Unit:2

Theory of Employment and Wages

and Employment

Prepared by Dr. Taral Patel

Theory of Employment and Wages and Employment

 Classical theory of Employment

 Say’s Law of Market
 Pigou’s Wage-cut theory
 Keynesian Theory of Income and Employment
 Theory of Effective Demand
Classical theory of Income and Employment

• The entire economic premise of the classical

economists was based on the assumption of
full employment of labour and other economic
resources.
• They were of the opinion that the economy
operates in the stable equilibrium situation in
the long run and any deviation thereto was
regarded as abnormal.
 Cont.
• Along with that, they also made an assumption
of perfect competition, fr4ee capitalist
economy and optimum use of resources in
long run.
• Here full employment does not mean the total
absence of the unemployment but there can be
frictional unemployment of temporary nature,
or seasonal unemployment.
Assumption of the classical theory of Income
and Employment
1. Perfect Competition

2. Wage- Price Flexibility

3. Homogeneous Labour

4. Constant stock of capital and technology

5. Liaises Faire Economy

6. All the units produced are sold in the market

 Say’s Law of Market (Supply creates its own Demand) 

• J.B. Say, a French economist of 19th century, arrested that,

“Supply creates its own Demand.” this appears to be simple
proposition but has had many different meanings, and many
sets of reasoning.
• According to this concept: Whenever any product is produced,
the demand of that product is also simultaneously generated
on account of or through the process of payment of
remuneration to the factors of production.
• In other words every output produced, results in an equivalent
demand being generated which leads to its sale so that there is
no surplus output or over production.
• Say’s law is applicable both in barter economy and in money
economy.
Assumptions under Say’s Law
1. Optimum Allocation of Resources

2. Perfect Equilibrium

3. Perfect Competition

4. Market Economy

5. Laissez Faire Policy of the government

6. Elastic market

7. Market Automatism

8. Circular Flow

9. Saving-Investment Equality

10. Long term concept

 A. Say’s Law in Barter Economy:
• In barter economy, the producers undertake to produce
the goods either to consume or to exchange them for
other goods which they need for consumption.
• In any case they create a demand for goods which is
equal to the supply of goods they have produced. “It is
production which creates market for goods: no sooner a
product is created, from that instant i8t affords a market
for other product to the full extent of its value. Thus, a
producer himself becomes a consumer for his own
product or somebody else’s product.
• In the words of J.S. Mill “all sellers are inevitably and
by meaning of the word buyer.”
B. Say’s Law in Money Economy:
• In money economy, people receive money in exchange
of the goods that they have produced. This implies that
the supply of product, through the process of production,
generates necessary income- occurring to the factors of
production in the form of rent, wages, interest, profits,
etc. to demand the goods produced so that an equivalent
demand is created in accordance with the supply. So we
can say that the main source of demand is the flow of
incomes generated from the process of production itself.
• However, in money economy, people may not spent all
the money income that they have received. They may
decide to save a part of their income.
 Cont..
• According to classical writers, the interest rate
mechanism would ensure the conversion of
saving into investment to ensure full employment.
• If people decide to save more than before, total
savings in the economy would increase leading to
fall in interest rates, which would encourage
entrepreneurs to invest more.
• The investments will increase till it becomes equal
to total savings. • So the income not spent for
consumption goods would be spent for
investment by entrepreneurs.
 Criticisms of Say’s Law:
Criticisms of Say’s Law:
1. The assumption of perfect competition is
unrealistic.
2. Savings and investments are not continuous
process.
3. Investment is mainly influenced by the Marginal
Efficiency of Capital and not solely on the changes
in the rate of interest.
4. According to Keynes, equilibrium can be attained at
any level below the full employment situation also.
 Effective Demand
• The principle of effective demand is basic to
Keynes’ general theory of employment.
Effective demand, which is the sole determinant
of employment, is the logical starting point of
Keynes’ theory of employment.
• Employment depends upon effective demand
and unemployment is the result of deficiency of
effective demand. As employment increases,
output and real income also increases.
 Cont..
• A fundamental principle is that as the real income
increases, consumption also increases, but by less
than the increase in income. Therefore, in order to
have sufficient demand to sustain an increase in
employment, there must be an increase in investment
equal to the gap between income and consumption
demand out of that income.
• In other words, employment cannot increase unless
investment increases. This is the core of the principle
of effective demand.
• Determinants of Effective Demand:
• Effective demand depends upon aggregate
demand and aggregate supply. It refers to the
point of intersection between aggregate demand
function and aggregate supply function. This
point also determines the volume of employment.
• Just as in the Marshallian analysis, price is
determined by the forces of market demand and
supply, similarly in the Keynesian analysis,
effective demand is determined by the forces of
aggregate demand and aggregate supply.
 There are two determinants of
effective demand:
1. Aggregate Demand Price
• “The aggregate demand price for the output of any
given amount of employment is the total sum of
money or proceeds, which is expected from the sale
of the output produced when that amount of labour is
employed.”
• Thus the aggregate demand price is the amount of
money which the entrepreneurs expect to get by
selling the output produced by the number of men
employed.
• Aggregate Supply Price:
When an entrepreneur gives employment to certain amount
of labour, it requires certain quantities of co-operant factors
like land, capital, raw materials, etc. which will be paid
remuneration along with labour. Thus each level of
employment involves certain money costs of production
including normal profits which the entrepreneur must cover.
“At any given level of employment of labour aggregate supply
price is the total amount of money which all the
entrepreneurs in the economy, taken together, must expect to
receive from the sale of the output produced by that given
number of men, if it is to be just worth employing them.
Aggregate Supply Schedule
Factors affecting AD and AS
 Determination of Effective Demand

• The level of employment is determined at the point where the

aggregate demand price equals the aggregate supply price.
• In other words, it is the point where what entrepreneurs
expect to receive equals what they must receive and their
profits are maximised. This point is called the effective
demand and here entrepreneurs earn normal profits.
• So long as the aggregate demand price is higher than the
aggregate supply price, the prospects of getting additional
profits are greater when more workers are provided
employment. The proceeds expected (revenue) rise more than
the proceeds necessary (costs).
• This process will continue till the aggregate demand price equals the
aggregate supply price and the point of effective demand are
reached. This point determines the level of employment and output in
the economy. The point of effective demand is, however, not
necessarily one of full employment but of underemployment
equilibrium.
• If the entrepreneurs try to provide more employment after this point,
the aggregate supply price exceeds the aggregate demand price
indicating that the total costs are higher than the total revenue and
there are losses. So the entrepreneurs will not employ workers
beyond the point of effective demand till the aggregate demand price
rises to meet the aggregate supply price at the new equilibrium point
which may be one of full employment.
Determination of employment with effective
demand
• Thus, in Keynes’ theory, unemployment is due
to the deficiency of effective demand. Only by
stimulating effective demand can a higher
level of employment be achieved. However,
Keynes goes on arguing that equi­librium level
of employment will not neces­sarily be at full
employment.
• A capitalist economy will always experience
underem­ployment equilibrium—an equilibrium
situ­ation less than full employment. Full employ­
ment, according to Keynes, can never be achieved.
In Keynes’ scheme of things, both consumption
and investment cannot be raised enough to employ
more work force. Therefore, he recommends
government to come forward and take appropriate
action to cure unemploy­ment problem.
• This means that aggregate de­mand is now the sum
total of all consumption, investment and
government expenditures. It is because of the
multiplier effect of both pri­vate investment
expenditure and government expenditure, that there
will be larger income, output and employment. But
equilibrium in the economy will be established at
less than full employment situation because of (i)
wage rigidity, (ii) interest inelasticity of investment,
and (iii) liquidity trap
 Criticisms of Keynesian Theory
(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 behavior 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.
 Classical View of
Wages and Employment
• The classical economists held the view that the economics system
automatically adjusted itself at the level of full employment
through wage price flexibility.
• A cut in money wages will lower marginal production costs and as
a result, lead to increase in output and employment.
• The output ( and hence employment) will increase because
reduction in production cost will enable the producers to lower
prices and stimulate demand.
• According to this view unemployment exists because wages are
kept at a higher level than what employers consider worthwhile.
• So long as there is some involuntary unemployment wages and
price must continue to fall.
• This will lead to increase in investment . Output and income , until
unemployment is eliminated.
 Assumption
• A cut in money wage result in reduction in the
real wage. It is reduction in real wage which
will stimulate investment and increase output
and employment.
• Reduction in real wage without a
corresponding fall in prices widens profit
margin, and hence provides incentives to the
producers to increase investment.
 Criticism
• Keynes severely criticized the classical view.
• The main flaw is that the classical economists
have ignored the demand aspect.
• They hold that reduction in wages will leave that
aggregate effective demand.
• The classical economists simply saw that when
wages in a particular industry were reduced,
profit there increased resulting large output and
employment.
• It is not necessary that ta cut in money wage
may lead to reduction in real wage.
• Lack of theory of effective demand.
Classical and Keynesian idea of wages
and employment
 Keynesian Analysis
• When real wage rose ,the volume of employment
was curtailed, vice versa. In other words , the
demand for labor depends on the real wage rates: it
increase when the real wage rate fall and decrease
real wage goes up.
• Keynes did not agree that a cut in money wage for
economy as a whole will necessarily cut real
wages. Other hand , a reduction in the money wage
reduced proportionately the total outlay demand
and prices so that the real wage remained the same.
• Keynes believed that, while keeping the
money wage constant, aggregate demand must
be raised to increase v employment.
• Keynes further believed that a rise in
aggregate demand , while the money wages
are kept constant would normally lead to
reduction in real wages. A reduction in real
wage would stimulate investment and increase
employment.
• According to Keynes, wage earner do not mind a
small rise in price and do not agitate for a
corresponding rise in money wages. But they
vigorously resist a cut in money wages.
• In order to explain the why generally cut in money
wage would not increase employment, Keynes
analyses the effect of cut in money wage on main
determinates of income and employment, Marginal
efficiency of capital, Consumption function and
interest rate.
 Money Illusion
• Professor Irving Fisher Introduced in economic
theory the term Money Illusion in his book in
1927.
• Money Illusion He meant that the people thought
that the a rupee was a rupee forever. That is it
value or purchasing power in term of goods and
service never changes. People generally fail to
perceive that unit of money does not always buy
the same quantity of goods and services.
Purchasing power varies time to time.
 Two possible explanation
• When price rise the workers in a particular
industry feel that the workers in other
industries are also hit to the same extent and
their relative position does not suffer in any
manner.
• The worker strongly resent a cut in their
money wage , because they feel that it has
been imposed by their own employer and they
must retaliate by going on the strike.
Effects of Wage cut on determinants of
Employment
Effect of Marginal Efficiency
of capital

Effect of Consumption
function

Effect of rate of Interest

 Modern theory of Employment
• The modern economist by and large agree with
keynesian analysis. But there are some differences.
• According to keynes , a decline in the real wage is
a condition for increase in employment in
improvement. We have already referred to his
argument that since organization equipment and
techniques do not change in the short run , an
increase in aggregate demand would lead to
increase output and rise marginal cost.
• But the mordern economist do not agree that
an increase in employment resulting form
increase in effective demand resulting from
increase in effective demand would
necessarily lower wage.
 Arguments
• It point out that fixing prices of their product ,
the producer usually follow full cost pricing
policy rather than fixing them on the basis of
marginal cost.
• Keynes assume that in short run there is no
change in organization, equipment and
techniques so that marginal cost must rise. But
we know that improvement in the respect are
continually being made.
• The modern economist belived that the
marginal cost curve remain flat over
considerable range of output , where as keynes
believes that marginal cost curves rise upward
even with small increase in output.
• Application to wage policy