Classical Theory as Economics of

Full employment
Module 9
 Assumptions
•Pure competition

• Flexible wages and prices

• Motivation of self-interests

• People can not be fooled by money illusion

 Important Pillars
•Say’s law of Market
•Quantity theory of money
• Aggregate Production Function
• Labour market equilibrium
 Aggregate Production Function
• Y = F (K,L) : How much output is produced from the inputs
of capital or labor.
– More inputs of either leads to increased output.
• In most situations we assume capital is fixed at a constant
level!
• LABOR is the only variation that changes the level of output
in the economy!
• Suppose that output is produced with two or more
inputs and that we increase one input while
holding the other inputs fixed.
• Beyond some point – called the point of
diminishing returns – output will increase at a
decreasing rate.
 The Demand and Supply of Labor
• Firms hiring depends on the REAL WAGE.
– The wage paid to workers adjusted for changes in prices.
– What determines the REAL WAGE?
• Marginal Benefit > Marginal Cost
– Increase level of activity
• Marginal Cost > Marginal Benefit
– Reduce activity
• Marginal Cost = Marginal Benefit
– IDEAL!
 Changes in Real Wages Affect Workers
Two Ways:
• SITUATION 1: Workers have to decide how many hours
they want to work and how much leisure time they want.
• Make working more attractive and raise the opportunity
costs of NOT working.
– SUBSTITUTION EFFECT: Substitution of work for leisure time.
• SITUATION 2: Higher wage raises workers income for the
same hours worked. Workers may choose more leisure
over work.
– INCOME EFFECT: Leads to decreased supply of labor.
 Labor Market Equilibrium and Full
Employment
•Demand for labour and supply of labour
determine the equilibrium in the labour market.

•Relation between wage and demand

• Relation between wage and supply
• Diagram
• It assures full emplotment
 The Role of Aggregate Supply
The foundation for the Classical Model is three
basic ideas:
1.Output is produced by capital and labor, 
2.Capital is fixed in the short run, and
3. Supply and demand for labor determine the
amount of labor hired.

The third point implies that there is no

unemployment in the long run so that aggregate
supply curve is vertical.  (diagram- real GDP along X
axis and price level on Y axis)
 Summary
 * Say’s law states that supply creates its own demand and
therefore desired expenditure will be equal to actual
expenditure.
* When saving is introduced into the model , equilibrium
occurs in the market through change in interest rate so that
desired saving equals desired investment at the equilibrium
rate of interest.
•In the labour market, full employment occurs at a wage
rate at which quantity demanded equals quantity supplied.
That particular level of employment is associated with a
certain value of real GDP per year.
• In classical model , because the LRAS is vertical, the
equilibrium level of GDP is supply determined. Any changes
in aggregate demand simply change the price level.