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

Scene 1

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.. 

Scene 2

Classical theory of output and employment
• There were two periods in the development of economic theory before 1930.
• The ﬁrst, termed classical, is the period dominated by the work of Adam Smith (Wealth of Nations, 1776), David Ricardo 
(Principles of Political Economy, 1st ed., 1817), and John Stuart Mill (Principles of Political Economy, 1st ed., 1848). 
• The second, termed the neoclassical period , had as its most prominent English representatives Alfred Marshall 
(Principles of Economics, 8th ed., 1920) and A. C. Pigou (The Theory of Unemployment, 1933).
Background:
• Classical economics emerged as a revolution against a body of economic doctrines known as mercantilism.
• Two tenets of mercantilism were 
(1)
bullionism, a belief that the wealth and power of a nation were determined by its stock of precious metals, and 
(2)
the belief in the need for state action to direct the development of the capitalist system.
• Adherence to bullionism led countries to attempt to secure an excess of exports over imports to earn gold and silver 
through foreign trade thereby providing export subsidies and charging import duties.
• State action was believed to be necessary to cause the developing capitalist system to further the interests of the state.
• Foreign trade was carefully regulated, and the export of bullion was prohibited to serve the ends of bullionism.

[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.. 

Scene 3

Classical theory of output and employment
• In contrast to the mercantilists, classical economists emphasized the importance of real factors in determining the 
“wealth of nations” and stressed the optimizing tendencies of the free market in the absence of state control.
• In Classical analysis, the growth of an economy was the result of increased stocks of the factors of production and 
advances in techniques of production.
• Money played a role only in facilitating transactions as a means of exchange.
• Classical economists stood against government regulations and stressed that should be free from any government 
regulations, except those necessary to ensure that the market remained competitive.
• One role for state action in the mercantilist view was to ensure that markets existed for all goods produced. Consumption, 
both domestic and foreign, must be encouraged to the extent that production advanced. 
• The Classical response to this was in the aggregate, production of a given quantity of output will generate suﬃcient 
demand for that output; there could never be a “want of buyers for all commodities” (consumption never needs 
encouragement). Classical economics stressed the self-adjusting tendencies of the economy. Government policies to 
ensure an adequate demand for output were considered by classical economists to be unnecessary and generally 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.. 

Scene 4

Classical theory of output and employment
•

[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.. 

Scene 5

Classical theory of output and employment
Employment
Assumptions:
• Firms and individual workers have perfect information about relevant prices. 
• There are no barriers to the adjustment of money wages; the market clears.
Labour Demand
• The purchasers of labor services are ﬁrms. To see how the aggregate demand for labor is determined, we begin by 
considering the demand for labor on the part of an individual ﬁrm, denoted the ith ﬁrm.
• In the classical model, ﬁrms are perfect competitors that choose their output to maximize proﬁts, and the level of output 
solely depends on the quantity of labour employed.
• The perfectly competitive ﬁrm will increase output until the marginal cost of producing a unit of output is equal to the 
marginal revenue (which in case of perfect competition is equal to P) received from its sale.
• Because labor is the only variable factor of production, the marginal cost of each additional unit of output is the marginal 
labor cost. Marginal labor cost equals the money wage divided by the number of units of output produced by the 
additional unit of labor.

[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.. 

Scene 6

Classical theory of output and employment
•. 

Scene 7

Scene 8

[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.. 

Scene 9

Classical theory of output and employment
Labour Demand Curve
• The condition for proﬁt maximization is met at the point 
where the real wage ( W/P ) is equated with the MPN.
• If the real wage is 8, then the ﬁrm will maximize proﬁts by 
hiring 3 workers because the MPN is 8.0. This is shown at 
point D on the graph of the demand for labor, MPN. 
• In order to get the ﬁrm to hire more labor, the real wage must 
fall because the additional output produced by each additional 
worker is declining.
• Suppose the MPN declines to 4, and real wage stays at 8, then this would mean that the real value of the labor 
is 5 units and they are getting paid much higher according to 8 units. Therefore, the ﬁrm should reduce the 
labor to 3 in order to maximise their proﬁts. 
• However, if the real wage falls to 5, the optimum level of labor to be employed will be 4 as now again, 
MPN=W/P.
• So, at each real wage rate the optimum quantity of labor is given by the labour input which equate the MPN 
and real wage, which is why, the MPN cure is the labour demand curve.

[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.. 

Scene 10

Scene 11

Scene 12

[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.. 

Scene 13

Classical theory of output and employment
Labour Supply Curve
• Substitution Eﬀect: A higher real wage rate means a higher price for leisure in terms of foregone income. At this higher 
price, we assume that the worker will choose less leisure. This eﬀect is analogous to the substitution eﬀect in the theory 
of consumer demand.
• Income Eﬀect: As the real wage increases, the worker is able to achieve a higher level of real income. At higher levels of 
real income, leisure may become more desirable relative to further increments in income. With successive increases in 
the real wage, a point may be reached at which the worker chooses to supply less labor as the real wage increases and 
consumes more leisure. At this point, the income eﬀect outweighs the substitution eﬀect; the labor supply curve 
assumes a negative slope and bends back toward the vertical axis. 
• Although a backward-bending portion of labour supply curve only at extremely high wage rates which might not be a 
reality. Therefore, we assume that for wage rates observed in industrialized nations, the aggregate labor supply curve 
does have a positive slope; the substitution eﬀect outweighs 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.. 

Scene 14

[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.. 

Scene 15

Classical theory of output and employment
Determinants of Output and Employment
• Let us now discuss the exogenous variables that, when changed, in turn cause changes in output and employment. 
These variables are determined outside the model.
• These are factors that shift the positions of  labour supply and demand curves and the production function (Total 
product curve).
• The production function is shifted by technical change that alters the amount of output forthcoming for given input 
levels.
• The production function also shifts as the capital stock changes over time.
• The labor demand curve is the MPN curve, the slope of the production function. Consequently, the position of the 
labor demand curve will shift if the productivity of labor changes because of technical change or capital formation.
• Labour supply curve will shift if the labour force (population) changes.
• The labor supply curve would also shift with changes in individuals’ preferences regarding labor–leisure 
trade-oﬀs (i.e., indiﬀerence curves U1, U2, U3).
• A common feature of the factors determining output in the classical model is that all are variables aﬀecting the supply 
side of the market for output—the amount ﬁrms choose to produce. In the classical model, the levels of output and 
employment are determined solely by supply factors.

[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.. 

Scene 16

Classical theory of output and employment
Determinants of Output and Employment
• To demonstrate this:
• Figure a shows the aggregate supply and demand curves for labor. Figure b 
plots labor supply and labor demand as functions of the money wage (W).
• Considering labour supply side ﬁrst, we can draw a positively sloped curve 
such as Ns(P1), which gives the amount of labor supplied for each value of the 
money wage, given that the price level is P1.
• The curve is upward-sloping because at the given price level a higher money 
wage is a higher real wage.
• However, workers care about real wages and so each price level will have a 
diﬀerent supply curve.
• At a price level of 2P1, or twice that of P1, the labor supply curve in Figure  b 
shifts to Ns(2P1); less labor is supplied for any money wage because at the 
higher price level a given money wage corresponds to a lower real wage.
• If the wage rate remains unchanged at W1, the labour supplied will be N2.
• Individual worker is interested only in the real wage and this can be seen from 
the fact that the same level of labor (N1) is supplied at a money wage of W1 and 
a price level of P1 (real wage W1 /P1 ), as at money wage and price 
combinations of 2W1, 2P1 or 3W1, 3P1 (real wage = W1 /P1 at both points).
• Equiproportional increases (or decreases) in both money wages and the price 
level leave the quantity of labor supplied unchanged.

[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.. 

Scene 17

Classical theory of output and employment
Determinants of Output and Employment
• Now consider the labor demand curve plotted against the money wage.
• If we want to know the quantity of labor that will be demanded at any 
money wage, as was the case for the quantity supplied, the answer 
depends on the price level. Given the money wage, the ﬁrm will choose 
the level of employment at which W = MPN*P. 
• The demand for labor depends on the real wage.
• At successively higher price levels (P1, 2P1, 3P1) the labor demand curve 
plotted against the money wage shifts to the right (from MPN * P1 to 
MPN*2P1 to MPN*3P1 ). 
• For a given money wage, more labor is demanded at higher price levels 
because that money wage corresponds to a lower real wage rate.
• At W1, the labour demanded is N2.
• This will put upward pressure on money wages.
• Equiproportional increases in the money wage and the price level from 
(W1, P1) to (2W1, 2P1) and (3W1, 3P1) leave 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.. 

Scene 18

Classical theory of output and employment
Determinants of Output and Employment
Aggregate supply curve
• Aggregate Supply Curve is ﬁrm’s output supply curve (microeconomics) 
which shows the amount of output to be supplied at each level of product 
price.
• For a perfectly competitive ﬁrm, the proﬁts are maximized at MPN = 
W/P, wherein we have taken money wage (W) as given.
• Because the money wage was assumed to be ﬁxed, the output supply 
curve for the ﬁrm is positively sloped. Higher prices mean lower real 
wages; consequently, the ﬁrm demands more labor and produces 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 are varied. 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.. 

Scene 19

Classical theory of output and employment
Determinants of Output and Employment
Aggregate supply curve
• Consider output supplied at the three successively higher price levels, P1, 
2P1, and 3P1. At price level P1 and money wage W1, employment was N1 
and we assume that the resulting output is Y1 (by plotting N1 on the 
production function).
• At a price level of 2P1, if the money wage remained at W1, labor demand 
would increase to N2.
• The higher price would mean a lower real wage, and ﬁrms would try to 
expand both employment and output.
• The money wage will not, however, remain at W1. 
• At a price level of 2P1 the labor supply curve will have shifted to 
Ns(2P1), and at a 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 till the money wage has increased suﬃciently to reequilibrate 
supply and demand in the labor market (at 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.. 

Scene 20

Classical theory of output and employment
Determinants of Output and Employment
Aggregate supply curve
• At this point, the initial real wage is restored and employment is back at 
its original level. Consequently, output supplied at price level 2P1 is 
equal to Y1, the output level for price level P1. 
• At a still higher price level of 3P1, the money wage rises to 3W1, but 
again, output is unchanged at Y1. 
• The aggregate supply curve is vertical.
• Higher prices provide a spur to output only if they are not matched by 
proportionately higher money wages—only if they lower the real wage.
• The vertical aggregate supply curve illustrates the supply-determined 
nature of output in the classical model. For output to be in equilibrium, 
we must be on the supply curve; output must be at Y1.

Classical Theory of Output and Employment.pptx

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.

avatar

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.