Classical Theory of Employment: Definition, Assumptions, and Criticisms

What is the Classical Theory of Employment?

The classical theory of employment states that there is always full employment in a free capitalist closed economy in the long run.

The Classical Theory of Employment was developed by the combined contribution of classical economists, such as Adam Smith, J.S. Mill, A.C. Pigou, Ricardo, etc. The theory is based on the assumption of full employment of labor and other resources of the economy.

Classical economists believed in the stable equilibrium at full employment level as a normal situation. If employment is in actual life, then there is always a tendency towards full employment. Less than full employment is an abnormal situation that will disappear in the long run through the automatic adjustment mechanism of the economic system. Full employment refers to a situation when all the persons who are willing to work at the existing wage rate will get work.

Full employment is a situation when involuntary unemployment is zero. Involuntary unemployment occurs when a person is willing to work at the going wage rate, but cannot find a job. A person who is unemployed voluntarily, i.e. when persons are not willing to work at the prevailing wage rate, is not regarded as unemployed. Moreover, there are always some workers who are moving from one job to another. Unemployment that occurs due to the movement of people from one job to another is called frictional unemployment. Persons who are frictionally unemployed are not regarded as unemployed.

Thus, full employment does not mean achieving zero unemployment Indeed, zero unemployed is impossible in any real economy. It is now agreed that full employment exists when unemployment is about 5 to 6 percent in the economy due to frictional unemployment. In other words, full employment stands from 94 to 95 percent employment rather than 100 percent employment.

Assumptions of Classical Theory of Employment

The classical theory of employment is on the following assumptions:

  • Full employment is a normal feature of a closed capitalist economy in the long run.
  • Individuals are rational human beings and are motivated by self-interest.
  • The government should not interfere in the automatic working of the economic system and should follow the policy of laissez-faire.
  • Money acts as a medium of exchange. Individuals do not suffer from money illusion.
  • Techniques of production and organizational structure of business do not change.
  • There is the existence of perfect competition in the market (i.e. product market, labor market, and money market).
  • People spend their entire income either on consumption or on investment.

The classical theory of employment is based on the assumption of the flexibility of wages, interest, and prices. This means that wage rate, interest rate, and price level change in their respective markets according to the forces of demand and supply. Changes in these variables automatically adjust the economic system in such a way as to ensure full employment.

The working of the self-regulating mechanism under the classical system can be understood by the analysis of the following five components:

Say’s Law of Market

Say’s the law of market provides justification to the assumption of full employment. Say’s law in its simplest form means that “supply creates its own demand.”

In a barter economy, a good is produced with the purpose of exchanging it for another good. Thus, additional supply represents additional demand. In a money economy, money serves as a medium of exchange. When a factor of production (say labor) is employed, it results in the production of commodities on the one hand and generates income (in the form of payments of the factor of production) on the other. The income received is spent in the market on the purchase of goods.

Thus, the employment of a factor of production pays its own way because it increases income by an amount equal (in equilibrium conditions) to the amount taken out of the income stream by way of selling its products. Hence, Say’s law, which rules out the possibility of general overproduction and general unemployment, applies both in barter as well as in a money economy.

Product Market

Maintenance of full employment level, according to Say’s law requires that the whole of the income generated at full employment level must be spent on the purchase of the whole of the output produced at that level. The total output comprises consumer goods (C) and investment goods (I). Again total income is partly spent on consumer goods (C) and partly saved (s). Hence, the part of income that is not consumed (i.e. S) must be spent on investment goods.

According to classical economists (classical theory of employment), equality between saving and investment is brought about through interest rate flexibility. Saving is a positive function of the rate of interest; saving will be more at the higher interest rate and less at the lower interest rate. Investment is a negative function of interest rate; investment increases at a low-interest rate and decreases at a higher interest rate.

The equilibrium rate of interest is determined at the level where saving and investment are equal. At this level whole of the full employment, the output is purchased. If saving exceeds investment, the rate of interest will fall. This will discourage saving and encourage investment, thus making saving and investment once again equal.

Money Market

Irving Fisher’s Equation of Exchange, PT = MV + M’V’, states that the total value of output is equal to total expenditure on final goods and services. According to classical economists, the long-run rate of final goods and services (T) remains constant at the full employment level. Similarly, V and V. also remain constant. Thus, the price level (P) is determined by the supply of money (M and M’) and there is a direct relationship between M and P changes in the money supply lead to proportional changes in the price level.

Labor Market

Flexibility in wage rate, according to the classical economists, assures labor equilibrium with full employment. The real wage rate is determined by the forces of demand and supply in the labor market.

Demand for labor is a negative function of the real wage rate; demand for labor increases with a fall in the real wage rate and decreases with a rise in the real wage rate. The supply of labor is a positive function of the real wage rate; the supply of labor increases with a rise in the real wage rate and decreases with a fall in the real wage rate.

The real wage rate is determined at the level where the demand for labor and supply of labor is equal. This level also represents the full-employment equilibrium level. If there exists some unemployment, the unemployed will compete for jobs and the real wage rate will fall.

A fall in the real wage rate will lead to an increase in the demand for labor and an increase in the supply of labor. This will remove unemployment. Thus, the flexibility of the real wage rate ensures full employment.

Production Function

According to classical economists, total output is a decreasing function of the number of workers employed. It is due to the operation of the law of diminishing returns but, at full employment level output remains stable.

Criticisms of the Classical Theory of Employment

Limitations of the classical theory of employment can be pointed out as follows:

Employment and Output

British economist J.M. Keynes criticized the classical theory of employment and output publishing a book “The General Theory of Employment, Interest, and Money” in 1936 A.D. Doe to the worldwide great depression in the 1930s classical theory failed.

The wrong assumption of full employment

According to classical economists, there is always full employment in the economy without any intervention of the government. But according to J.M. Keynes, there is underemployment. For full employment, there is a need for government intervention.

State Interventions

According to classical theory, an economy is a free enterprise economy without government. But in reality, for fiscal policy, the balance of payments, tax, and subsidies, there is a need for government.

Supply does not create its own demand itself

To increase the demand for the product the government should develop different infrastructures to increase the income level of the people and their job opportunities. Similarly, to maintain business government should purchase the products of businesses.

The wrong assumption of the long-run analysis

The classical theory of employment always talks about every activity based on the long run. They forget the present condition. But, Keynes argued the greater importance of short-run equilibrium. Without appropriate use of resources in the short run, in the long run to be equilibrium automatically is not realistic.

A wage cut policy is not a solution

Because there is a strong labor union. Due to labor unions, any industry or organization has no full authority to directly fire its employees.

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