Classical Theory of Output and Employment.pptx

Macroeconomics Reading and Reference: Macroeconomics- Theories and Policies by Richard T. Froyen (Chapter-3) Classical theory of output and employment.

[Audio] Classical economics developed as a response to the mercantilist belief that a country's wealth and strength were linked to its supply of precious metals. This approach also called for government involvement in the economy to support national goals. However, classical economists such as Adam Smith, David Ricardo, and John Stuart Mill stressed the influence of tangible factors like technological progress and productivity growth in propelling economic development. They maintained that the market could achieve optimal results without the intervention of the government..

[Audio] In contrast to the mercantilists, classical economists believed that the wealth of nations was determined by real factors, not just money. They thought that the free market would optimize itself if left alone, without government interference. Economic growth came from increasing the stock of factors of production and improving techniques. Money's role was limited to facilitating transactions. Classical economists opposed government regulations, except those necessary to maintain competition. In their view, consumption didn't need encouragement because production would always create sufficient demand. They believed the economy would self-correct, making government intervention unnecessary and potentially harmful..

[Audio] In the classical tradition, economists believed that the economy was self-correcting, meaning that it would naturally return to equilibrium after any disturbances. This idea was challenged by the Great Depression, which showed that the economy could get stuck in a state of unemployment and low production. The classical theory of output and employment focused on the factors that determine the level of output and employment in the economy. It emphasized the importance of supply and demand in determining prices and resource allocation. According to this theory, changes in aggregate demand can lead to fluctuations in output and employment, but these fluctuations are temporary and will eventually be corrected by the market forces..

[Audio] Firms, being perfect competitors, strive to maximize profits. They continue producing goods until the marginal cost of each additional unit of output equals the marginal revenue received from its sale. Since labor is the sole variable factor of production, the marginal cost of each additional unit of output is the marginal labor cost, which is the money wage divided by the number of units of output produced by the additional unit of labor. As a result, firms adjust their output levels based on the price of labor, ensuring that the market clears..

[Audio] In the classical tradition, economists believed that the economy was self-correcting, meaning that it would automatically return to full employment if left alone. This idea was based on the concept of Say's Law, which states that supply creates its own demand. According to this law, when businesses produce more goods and services, they create new jobs and stimulate economic activity. As a result, there is no need for government intervention in the economy, as the market will naturally adjust itself to achieve full employment..

Classical theory of output and employment •.

Classical theory of output and employment •.

[Audio] The firm's goal is to maximize profits by finding the optimal level of labor. This can be seen by examining the real wage and the marginal product of labor. When the real wage is 8, the firm hires 3 workers because the marginal product of labor is also 8, as shown at point D on the graph. To increase labor further, the real wage needs to decrease because the additional output produced by each additional worker is decreasing. If the marginal product of labor decreases to 4 and the real wage stays at 8, the firm should reduce labor to 3 to maximize profits. On the other hand, if the real wage falls to 5, the optimal level of labor becomes 4. This is because the marginal product of labor equals the real wage. Therefore, at each real wage rate, the optimal quantity of labor is determined by the labor input that equates the marginal product of labor and the real wage, which is why the labor demand curve is shaped like it is..

[Audio] In the classical theory of output and employment, it is assumed that the economy is self-correcting, meaning that any deviations from full employment will automatically correct themselves over time. This idea was challenged by the Great Depression, which showed that the economy can get stuck in a state of unemployment. The classical economists believed that wages would adjust downward to clear the labor market, but this did not happen during the Great Depression. Instead, governments intervened to implement policies aimed at stimulating the economy..

Classical theory of output and employment •.

Classical theory of output and employment •.

[Audio] As the real wage rate increases, it becomes more expensive for workers to engage in leisure activities, leading to the substitution effect, where workers respond by choosing less leisure time. This is similar to how consumers behave in response to changes in prices in the theory of consumer demand. Additionally, as the real wage increases, workers can earn a higher level of real income, making leisure more appealing compared to further increments in income, resulting in the income effect. However, if the real wage continues to rise, the income effect eventually gives way to the substitution effect, resulting in a negatively sloped labour supply curve. It's worth noting that this backward-bending portion of the labour supply curve is typically only observed at extremely high wage rates, which may not be realistic. Therefore, for wage rates commonly seen in industrialized nations, the labour supply curve tends to have a positive slope, with the substitution effect dominating the income effect..

[Audio] The classical theory of output and employment assumes that the economy naturally tends towards full employment, where all available resources are fully utilized. This implies that there are no unemployed workers, and all industries operate at their maximum capacity. The concept of supply and demand plays a key role in determining the level of output and employment. According to this theory, any changes in the money supply or government intervention can disrupt the natural equilibrium of the economy, resulting in fluctuations in output and employment..

[Audio] The classical theory of output and employment posits that various determinants can lead to changes in these variables. External to the model, these factors influence the positions of labor supply and demand curves and the production function. Technical advancements, increasing labor productivity, can shift the production function and labor demand curve. Over time, changes in the capital stock also modify the production function. The labor supply curve is affected by alterations in the labor force, population, and individual preferences regarding labor-leisure trade-offs. These factors impact the supply side of the market for output, ultimately determining the levels of output and employment in the classical model..

[Audio] The classical theory of output and employment is based on the idea that the money wage adjusts to maintain equilibrium in the labor market. In this context, the labor supply curve is drawn against the money wage, showing the quantity of labor supplied at each level of money wage. The labor demand curve is also drawn against the money wage, showing the quantity of labor demanded at each level of money wage. The intersection of these two curves determines the equilibrium level of employment and output. The theory assumes that the money wage adjusts to changes in the price level, ensuring that the labor market is always in equilibrium. This means that changes in the price level do not affect the quantity of labor supplied or demanded, but rather cause the money wage to adjust accordingly..

[Audio] The demand for labor depends on the real wage. As the price level rises, the money wage also increases, but the real wage decreases. Therefore, firms demand more labor at higher price levels because they can afford it at a lower real wage rate. For instance, at W1, the labor demanded is N2, which puts upward pressure on money wages. Moreover, if the price level doubles, the money wage also doubles, leaving labor demand unchanged at level N1..

[Audio] The firm's output supply curve, also known as the aggregate supply curve, shows the quantity of output that firms are willing to produce at different levels of product price. Profits are maximized when marginal private net benefit equals the wage rate divided by the price level. Since the money wage is assumed to be fixed, the output supply curve is positively sloped, meaning that higher prices lead to lower real wages, causing firms to demand more labor and produce more output. However, in constructing the aggregate supply curve for the economy, we cannot assume that the money wage remains fixed as output and labor input vary. Instead, the money wage must adjust to maintain equilibrium in the labor market..

[Audio] The higher price level means a lower real wage, and firms would try to expand both employment and output. However, the money wage will not remain constant. At the higher price level, the labor supply curve shifts to Ns(2P1), and at the money wage of W1, labor supply will be only N'2 units. There will be an excess demand for labor equal to (N2 - N'2) units, and the money wage will rise. This puts upward pressure on money wages, and the increase will continue until the money wage has increased sufficiently to reequilibrate supply and demand in the labor market, at a money wage of 2W1..

[Audio] The classical theory of output and employment emphasizes the importance of wages and prices in determining the level of output in an economy. The aggregate supply curve is vertical, indicating that higher prices can only stimulate output if there is no proportionate increase in money wages, keeping the real wage constant. For output to be in equilibrium, it must be on the supply curve, and output must be at Y1..