criticism of classical theory of employment

Each market involves a built-in equilibrium mechanism to ensure full employment in the economy. Criticisms. Plagiarism Prevention 4. Ignores Effect of Changes in Income Level: In Keynes’s view, the most fundamental defect with the classical theory is its neglect of the influence of changes in income on saving and investment. Thus it is variations in income rather than in interest rate that bring the equality between saving and investment. Assuming V and T to be constant, a change in the supply of money (M) causes a proportional change in the price level (P). This will remove unemployment and once again establishes full employment level ON. Terms of Service 7. Frictional unemployment is a temporary phenomenon which arises due to the imperfections in the labour market, such as, ignorance of job opportunities, immobility of labour, seasonal nature of work, shortage of raw materials, breakdowns of machinery, etc. The quantity of money is given and money is only the medium of exchange. 6. Contrariwise, with the fall in the wage from W/P0 to W/P2, the demand for labour increases more than its supply by s1d1, the workers demand higher wage. This level also represents full employment equilibrium level. If there exists some unemployment, the unemployed will compete for jobs and the real wage rate will fall. It ignores the empirical facts of changing levels of employment in the real world. According to Pigou, reduction in money wages, through its downward effect on cost of production and prices, tends to increase employment. Perfect competition does not exist in the real world. If real wage rate is maintained at a higher level, (W/P)1, supply of labour will exceed demand for labour by GH, which indicates the amount of unemployment. Where DN = demand for labour, W = wage rate and P = price level. In the classical theory, the determination of output and employment takes place in labour, goods and money markets of the economy, as shown in Fig. The Classics' remedy for unemployment was to lower money wages. He pointed out that the earning of interest from assets meant for transactions and precautionary purposes may be very small at a low rate of interest. Real wage rate is determined at the level where demand for labour and supply of labour are equal. In short, when the classical economists assume full employment, they mean to say- (a) that involuntary unemployment does not exist; (b) that there is a possibility of some amount of frictional unemployment, and (c) that such frictional unemployment will disappear in the long run i.e., there is always a tendency towards full employment. This, in turn, leads to general unemployment. Content Filtration 6. According to this, supply creates its own demand and the problem of overproduction and unemployment does not arise. Thus the existence of involuntary unemployment in capitalist economies (entirely ruled out by the classicists) proves that underemployment equilibrium is a normal situation and full employment equilibrium is abnormal and accidental. At that point of time, total demand equals total supply and the economy is in a state of full employment. In case of unemployment, a general cut in money wages would take the economy to the full employment level. The Classical Theory Of Employment amd output The fundamental principle of the classical theory is that the economy is self-regulating. It does not provide any solution to the problems of unemployment or trade cycles. The logic of this argument can be easily grasped with the help of the following algebric expression. The relation between quantity of money, total output and price level is depicted in Figure 5 where the price level is taken on the horizontal axis and the total output on the vertical axis. Keynes calls it ‘under-employment equilibrium’. S) must be spent on investment goods. If there is overproduction and unemployment, the automatic forces of demand and supply in the market will bring back the full employment level. Hence, Say’s law, which rules out the possibility of general over-production and general unemployment, applies both in barter as well as in a money economy. Classical organization theory - key criticisms. Given K and T, the production function becomes Q = f (AO which shows that output is a function of the number of workers. Wage rate, interest rate and the price level are determined in their respective markets through the equality of demand and supply forces. in a welfare state. Keynes’ main criticism of the classical theory was on the following two grounds: (a) The classical prediction that full- employment equilibrium will be achieved in the long-run was not acceptable to Keynes, who wanted to solve the short run problem of unemployment. He pointed out that the capitalist system was not automatic and self-adjusting because of the non-egalitarian structure of its society. When government intervenes by recognising trade unions, passing minimum wage legislation, etc., and labour adopts monopolistic behaviour, wages are pushed up which lead to unemployment. Even at full employment, there may exist, voluntary unemployment, frictional unemployment, seasonal unemployment, structural unemployment or technical unemployment. The demand for labour also depends on the wage rate, DL =f (W/P), and is a decreasing function of the wage rate. Changes in these variables automatically adjust the economic system in such a way as to ensure full employment. Thus, flexibility of real wage rate ensures full employment. In modern times, workers have formed strong trade unions which resist a cut in money wage. (viii) Interest rate flexibility establishes equality between saving and investment. Plagiarism Prevention 5. The problem of unemployment arises in the economy in the short run. The Classical Theory of Employment: Assumption and Criticism! Since every worker is paid wages equal to his marginal product, therefore the full employment level NF is reached when the wage rate falls from W/P1 to W/P0. According to Say’s law, an increase in employment increases income, the whole of which is automatically spent either on consumer goods or on investment goods. This is Keynes ‘liquidity trap’ which the classicists failed to analyse. But the speculative demand for money would be infinitely large at a low rate of interest. As a result, the price level would rise from OP to OP1 given the same level of output OQ. The higher the rate of interest, the higher the saving, and lower the investment. As explained above, the demand for labour is a decreasing function of the real wage rate. This rise in the price level is exactly proportional to the rise in the quantity of money, i.e., PP1 = MM1 when the full employment level of output remains OQ. It follows that the money wage should be reduced in order to attain the full employment level in the economy. The classical theory of employment is not a general theory. ADVERTISEMENTS: The Say’s Law of Market: Proposition, Implication and Criticism! Supply of labour is a positive function of real wage rate; supply of labour increases with a rise in the real wage rate and decreases with a fall in the real wage rate. This is because the capitalist society does not function according to Say’s law, and supply always exceeds its demand. Therefore, a reduction in the money wage would not reduce the real wage, as the classicists believed, rather it would increase it. Thus there is general deficiency of aggregate demand in relation to aggregate supply which leads to overproduction and unemployment in the economy. It is subject to the law of diminishing marginal returns. The consequent unrest in the economy would bring a decline in output and income. This led him to develop a systematic theory of employment, explaining the phenomenon of unemployment and suggesting the remedial measures. THEORY OF EMPLOYMENT 2. 7. There are two principal classes, the rich and the poor. The Criticisms of Classical Economics: Counterarguments and Limitations One of the modern criticisms of classical economics involves a perceived lack of cohesion. If community decides to increase saving at all levels of rate of interest, the saving curve will shift to the right to S1 curve. Theory of emplyment 1. Saving is a positive function of rate of interest; saving will be more at higher interest rate and less at lower interest rate. Keynes did not agree with Pigou that “frictional maladjustments alone account for failure to utilise fully our productive power.” The capitalist system is such that left to itself it is incapable of using productive powerfully. This will remove unemployment. In a money economy, money serves as medium of exchange. Keynes did not agree with the classical view that the laissez-faire policy was essential for an automatic and self-adjusting process of full employment equilibrium. He mentioned three cases when the economic system does not remain self-adjusting: (i) When liquidity preference schedule becomes perfectly elastic (i.e., liquidity trap) as a result of the investors’ expectation that the rate of interest cannot fall further. Pigou explains the entire proposition in the equation: N = qY/W. 3. To them, both saving and investment are the functions of the interest rate. The price level OP is determined by total output (Q) and the quantity of money (MV), as shown in Panel (E). The basis of this perspective had existed for many centuries in one form or another. According to Keynes, there may be full employment, over-full employment or under-employment. But, there is no guarantee that the saved part of income will be spent on investment goods. The equilibrium rate of interest is determined at the level where saving and investment are equal. When the money wage increases, the real wage also increases in the same proportion and there is no effect on the level of output and employment. The money market is in equilibrium when the demand for money equals the supply of money. In this equation, N is the number of workers employed, q is the fraction of income earned as wages, Y is the national income and W is the money wage rate. When prices fall, demand for products will increase and sales will be pushed up. The equilibrium in the money market is shown by the equation MV = PT where MV is the supply of money and PT is the demand for money. B. The Criticism of The Classical Theory of Interest The criticism of the classical theory of interest is as follows. This is shown in the form of the following production function: Q=f (K, T, N), where total output (Q) is a function (f) of capital stock (K), technical knowledge (T), and the number of workers (N). Keynes has criticised Pigou’s formulation of Say’s law on both theoretical as well as practical grounds: (i) On the theoretical side, Keynes rejected the Pigovian wage-adjustment mechanism. (ii) When investment function becomes interest inelastic. Thus the rate of interest will not fall below a certain minimum level, and the speculative demand for money would become perfectly interest elastic. Flexibility of wages always tends to maintain full-employment equilibrium. The scientific approach the use of work study techniques to the systematic investigation of work and the subsequent matching of worker to the job requirements. 12. 6. (vi) The government should not interfere in the automatic working of the economic system and should follow the policy of laissez faire. Output is an increasing function of the number of workers, output increases as the employment of labour rises. Image Guidelines 5. Content Guidelines 2. In a barter economy, a good is produced with a purpose of exchanging it for another good. This is because the equation MV = PT holds on all points of this curve. The equilibrium of the money market explains the price level corresponding to the full employment level of output which relates Panel (E) and Panel (B) with MQ line. Neglects the credit. If the wage rate rises from WP0 to WP1 the supply of labour will be more than its demand by ds. Equality between saving and investment. In the classical theory, output and employment are determined by the production function and the demand for labour and the supply of labour in the economy. According to Pigou, the tendency of the economic system is to automatically provide full employment in the labour market when the demand and supply of labour are equal. In the long run, the economy will automatically tend toward full employment when the demand and supply of goods become equal. For example there is evidence of the … 10. Therefore, state intervention is necessary. Report a Violation 11. As a result of this excessive saving, the rate of interest will fall, which on the one hand leads to increase in investment and on the other hand tends to reduce saving. A reduction in wages, if on the one hand produces favourable effect on employment through reduction in costs and prices, also, on the other hand, reduces income which, in turn, decreases aggregate demand and hence employment.

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