Name - Neha

Class – M.A. (Economics), 1st semester

College - St. Aloysius’ college, Jabalpur

Subject - Macro Economics

Submitted to – Dr. Reeta Chauhan

Topic - Unit 4

THEORIES OF EMPLOYMENT
Q.1. Explain Keynesian theory of employment
Ans. As per Keynes theory of employment, effective demand signifies
the money spent on the consumption of goods and services and on
investment.

The total expenditure is equal to the national income, which is

equivalent to the national output.

Therefore, effective demand is equal to total expenditure as well as

national income and national output.

The theory of Keynes was against the belief of classical economists that
the market forces in capitalist economy adjust themselves to attain
equilibrium. He has criticized classical theory of employment in his
book. Vie General Theory of Employment, Interest and Money. Keynes
not only criticized classical economists, but also advocated his own
theory of employment.
His theory was followed by several modern economists. Keynes book
was published post-Great Depression period. The Great Depression had
proved that market forces cannot attain equilibrium themselves; they
need an external support for achieving it. This became a major reason
for accepting the Keynes view of employment.

The Keynes theory of employment was based on the view of the short
run. In the short run, he assumed that the factors of production, such
as capital goods, supply of labor, technology, and efficiency of labor,
remain unchanged while determining the level of employment.
Therefore, according to Keynes, level of employment is dependent on
national income and output.

In addition, Keynes advocated that if there is an increase in national

income, there would be an increase in level of employment and vice
versa. Therefore, Keynes theory of employment is also known as theory
of employment determination and theory of income determination.

Principle of Effective Demand:

The main point related to starting point of Keynes theory of
employment is the principle of effective demand. Keynes propounded
that the level of employment in the short run is dependent on the
aggregate effective demand of products and services.

According to him, an increase in the aggregate effective demand would

increase the level of employment and vice-versa. Total employment of
a country can be determined with the help of total demand of the
country. A decline in total effective demand would lead to
unemployment.

As per Keynes theory of employment, effective demand signifies the

money spent on the consumption of goods and services and on
investment. The total expenditure is equal to the national income,
which is equivalent to the national output. Therefore, effective demand
is equal to total expenditure as well as national income and national
output.

The effective demand can be expressed as follows:

Effective demand = National Income = National Output

Therefore effective demand affects employment level of a country,

national income, and national output. It declines due to the mismatch
of income and consumption and this decline lead to unemployment.

With the increase in the national income the consumption rate also
increases, but the increase in consumption rate is relatively low as
compared to the increase in national income. Low consumption rate
leads to a decline in effective demand.

Therefore, the gap between the income and consumption rate should
be reduced by increasing the number of investment opportunities.
Consequently, effective demand also increases, which further helps in
reducing unemployment and bringing full employment condition.

Moreover, effective demand refers to the total expenditure of an

economy at a particular employment level. The total equal to the total
supply price of economy (cost of production of products and services)
at a certain level of employment. Therefore, effective demand refers to
the demand of consumption and investment of an economy.

Determination of Effective Demand:

Keynes has used two key terms, namely, aggregate demand price and
aggregate supply price, for determining effective demand. Aggregate
demand price and aggregate supply price together contribute to
determine effective demand, which further helps in estimating the level
of employment of an economy at a particular period of time.

In an economy, the employment level depends on the number of

workers that are employed, so that maximum profit can be drawn.
Therefore, the employment level of an economy is dependent on the
decisions of organizations related to hiring of employee and placing
them.

The level of employment can be determined with the help of aggregate

supply price and aggregate demand price. Let us study these two
concepts in detail.

Aggregate Supply Price:

Aggregate supply price refers to the total amount of money that all
organizations in an economy should receive from the sale of output
produced by employing a specific number of workers. In simpler words,
aggregate supply price is the cost of production of products and
services at a particular level of employment.

It is the total amount of money paid by organizations to the different

factors of production involved in the production of output. Therefore,
organizations would not employ the factors of production until they can
recover the cost of production incurred for employing them.

A certain minimum amount of price is required for inducing employers

to offer a specific amount of employment. According to Dillard, “This
minimum price or proceeds, which will just induce employment on a
given scale, is called the aggregate supply price of that amount of
employment.”

If an organization does not get an adequate price so that cost of

production is covered, then it employs less number of workers.
Therefore the aggregate supply price varies according to different
number of workers employed. So, aggregate supply price schedule Id
Tut can be prepared as per the total number of workers employed.

Aggregate supply price schedule is a schedule of minimum price

required to induce the different quantities of employment. Thus, higher
the price required to induce the different quantities of employment,
greater the level of employment would be. Therefore, the slope of the
aggregate supply curve is upward to the right.

Aggregate Demand Price:

Aggregate demand price is different from demand for products of
individual organizations and industries. The demand for individual
organizations or industries refers to a schedule of quantity purchased at
different levels of price of a single product.

On the hand, aggregate demand price is the total amount of money

that an organization expects to receive from the sale of output
produced by a specific number of workers. In other words, the
aggregate demand price signifies the expected sale receipts received by
the organization by employing a specific number of workers.

Aggregate demand price schedule refers to the schedule of expected

earnings by selling the product at different level of employment Mo
higher the level of employment, greater the level of output would be.

Consequently, the increase in the employment level would increase the

aggregate demand price. Thus, the slope of aggregate demand curve
would be upward to the right. However, the individual demand curve
slopes downward.

The basic difference between the aggregate supply price and aggregate
demand price should be analyzed carefully as both of them seem to be
same. In aggregate supply price, organizations should receive money
from the sale of output produced by employing a specific number of
workers.

However, in aggregate demand price, organizations expect to receive

from the sale of output produced by a specific number of workers.
Therefore, in aggregate supply price, the amount of money is the
necessary amount that should be received by the organization, while in
aggregate demand price the amount of money may or may not be
received.

Determination of Equilibrium Level of Employment:

The aggregate demand price and aggregate supply price help in
determining the equilibrium level of employment.

The aggregate demand (AD) and aggregate supply (AS) curve are used
for determining the equilibrium level of employment, as shown in
Figure-3:

In Figure-3, AD represents the aggregate demand curve, while AS

represents the aggregate supply curve. It can be interpreted from
Figure-3 that although the aggregate demand and aggregate supply
curve are moving in the same direction, but they are not alike. There
are different aggregate demand price and aggregate supply price for
different levels of employment.

For example, in Figure-3, at AS curve, the organization would employ

ON1 number of workers, when they receive OC amount of sales
receipts. Similarly, in case of AD curve, the organization would employ
ON1 number of workers with the expectation that they would produce
OH amount of sales receipt for them.
The aggregate demand price exceeds the aggregate supply price or vice
versa at some levels of employment. For example, at ON1 employment
level, the aggregate demand price (OH) is greater than the aggregate
supply price (OC). However, at certain level of employment, the
aggregate demand price and aggregate supply price become equal.
At this point, aggregate demand and aggregate supply curve intersect
each other. This point of intersection is termed as the equilibrium level
of employment. In Figure-3, point E represents the equilibrium level of
employment because at this point, the aggregate demand curve and
aggregate supply curve intersect each other.

In Figure-3, initially, there is a slow movement in the AS curve, but after

a certain point of time it shows a sharp rise. This implies that when a
number of workers increases initially, the cost incurred for production
also increases but at a slow rate. However, when the amount of sales
receipt increases, the organization starts employing more and more
workers. In Figure-3, the ON1 numbers of workers are employed, when
OT amount of sales receipts are received by the organization.
On the other hand, the AD curve shows a rapid increase initially, but
after some time it gets flattened. This means that the expected sales
receipts increase with an increase in the number of workers. As a
result, the expectations of the organization to earn more profit
increases. As a result, the organization start employing more workers.
However, after a certain level, the increase in employment level would
not show an increase in the amount of sales receipts.

In Figure-3, before reaching the employment level of ON2, the

employment level keeps on increasing as the organizations want to
higher more and more workers to get the maximum profit. However,
when the employment level crosses the ON21 level, the AD curve is
below the AS curve, which shows that the aggregate supply price
exceeds the aggregate demand price. As a result, the organization
would start incurring losses; therefore would reduce the employment
rate.
Thus, the economy would be in equilibrium when the aggregate supply
price and aggregate demand price become equal. In other words,
equilibrium can be achieved when the amount of sales receipt
necessary and the amount of sales receipt expected to be received by
the organization at a specified level of employment are equal.

Q.2. Explain Say’s law of market.

Ans. An important element of classical economics is Say’s Law of
Markets, after J.B. Say, a French economist who first stated the
law in a systematic form.

Briefly stated, this law means that ‘supply always creates its own
demand.’ In other words, according to J.B. Say, there cannot be general
overproduction or general unemployment on account of the excess of
supply over demand because whatever is supplied or produced is
automatically exchanged for money.

In an exchange economy whatever is produced represents the demand

for another product because whatever is produced is easily sold.

Whenever additional production takes place in the economy, necessary

purchasing power is also generated at the same time to absorb the
additional supply; hence, there is no scope of supply exceeding demand
and causing unemployment. This law was the basis of their assumption
of full employment in the economy which rested on the plea that
income is spent automatically at a rate which will always keep the
resources fully employed.

Savings, according to classical are just another form of spending; all

income, they believed, is partly spent on consumption and partly on
investment. There is no ground to fear a break in the flow of income
stream in the economy. Hence there cannot be any general over-
production or unemployment.

The classical economists always assumed a state of employment in the

economy. The normal situation in an economy, according to them was
full employment equilibrium. Less than full employment, they believed,
was an abnormal situation. Classical always held that there are no
lapses from full employment equilibrium and even if there are any,
there is always a tendency to return to full employment. This belief of
the classical economists was based on the views of a French economist,
J.B. Say (1767-1832).

J.B. Say made popular the ideas of Adam Smith in France and on the
European continent. His law of markets which Galbraith described as
having had the status of an article of faith with classical economists for
over a hundred years is the formal expression of the idea that
widespread and involuntary unemployment because of general over-
production is impossible. In other words, there cannot be any
involuntary unemployment because of a deficiency of effective demand
or total demand.

In his analysis of the market mechanism, J.B. Say noted down: “…a
product is no sooner created, than it from that instant, affords a market
for other products to the full extent of its value. When the producer has
put the finishing hand to his product, he is most anxious to sell it
immediately, lest the value should vanish in his hands. Nor is he less
anxious to dispose of the money he may get for it; for the value of
money is also perishable. But the only way of getting rid of money is
the purchase of some product or other. Thus, the mere circumstance of
the creation of one product immediately opens a vent for other
products.”

Briefly stated, it means that “supply creates its own demand”. He

asserted that there cannot be any general over-production or general
unemployment in the economy as whatever is produced is
automatically consumed. In other words, every producer who brings
goods lo the market does so only to exchange them for other goods.

Say believed that people did not work for its own sake but to obtain
other goods and services that go to satisfy their wants. To be employed
simply meant to work in a field or to start a shop and to sell one’s own
product in the market. The organisation of the economy was simple
under which people spent on tools and consumer goods. Saving and
investment were not separate processes.

The producer sold his product and not his labour. Products were
exchanged for products. Ricardo expressed Say’s Law of Markets in the
following words: “No man produces but with a view to consume or sell,
and he never sells but with an intention to purchase some other
commodity which may be useful to him, or which contributes to future
production. By producing, then tie necessarily becomes either the
consumer of his own goods or the purchaser and consumer of the
goods of some other person. Productions are always bought by
productions; money is only the medium by which the exchange is
effected.”

Say believed that during the process of production necessary

purchasing power is generated which absorbs the additional supply, for
example, when a new car is manufactured, necessary purchasing power
is simultaneously generated in the form of wages, profits etc. so that
the car is used. Hence there is no possibility of the aggregate demand
becoming deficient.

“Say’s Law, in a very broad way, is description of a free exchange

economy. So conceived, it illuminates the truth that the main source of
demand is the How of factor incomes generated from the process of
production itself. A new productive process, by paying out income to its
employed factors, generates demand at the same time that it adds to
supply.” Say, no doubt, admitted that supply of a particular commodity
may exceed its demand temporarily on account of the wrong
calculations of businessmen, but general overproduction and hence
general unemployment is impossible.

He admitted that specific commodities might be overproduced but a

general glut in the sense of a general depression was unthinkable, for
the very process of production created the required effective demand
necessary to absorb total output. If, however, due to some mistake,
over-production comes to exist in respect of a particular industry, it will
be corrected automatically when businessmen suffer losses and switch
over from the production of goods they cannot sell to the production of
goods they can sell. Say was supported in his view by Ricardo and Mill
for they also held the view that a general glut of the market could not
occur.

Assumptions:
The orthodox statement as enunciated above is based, more or less,
on the following assumptions:
(i) That the free enterprise system based on price mechanism provides
a place for growing population and an increase in capital.

(ii) In an expanding economy new firms and workers find their way into
the productive process, not by displacing others but by offering their
own products in exchange.

(iii) The extent of the market is not limited i.e., incapable of expansion.
The extent of the market is as big as the volume of products offered in
exchange.

(iv) No necessity on the part of the government to intervene in business

matters so that the attainment of automatic adjustment is facilitated.
(v) Flexibility of interest rates and long period were considered
essential for its successful working.

J.S. Mill has supported Say’s Law and regarded it as extremely

important. The older formation of Say’s law by David Ricardo and James
Mill was cast in terms of a society that has become mostly a matter of
the past—a society in which producers were self-employed either as
peasant, proprietors, craftsmen, or as individual proprietors.

Mill took note of the depressed state of the market accompanying a

crisis. At such times “…everyone dislikes to part with ready money, and
many are anxious to procure it at any sacrifice.” Depression, Mill said, is
“a glut of commodities or a dearth of money. It is a temporary
derangement of markets caused by contraction of credit.”

Such periodic depressions, Mill felt, do not go to contradict Say’s law.

Such maladjustments or disturbances do not prove that there are not
powerful hidden forces tending to restore full employment equilibrium.
Marshall in his Principles (1890), strongly supported Mill’s views. Lack
of confidence, Marshall felt, was the chief cause of depression. When
confidence is shaken, though men have the power to purchase, they
may not choose to use it. American orthodox economist, F.M. Taylor, in
his Principles (1921) endorsed Say’s law. Business depressions, in his
opinion, do not disprove Say’s law.

He expressed the view that in the short-run the smooth and automatic
process of exchange of products may be broken by temporary
disturbances but these do not invalidate the efficacy of fundamental
forces (which Say’s law sought to illuminate) tending automatically
towards full employment.

Implications of Say’s Law:

1. According to Say’s Law of markets there is automatic adjustment in
the economy as whatever is produced is consumed. In other words,
every output brings along with it the necessary purchasing power in
circulation which will lead to its sale, so that there is no over-
production. Hence, there is no necessity on the part of the government
to intervene in business matters as that will come in conflict with the
automatic adjustment mechanism of Say’s Law of Markets.

2. Since supply creates its own demand, hence general unemployment

and over-production are impossible.

3. Again according to Say’s Law of Markets as long as there are

unemployed resources in the economy it is profitable to employ them
because they can pay their own way. In other words, when the
unemployed resources are used, they lead to more production so as to
cover their own costs.

4. Another important implication is the mechanism of flexibility in the

rate of interest, which brings about equality between savings and
investment. To classicals, saving is another form of spending. Therefore,
whatever is saved is necessarily invested. Hence, there is no possibility
of the deficiency of aggregate demand and the mechanism through
which it is maintained is the rate of interest.

5. Further implication of Say’s Law of Markets flows from the Pigovian

formulation, i.e., wage rate is the mechanism which helps to bring
automatic adjustment, i.e., a lowering of the wage rate will lead to full
employment under free and perfect competition. The government
should, as far as possible, ensure a free market and there should be
absolutely no regulation of wage rates.

6. Because goods are exchanged for goods, money acts as a veil and has
no independent role to play. Money is only a medium of exchange to
facilitate transactions.
 Q.3. Compare Classical and Keynes Theory
Ans. The following points highlight the six main points of differences
between Classical and Keynes Theory.

Difference # 1. Assumption of Full Employment:

Classical theorists always assumed full employment of labour and other
resources.

To them, full employment was a normal situation and unemployment

was an abnormal situation.

According to Classicals, even if there is less than full employment in the

economy, there is always a tendency towards full employment.

By the term full employment of the available resources, the classical

economists meant that ‘there is no involuntary unemployment’. If there
is unemployment in the economy, classicists felt that it was due to the
existence of monopoly in industry and governmental interference with
the free play of the forces of competition in the market or it may be
due to the imperfections of the market owing to immobility of the
factors of production.

If these limitations could somehow be eliminated, full employment,

according to classical economists, would always exist. Hence, the best
way to ensure full employment for the Government was to pursue the
policy of ‘laissez faire’ capitalism under which free competitive market
forces were allowed to have full and free play.

Difference # 2. Emphasis on the Study of Allocation of Resources Only:

The existence of ‘full employment’ being a normal situation in the
classical scheme, it followed that factors of production are always fully
employed and there is no further scope for additional employment of
resources in new industries. The choice, according to classsicals, was
not between employment and unemployment but between
employment here and employment there, i.e., increase in production in
one direction could be achieved only at the cost of some decrease in
another direction in the economy.

In other words, classicals fell there could not be any significant

misallocation of resources as the price mechanism, acting as an
‘invisible hand’ would achieve the best, the most efficient allocation of
resources. Since the optimum allocation of a given quantity of
resources was the main subject-matter of classical economics, it was
but natural that they did not discuss the problem of national output,
income or employment.

With their assumption of full employment, there obviously could not be

any change in the real national income of the community through
additional employment of resources. What could possibly be done,
given, the composition and volume of the real national income, was a
more efficient allocation of the given resources.

As such, they remained concerned with the special case of full

employment and not with the general factors that determine
employment at any time. In brief, the well-known theory of value,
distribution and production formed the ‘core’ of classical economics.
That unemployment of resources could also persist to pose a problem
did not occur to them at all.

Difference # 3. Policy of ‘Laissez Faire’:

Classicals had great faith in the philosophy of laisez-faire capitalism,
which meant ‘leave alone’ or ‘let alone’ in business matters. Laissez-
faire capitalism would not tolerate any kind of intervention by the
Government in business matters; they rather considered it a positive
hindrance in the free working of the market economy.
Classicals believed in Laissez-faire capitalism as it was the traditional
model of study from the very’ beginning. Classicals had great faith in
price mechanism, profit-motive, free and perfect competition and the
self-adjusting nature of the system. They felt that if the system is
allowed to work freely without any encroachments on the part of the
state, it has potentialities to overcome the maladjustments in the
economic system, if there are any.

Difference # 4. Wage-Cut Policy as a Cure for Unemployed Resources:

Classicals further believed that involuntary unemployment could be
easily cured by cutting wages down through office and perfect
competition which always exists in the labour market. They argued that
so long as labour does not demand more than what it is ‘worth’ or
more than its marginal productivity, there in no possibility of persistent
unemployment in the economy.

Classicals believed that employment is determined by the wage

bargains between the workers and employers, therefore, wage-cuts will
reduce unemployment; such a policy if pursued vigorously can restore
full employment as well. Basing their reasoning on the existence of free
and perfect competition in the product and labour markets, classicals
argued that the unemployed workers will cut down wages leading to a
fall in prices, which, in turn, will encourage demand giving a fillip to
sales.

As a result of all this, more will be produced as more is demanded and

employment would increase because workers are employed at lower
wages to increase production. Wage-cuts, thus occupied a central place
in the classical scheme of reasoning for automatic functioning of the
capitalist economy at full employment.

Difference # 5. Assumption of Neutral Money:

Classicals did not give much importance to money treating it only as a
medium of exchange its role as a store of value was not considered. To
them, money facilitated the transactions of goods but had no effect on
income, output and employment. They considered it as a ‘veil’ which
hides real things goods and services. In other words, they assumed that
people have one motive for holding money, i.e. the transaction motive.

Classicals completely ignored the precautionary and speculative

motives for holding money. In short, they never recognised that money
could also influence the level of income, output and employment. In
contrast to this view, Keynes considered money on as on active force
that in influences total output.

Difference # 6. Interest Rate as the Equilibrating Mechanism between

Saving and Investment:
Classicals would give the pride of place to the rate of interest as the
equalizer of saving and investment at full employment of resources.
The implied assumption was that both saving and investment are highly
sensitive to changes in the rate of interest.

The belief was firmly rooted that saving and investment can be equal
only at full employment, and that ‘under employment equilibrium’ is a
disequilibrium situation which would not last long in an atmosphere of
wage price flexibility under the pressure of competition.

Q.4. Explain pigou’s version of Labour market.

Ans. Pigou’s Version has given final touch to classical theory of
employment, who formulated Say’s law in terms of labour
market. According to Pigou, under free competition the tendency
of economic system is to automatically provide full employment
in labour market. Flexibility in wage rate assures equilibrium in
labour market with full employment. Real wage rate is
determined by the forces of demand and supply of labour in
 market. Demand for labour is negative function of real wage rate.
In classical model of employment, changes in money wages and
real wages are directly related and are proportional. Therefore,
demand for labour increases with a fall in real wage rate and
decreases with rise in real wage rate.

On the other hand, supply of labour is positive function of real wage

rate. Supply of labour increases if wage rate increases and it decreases
when wage rate falls. Wage rate is determined at the level where
demand for labour and supply of labour are equal. This level of wage
rate represents full employment equilibrium level. According to 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. He has given a equation to explain it

N = qY/W, here N is the number of workers employed, q is fraction of

income earned as wages, Y is national income and W is money wage
rate, N can be increased by reducing W. Thus, the key to full
employment is a reduction in money wage. This is explained in
following figures.
In above figure-(A), SL is supply of labour and DL is demand for labour.
At point e, two curves interest each other, it is point of full
employment. NF and the real wage wage w/p at which full employment
is recurred. If the real wage increased at a higher level than w/p. Supply
of labour exceeds the demand labour by TR. In this situation
N1NF number of labours are unemployed. Unemployment dis-appears
only when the wage is reduced to w/p level. Thus full employment is
attained.

In lower figure-(B), MPL is marginal productivity of labour which slopes

downward as more labour are employed. Since every labour is paid
wages equal to its marginal product, therefore the full employment
level NF is reached when the wage rate falls from w/p1 to w/p

Q.5. Mention Criticisms of Keynesian theory

Ans. Criticisms of Keynesian Theory:
Though Keynes has revolutionised the modern economic thinking, his
analysis has some inherent weakness:
(i) Keynesian theory is not a complete theory of employment in the
sense that it does not provide a comprehensive treatment of
unemployment, (a) It deals only with cyclical unemployment and
ignores other forms of unemployment, such as, frictional
unemployment, technological unemployment, etc. (b) It does not tell us
how to secure full and fair employment.
(ii) There exists no direct and determinable relationship between
effective demand and volume of employment. It all depends upon the
relationship between wage rate, prices and money supply. Moreover, in
modern times, most countries are facing the problem of stagflation
(i.e., unemployment with inflation).
(iii) Keynesian theory assumes perfect competition which is not a very
realistic assumption. He completely ignored the problems of monopoly.
(iv) Keynesian theory deals with short-run phenomenon. It pays no
attention in the long-run problems of the dynamic economy.
(v) Keynesian economics is static in nature. It ignores the time lags in
the behaviour of economic variables. However, the post-Keynesians
have filled this gap by providing truly dynamic analysis.
(vi) Keynesian theory is purely macro-economic theory which deals with
aggregates. Micro-economic problems have been completely ignored.
(vii) Keynes assumes a closed economy. In this way, his analysis does
not take into account the impact of international trade on the growth
of employment and income of the economy.
(viii) Keynesian economics is, by and large, a depression economics. It is
the product of Great Depression of 1930s and attempts to suggest
measures to solve the problems of unemployment. It pays little
attention to deal with the inflationary situation.
(ix) It is basically a capitalistic theory. It examines the determinants of
employment in a free enterprise economy. Though Keynes has
suggested government intervention and controlled capitalism, his
theory fails to deal socialist economic system.
(x) Keynesian theory is not applicable in underdeveloped countries.
Keynes deals with the problem of cyclical unemployment, whereas the
underdeveloped countries face the problems of chronic unemployment
and disguised unemployment.
As a remedial measure, Keynes suggested expansion of aggregate
demand and discouragement to saving, while the underdeveloped
countries need curbs on spending, and increases in saving for capital
formation and for large-scale investment to break the vicious circle of
poverty.