MACROECONOMICS 1

CLASSICAL ECONOMICS (I):

EQUILIBRIUM OUTPUT AND
EMPLOYMENT
 CLASSICAL ECONOMICS

• Two periods:
1) Classical
• Adam Smith (Wealth of Nations, 1776),
• David Ricardo (Principles of Political Economics, 1st ed.,
1817),
• John Stuart Mill ( Principles of Political Economy, 1st ed.,
1848).

2) Neo-classical
• Alfred Marshall (Principles of Economics, 8th ed., 1920)
• A. Pigou, C. (1933).

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 CLASSICAL REVOLUTION

• Revolution against the doctrine of mercantilism.

• Mercantilists: Rise of the nation-state in Europe during the 16th

and 17th centuries. Two tenets:
- bullionism;
- need for state action.

• Classicalists:
- the importance of real factors (increased stocks of factors of
production and advances in techniques of production) in
determining the ‘wealth of nations.’
- money as a means of exchange (no intrinsic value)
- no state control (free market mechanism or non-
interventionist approach).

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 CLASSICAL REVOLUTION

• Classicalists believe that there could never be a ‘want for

buyers for all commodities.’ On aggregate, production of a
given quantity of output will generate sufficient demand for that
output.

• Say’s Law (Jean Baptiste Say, 1767-1823) - “Supply creates its

own demand.”

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 CLASSICAL ASSUMPTIONS

• Market clears.
• Income is at full employment.
• Firms and individuals have perfect information about relevant
prices.
• Firms are perfect competitors (price takers).
• Labour demand and labour supply are determined by real
wages.
• W and P are perfectly flexible.

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 CLASSICAL MODEL

A. Production Function
• the relationship between total inputs and total outputs for a
given level of technology.
• Y = F (K, N)
Where;
Y = real output
K = stock of capital (plant & equipment)
N = quantity of homogeneous labour input

• For the SR, Y varies directly with N because K is assumed

fixed, and technology and population are assumed constant.
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 CLASSICAL MODEL

• Constant returns to scale; diminishing returns to scale and

negative returns to scale.

• Marginal production of labour (MPN) where;

MPN = (ΔY/ΔN)

• MPN = addition to total output due to the addition of a unit of

labour (slope of the production function)

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CLASSICAL MODEL

Figure 3.1
 CLASSICAL MODEL

B. Labour Demand
• on the part of the individual firm.
MCi = MRi and MRi = P
MCi = W/MPNi where W = money wage
• Therefore the SR profit-maximizing:
P = W/MPNi or W/P = MPN
• The MPN is the firm’s demand curve for labour (see Figure 3.2)
• The aggregate labour demand curve (Nd):
Nd = f (W/P),
Where an increase in (W/P) lowers Nd (negative
relationship)

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CLASSICAL MODEL

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 CLASSICAL MODEL

C. Labour supply
• on the part of workers.
• Individuals maximize utility (which depends on real income and
leisure).
• Figure 3.3.
• The aggregate labour supply (Ns) curve:
Ns = g (W/P)
• An increase in (W/P) increases Ns (positive relationship).

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CLASSICAL MODEL
 EQUILIBRIUM: Y & N

• Ns = Nd
• Quantity of labour employed is determined by the forces of
demand and supply in the labour market.
• The equilibrium level of labour input (N*) results in an
equilibrium level of output (Y*)
• Figure 3.4
• Y, N and W/P are endogenous.

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EQUILIBRIUM: Y & N

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 EQUILIBRIUM: Y & N

• Intersection of the labour demand and supply curves indicates

the equilibrium level of employment (Figure 3.5)

• Aggregate supply (AS) curve is vertical (Figure 3.5).

• Levels of Y and N are determined solely by supply factors

• Changes in P do NOT affect any of the real variables (W/P, N

and Y).

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EQUILIBRIUM: Y & N

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EQUILIBRIUM: Y & N