markets is the core of the classical theory of employment. Jean Baptiste Say, an early 19th century French Economist gave the proposition that “supply creates its own demand.” This is known as Say’s Law. In Say’s own words, “It is production which creates markets for goods. A product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. Nothing is more favourable to the demand of one product, than the supply of another.”

The Quantity Theory of Money and Price Level:

The validity of Say’s Law in a money economy directly depends on the classical quantity theory of money which states that the general price level changes directly and proportionately to the supply of money. Algebraically stated the theory states that MV = PT where M, V, P and 7′ are the supply of money, velocity of money, price level and the volume of transactions. The equation tells that the total money supply MV equals the total value of output PT in the economy.

Assuming V (the velocity of money) and T (the total output) to be constant, a change in the supply of money (AY) causes a proportional change in the price level (P). This is based on the assumption that money acts only as a medium of exchange.

Wages Flexibility and Employment:

During the days of the Great Depression, Professor A C. Pigou supplied the most logical part of the classical theory of employment. According, to Pigou, under free competition the tendency of the economic system is to automatically provide full employment in the labour market. Unemployment results from rigidity in the wage structure and state interference in the working of the free market economy.

When the state intervenes by recognising trade unions, passing minimum wage laws, etc., and labour adopts monopolistic behaviour, wages are pushed upto unreasonable levels and unemployment results. Prof. Pigou’s contention was that if all government interferences are removed and forces of competition are allowed to work freely, the market induced changes of wage rates will lead to full employment. As pointed out by Pigou, “With perfectly free competition……. there will always be at work a strong tendency for wage rates to be so related to demand that everybody is employed.” Professor Pigou illustrated his point by using the following equation:

N = q.Y/W

In this equation, N is the number of workers employed, q is the fraction of income earned as wages and salaries, Y is the full employment national income and W is the average money wage rate. If Y is a given, N can be increased only by a reduction in W. Thus, the key to full employment is a reduction in the real wage. To explain his point, Pigou employed a mixture of micro and macro-economics.