The Classical Theory of Employment
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 classical economists believed in the stable equilibrium at full employment level as a normal situation.
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. If there is not full employment in the actual life, then there is always a tendency towards full employment. Less than full employment is an abnormal situation which will disappear in the long-run through automatic adjustment mechanism of the economic system.
Assumption :
The classical theory of employment is on the following assumptions:
1. Full employment is a normal feature of a free capitalist closed economy in the long-run.
2. Individuals are rational human beings and are motivated by self-interest.
3. Money acts as a medium of exchange. Individuals do not suffer from money illusion.
4. Techniques of production and organizational structure of business do not change.
5. There is existence of perfect competition in all markets (i.e. product market, labour market and money market)
6. People spend their entire income either on consumption or on investment.
7. Wages, interest and price level are flexible.
8. There is operation of law of diminishes returns in the productivity of labour.
On the basis of these assumptions, the classical theory can be explained considering labour market as shown below. This concept can be extended to other markets also.
In the upper panel of the figure, demand curve for labour (DL) and supply curve of labour (SL) are intersected at point E where DL = SL and equilibrium real wage rate is determined as WF. If real wages is more than WE, there will be excess supply of labour (DL < SL) i.e., unemployment. In such competition among case, the labour reduces the real wage to WF. This is possible because of wage flexibility in the absence of labour union intervention. Similarly, if real wage is below WF, due to excess demand, real wage increase to WF.
In the lower panel of the figure, production function is shown by Q = f(L,K). This function shows the different level of output at different level of employment. When labour market is in equilibrium, LF number of labour is employed and corresponding full employment output is QF. Any fluctuation in QF is temporary, as explained by the Say's Law of market. It states that supply creates its own demand. To produce goods and services land, labor, capital and entrepreneurship are used which are rewarded in terms of rent, wages, interest and profit respectively which in turn creates demand for goods and services in the market. Hence, Aggregate Supply (AS) or production has equal Aggregate Demand (AD). The over or under production is only a temporary phenomena.
In the same way, interest rate flexibility helps to maintain equality between saving and investment.
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