4. The Classical Model of Income Determination – Macroeconomics: Theory and Policy

4

The Classical Model of Income Determination

After studying this topic, you should be able to understand

  • Say’s law states that ‘supply creates its own demand’.
  • The aggregate of the demand in all the markets will always be equal to the aggregate of the supply.
  • The production function describes the relationship between the inputs and the output.
  • The marginal product schedule is the firm’s demand curve for labour.
  • The classical theory had propagated a free market economy, which classical economists believed would automatically lead to full employment.
INTRODUCTION

In his book General Theory of Employment, Interest and Money, Keynes had pointed out that the term ‘the classical economists’ was invented by Marx to represent the followers of Ricardo and, in fact, those economists who had complete faith in Ricardo and his principles. J. S. Mill, Edgeworth and Marshall accepted and improved upon what can be termed as Ricardian economics.

The general opinion among the classical economists was that it was impossible to have a situation of general unemployment. They believed that an economy will always operate at full employment. Unemployment, according to the classical economists, was an exception.

Economists today believe that full employment is an exception. The situation most prevalent in any economy is that of unemployment, which is totally against what the classical economists propagated.

BOX 4.1

J. B. Say was born in Lyon to a protestant family. Say was expected to take up a commercial career. He went to England to a merchant for whom he acted as a clerk. Later, he moved to London under another employer. Then he returned to France to work in a life assurance company. Say first wrote a pamphlet on the liberty of the press in 1789. In the year 1793, Say got married to the daughter of a former lawyer. Later, he edited a periodical in which he developed the doctrines of Adam Smith. In 1831, Say became a professor of political economy at a college in France. His wife passed away in 1830 and since then his health started declining. He died in Paris on 15 November 1832.

SAY’S LAW

Say’s law is one of the most important conclusions, which have been provided by the classical economists. It is named after the famous economist J. B. Say who refused to believe that general overproduction and unemployment are common occurrences. Many economists of the early nineteenth century accepted this law as a true explanation of the working of any economic system.

 

The most famous tenet of Say’s law is ‘supply creates its own demand’.

Some assumptions, which are implicit in the Say’s law are as follows:

  1. The income, which the households receive, is spent on goods and services. Hence, the average propensity to consume is one. This obviously implies that savings will be zero.
  2. The government does not perform any economic functions. This implies that there are no government expenditures, no taxation or subsidies or government borrowing.
  3. The economy is a closed economy. This implies that there is no trade or any other links with the rest of the world.
  4. The prices are flexible in that they can rapidly adjust upwards or downwards.

Basically, there are only two sectors in the economy which are under consideration. These two sectors, the firms and the households, are engaged in production and consumption, respectively. There is a circular flow of money from firms to households and from households to firms.

The most famous tenet of Say’s law is ‘supply creates its own demand’. By the very act of production, each producer aims at either the direct satisfaction of his wants or to exchange the goods that he produces for the other goods that he needs. Thus, the production of the goods itself involves a creation of demand for them.

In a barter economy, there is no doubt that this law will function. When a producer produces a good, he does so with the specific purpose of exchanging it for another good. Thus, the production or supply of the good creates a direct demand for the good in a barter economy.

In a money economy, goods are sold in the market for a price which is expressed in terms of money. According to the classical economists the producers of the goods, once they receive the money for the goods sold, use this money to buy more factors of production. The only function of money, according to the classical school, is to facilitate the process of exchange or to solely act as a medium of exchange. Its purpose is to avoid the problems faced in a barter economy. Thus, it is obvious that in any economy the supply of any commodity implies a demand for the other commodities in the economy. Hence, the aggregate of the demand in all the markets will always be equal to the aggregate of the supply. It is possible that for an individual market, the equality between the supply and the demand may not hold. But an excess supply or overproduction in one market will necessarily be accompanied by an excess demand or underproduction in the other market for the Say’s law to hold.

 

RECAP
  • In a barter economy, there is no doubt that the Say’s law will function.
  • In a money economy, for the Say’s law to hold, an excess supply in one market should necessarily be accompanied by an excess demand in the other market.
BOX 4.2

An important point to note is that Say had himself not used any of the short definitions of the Say’s law. Some of his contemporaries and those who came after him developed this law. The ‘law of markets’ evolved from the work of James Mill, David Ricardo, John Stuart Mill, and many others. It formed the basic framework of macroeconomics.

OUTPUT AND EMPLOYMENT IN THE CLASSICAL MODEL

The classical model, which is being discussed here, is highly simplified. It is limited to the determination of employment, output and price level.

The Production Function

The production function describes the input-output relationship. It is being defined for the short run, here. Short run is the length of time, which is too short for the firms to be able to vary the plants and equipment that they use in production. In addition, the technology or the production method is also assumed to be constant in the short run. Thus, we can represent our short-run aggregate production function as

 

             Y = f (L, K)
where, Y = real output
             L = labour input
             K = capital input

 

The production function describes the input–output relationship.

As already discussed, it is being assumed that:

  1. the stock of capital, or in other words, the plant and equipment are constant; and
  2. the technology is constant.

Figure 4.1 The Short–run Aggregate Production Function

In Figure 4.1, the production function has been shown. It can be divided into the following three parts:

  1. Up to labour input L1 is the linear portion of the production function. It indicates proportional returns or, in other words, the output varies proportionately with labour.
  2. Between L1 and L2 units of labour, the output increases less than proportionately for every unit of increase in labour. This is because the increasing units of labour are applied to the fixed amounts of plant and capital equipment. Hence, this is the stage of diminishing returns as the marginal product of labour (the increase in the total product due to a unit increase in labour) decreases as the quantity of labour input increases. Thus, the diminishing returns begin at L1 units of labour and keep diminishing to become zero at L2 units of labour.
  3. Beyond L2 units of labour, further additions to the labour input will not lead to an increase in the output. In fact at some higher levels of the labour input, the output may start decreasing if more labour is hired.

Given the production function, it is obvious that a firm will not hire labour beyond L2 units.

The Labour Market in the Classical Theory

It is assumed that

  1. the workers and the firms have complete knowledge about the prices, which are prevailing in the market;
  2. the money wages adjust and thus, the market clears. There is flexibility in the wages and prices.

Demand for Labour

A perfectly competitive profit maximizing firm will go on increasing the output level till the marginal cost of producing an additional unit of the output is equal to the marginal revenue from the sale of the unit. Thus,

 

              W/P = MPL
where, W/P = real wage
             MPL = marginal product of labour

 

The marginal product schedule is the firm’s demand curve for labour.

Thus, a profit maximizing firm will go on hiring labour till the marginal product of labour (MPL) is equal to the real wage. In other words, the marginal product schedule is the firm’s demand curve for labour.

The individual firm’s demand curve for labour can be summed up horizontally to arrive at the aggregate demand curve for labour. Thus, the aggregate demand schedule for labour can be expressed as

        Ld = Ld (W/P)

where,

        Ld = aggregate demand schedule for labour

    W/P = real wage

In Figure 4.2, the short-run aggregate demand for labour curve has been shown. Ld is downward sloping showing that the decrease in the real wage rate will lead to an increase in the aggregate demand for labour.

Figure 4.2 Aggregate Demand Curve for Labour

Supply of Labour

The labour in an economy is supplied by the individual workers who aim at maximizing their utility. Utility depends on both leisure and the real income. Although income can be increased by putting in more work, but work leads to a reduction in the leisure time. Hence, there appears to be a trade-off between leisure and income (or work).

The derivation of the individual’s supply curve of labour has been depicted in Figure 4.3.

where,

         x-axis = total number of hours available for leisure or work to an individual over a given period of time.
       y-axis = real income
   I1, I2, I3 = indifference curves

    ZW1/P1, Z-W2/P2, ZW3/P3 = individual’s budget lines

Figure 4.3 Derivation of the Individual’s Supply Curve of Labour

It is important to understand that:

  1. An indifference curve shows the different combinations of income and leisure, which give the individual the same level of satisfaction. Thus, he is indifferent between these combinations. The higher the indifference curve the greater is the utility or satisfaction associated with it. The individual aims at reaching the highest possible indifference curve. The slope of an indifference curve shows the rate at which the individual is willing to trade-off leisure for income.
  2. Real income is equal to the real wages (W/P) multiplied by the total number of hours the individual works.
  3. The slope of the budget line shows the real wage. The larger the real wage the steeper will be the budget line.

The individual aims at maximizing his utility for any given real wage. He will do so by choosing that particular point on the indifference curve where the budget line (which corresponds to that particular wage rate) is tangential to the indifference curve. At this particular point, the slope of the indifference curve is equal to the slope of the budget line. This implies that the rate at which he is willing to trade-off the leisure for income is equal to the rate at which he is actually able to trade-off.

In Figure 4.3,

  1. When the real wage rate is W1/P1, the individual is in equilibrium at point E′ working for EZ hours, earning an income of EE′ and spending OE hours on leisure.
  2. When the real wage increases to W2/P2, the individual is in equilibrium at point F′ working for FZ hours, earning an income of FF′ and spending OF hours on leisure.

Similarly, the other points like G′ can be derived. Joining these points such as E′, F′ and G′ in Figure 4.3, we can derive the supply curve for labour as shown in Figure 4.4.

Figure 4.4 The Individual’s Supply Curve of Labour

The aggregate supply curve for labour can be arrived at by summing up horizontally the individual supply curves of labour. The aggregate supply curve of labour can be expressed as Ls = Ls (W/P).

The aggregate supply curve of labour portrays following two characteristics:

  1. The wage is the real wage rate.
  2. The curve is positively sloped showing that the supply of labour increases as the real wage rate increases. (This relationship may not exist at some very high wage rate and in that case the supply curve of labour may bend backwards.)

The Determination of Employment, Real Wage Rate and Output

The aggregate demand and aggregate supply curves of labour can now be utilized to determine the equilibrium level of output, employment and the real wage rate.

Figure 4.5(a) depicts the intersection of the aggregate demand curve for labour and aggregate supply curve for labour. The two curves intersect at point E*. Thus, the equilibrium level of employment will be L* and the real wage rate will be (W/P)*. The classical economists had proposed that this will be the full employment level, which will prevail in the long run.

Figure 4.5(b) depicts the short-run production function. Given the equilibrium level of employment at L*, as determined in Figure 4.5(a), the corresponding equilibrium level of output can be determined from the production function at Y*. Hence this implies that according to the classical theory, L* amount of labour will produce an output of Y*, given the fixed capital and the technology.

It is obvious from the above that in the classical theory, the main role in the determination of output, employment and the real wage rate is played by the supply side in the labour market. The demand for labour is directly derived from the production function. Thus, the factors operating on the supply side in the labour market determine the level of employment, output and the wage rate.

Figure 4.5 (a) and (b) The Determination of Employment, Real Wage Rate and Output

RECAP
  • One can arrive at the aggregate demand curve for labour by summing up horizontally the individual firm’s demand curve for labour.
  • There exists a trade-off between leisure and income.
  • One can arrive at the aggregate supply curve for labour by summing up horizontally the individual supply curves of labour.
  • In the classical theory in the determination of output, the most important role is that of the supply side in the labour market.
A CRITICISM OF THE CLASSICAL MODEL

The classical economists had very vehemently opposed any government interference with the market. They had propagated a free market economy, which they believed would automatically lead to full employment. It also seems that the classical equilibrium could be easily extended, with some minor adjustments, to an open economy.

BOX 4.3

It is important to note at this point that some economists are of the opinion that according to the classical theory, the aggregate supply curve is inelastic or vertical and not upward sloping. This implies that an economy will always operate at the full employment level, whatever is the wage rate.

However, some criticisms have been put forward against the classical theory. Some of them are as follows:

  1. Keynes had argued that the classical assumption of wage price flexibility is totally unrealistic. In the real world, the existence of monopolistic and oligopolistic firms, labour unions, government support programmes and minimum wage legislations are all responsible for erecting barriers in the functioning of the wage price mechanism as envisaged by the classical economists. Thus, the self-correcting mechanism of the classical school fails in its proper functioning.
  2. Keynes had no faith in the classical belief that the free enterprise system could be self-regulating. He asserted that it required periodic interventions by the authorities to evade the fluctuations and instabilities involved in the economic activities.
  3. Keynes had criticized the Say’s law as a truism, which he felt could be true only under the barter system. In such a system, whatever goods are produced in the economy are either sold in the market or are used for self-consumption. Thus, supply and demand are always equal. Hence, there cannot be either a surplus or a glut. This is not true in a modern economy where every transaction involves or is carried out with money.

The Great Depression was a crucial time when the classical theory was put to test and it failed in that the classical school could not provide any solutions to the problems that the world faced at that time. This was responsible for the loss of faith in the classical economics and paved the way for the Keynesian economics.

RECAP
  • The classical economists believed that voluntary and frictional unemployment were consistent with a full employment level.
  • Keynes had criticized the classical assumption of wage price flexibility as totally unrealistic.
  • Keynes had criticized the Say’s law as a truism.
SUMMARY
INTRODUCTION

The general opinion among the classical economists was that an economy will always operate at full employment.

SAY’S LAW
  1. Say’s law is one of the most important conclusions, which have been provided by the classical economists. It is named after the famous economist J. B. Say who refused to believe that general overproduction and unemployment are common occurrences.
  2. Some assumptions, which are implicit in the Say’s law are: the average propensity to consume is one and thus savings will be zero; government does not perform any economic functions; the economy is a closed economy; and that the prices are flexible.
  3. There are only two sectors in the economy—the firms and households—who are engaged in production and consumption, respectively.
  4. The most famous tenet of the classical theory is the Say’s law, ‘supply creates its own demand’. Thus, the production of the goods itself creates a demand for them.
  5. In a barter economy, there is no doubt that this law will function where the production or supply of the good creates a direct demand for the good.
  6. In a money economy, goods are sold in the market for a price which is expressed in terms of money. The only function of money is to act as a medium of exchange. The aggregate of the demand in all the markets will always be equal to the aggregate of the supply.
OUTPUT AND EMPLOYMENT IN THE CLASSICAL MODEL
  1. The production function describes the input—output relationship.
  2. We can represent our short-run aggregate production function as Y = f (L, K). A profit maximizing firm will operate in the stage of diminishing returns.
  3. As far as the labour market is concerned, it is assumed that the workers and the firms have complete knowledge about the prices that are prevailing in the market and also that there exists wage price flexibility.
  4. As far as the demand for labour is concerned, a perfectly competitive profit maximizing firm will go on hiring labour till the MPL is equal to the real wage. Thus, the marginal product schedule is the firm’s demand curve for labour.
  5. The individual firm’s demand curve for labour can be summed up horizontally to arrive at the downward sloping aggregate demand curve for labour, Ld = Ld (W/P).
  6. As far as the supply of labour is concerned, there appears to be a trade-off between leisure and income.
  7. The individual’s supply curve of labour can be derived diagrammatically through indifference curves and budget lines where the indifference curve shows the different combinations of income and leisure, which give the individual the same level of satisfaction whereas the slope of the budget line shows the real wage.
  8. The individual aims at maximizing his utility for any given real wage. He will do so by choosing that particular point on the indifference curve where the budget line (which corresponds to that particular wage rate) is tangential to the indifference curve.
  9. We can derive the individual’s supply curve for labour.
  10. The aggregate supply curve for labour can be arrived at by summing up horizontally the individual supply curves of labour, Ls = Ls (W/P).
THE DETERMINATION OF EMPLOYMENT, REAL WAGE RATE AND OUTPUT
  1. The intersection of the aggregate demand and aggregate supply curves of labour determines the equilibrium level of output, employment and the real wage rate.
  2. Given the conditions in the short run, the classical economists had proposed that this will be the full employment level.
  3. Given the equilibrium level of employment, the corresponding equilibrium level of output can be determined from the production function.
  4. In the classical theory, the main role in the determination of output, employment and the real wage rate is played by the supply side in the labour market.
A CRITICISM OF THE CLASSICAL MODEL
  1. The classical theory had opposed any government interference with the market and had propagated a free market economy, which they believed would automatically lead to full employment.
  2. However, many criticisms have been put forward against the classical theory: Keynes had argued that the classical assumption of wage price flexibility is totally unrealistic. He had criticized the Say’s law as a truism only under the barter system.
  3. The Great Depression was a crucial time when the classical theory was put to test and it failed. This was responsible for the loss of faith in the classical economics and paved the way for the Keynesian economics.
REVIEW QUESTIONS
TRUE OR FALSE QUESTIONS
  1. The general opinion among the classical economists was that it was impossible to have a situation of full employment.
  2. As of today the situation most prevalent in any economy is that of unemployment, which is totally against what the classical economists propagated.
  3. The most famous tenet of Say’s law is ‘demand creates its own supply’.
  4. The only function of money, according to the classical school, is to act as a store of value.
  5. The marginal product schedule is the firm’s demand curve for labour.
VERY SHORT-ANSWER QUESTIONS
  1. What are the views of the classical school regarding full employment?
  2. Till what stage will a profit maximizing firm go on hiring labour?
  3. What are the two characteristics portrayed by the aggregate supply curve of labour?
  4. Which side, the demand side or the supply side, of the labour market plays the main role in the determination of output, employment and the real wage rate?
  5. What did the classical economists favour: government interference or a free market economy?
SHORT-ANSWER QUESTIONS
  1. What is Say’s law? Discuss in brief.
  2. According to the Say’s law, in a money economy ‘the aggregate of the demand in all the markets will always be equal to the aggregate of the supply’. Explain.
  3. Write a short note on the production function in the classical theory.
  4. How does an individual maximize his utility for any given real wage?
  5. Discuss any two criticisms of Keynes against the classical theory.
LONG-ANSWER QUESTIONS
  1. The most famous tenet of the classical theory is the Say’s law ‘supply creates its own demand’. Discuss.
  2. In the classical theory, ‘the individual firm’s demand curve for labour can be summed up horizontally to arrive at aggregate demand curve for labour’. Elaborate.
  3. How can the aggregate supply curve for labour be arrived at from the individual supply curve of labour? Discuss by throwing light on the trade-off between leisure and income.
  4. How are the equilibrium levels of employment, real wage rate and output determined in the classical theory? Explain.
  5. What are the criticisms levelled against the classical theory of employment, real wage rate and output? Discuss.
ANSWERS
TRUE OR FALSE QUESTIONS
  1. False. The classical economists believed that it was impossible to have a situation of unemployment.
  2. True. In every economy, there exists at least some unemployment.
  3. False. The most famous tenet of Say’s law is ‘supply creates its own demand’.
  4. False. The only function of money, according to the classical school, is to act as a medium of exchange.
  5. True. A profit maximizing firm will go on hiring labour till the MPL is equal to the real wage.